Income Tax I - Bogdanski - Sample Exam Answers to Question 1

Income Tax I
Bogdanski
Fall 2017

Sample Answers to Question 1

Wedding present.

Hallie will not be taxed as the transfer of the property is a gift. There is no evidence in the facts that suggest that he father is transferring the property with anything other then detached and disinterested generosity. This is further supported by the fact that the property was given as wedding anniversary present.

Basis in the property.

As the FMV of the gift is greater then the adjusted basis of the property at the time of the transfer, the gift will have a carryover basis of 200,000. The only thing that may effect the basis is if the gift is subject to any form of gift tax, in which case the basis would increase by the amount of tax payed on the gift.

Education expense.

It is unlikely that Hallie will be able to deduct the cost of tuition. While the expense falls under 212 as an expense for the production of income, you can only deduct the expense if it if it improves required skills in an existing trade or business. Since this is a new venture for Hallie it is unlikely that she will be able to deduct the expenses. She may try and claim that she had the property for a couple weeks before taking the classes and thus she was already in the trade or business, but this is unlikely to be succesful given how new she is to owning rental property and that her reason to take the class is because she is new to running a rental property.

She could try and argue that this is an expense related starting a new trade or business under 195. However given that this is not her main form of business it is unlikely.

It is unlikely she will be able to use any education credit against the tuition because she is a physician and likely already used all of her allowed education credits to obtain her degree.

Depreciation.

As this is depreciable real property, she will be able to to depreciate her basis under the straight line method over a 20 year period.

Income v. Depreciation first year.

All of her expenses related to the rental property are deductible in the first year as itemized miscellaneous expenses subject to the 2% floor as the expenses fall under 212 as expenses for the production of income. As none of the expenses listed have any sign of producing a long term benefit for Halie she will be able to deduct all of those expenses immediately. It is not clear whether the 2% floor has already been calculated in determining her 8,000 profit after expenses but if it was not, then the 2% floor will eat into her profits. All of this assumes that the expenses she did pay on the property do exceed the 2% floor which is likely but not certain given her high salary as a physician.

Like her expenses the depreciation can only be taken against her rental income because of the passive loss rules. Under the passive loss rules, a taxpayer can only take passive deductions against passive income. Rental income is per say passive except for real estate dealers and per the mom and pop rental income exception. Hallie does not qualify for either exception because she is not a real estate dealer and she likely makes more than the 150,000 phaseout which applies to the mom and pop exception. Further, since she does not hold the rental property in trade or business but as an income producing investment, the deduction is going to be subject to 212 as an itemized miscellaneous exception. Without knowing her actual income it is not clear how much of the 10,000 she can deduct against her rental income of 8,000.

To the extent she has any extra depreciation loss she will be able to carry that loss back as an NOL against any other passive income she has in the previous 2 years and carry forward any remainder through the next 20 years against her passive income.

All of the above assumes that her itemized deductions are greater than her standard deductions, if her standard deduction is greater then she will take the standard deduction instead of the itemized. This is incredibly unlikely give the amount of deductions she can take just for the rental property, let alone any other itemized deductions she likely has.

To the extent she receives any gain from her property it will taxed as ordinary income because it does not arise from the sale of a capital asset.

AMT.

It is also likely that she will not get to claim any of these deductions as she may qualify for the Alternative Minimum tax. Given her high income she likely pays a lot of state and local taxes and misc. deductions are not allowed under the AMT, her tax liability is likely higher under the AMT and will not be able to take the misc. Deductions as previously discussed.

Equity Loan.

Hallie will not be taxed on the value of the loan. Loans are excluded from income for purposes of tax because the money received comes with a corresponding obligation to repay.

Deduction of interest.

It is unlikely that Hallie will be able to deduct the interest on the loan. A taxpayer is able to deduct the interest of a loan for two reasons either the loan is an expense for the production of income, or it is a home equity loan on your principle place of business or vacation home.

Hallie will be able to deduct the interest under either theory. As she took the equity loan against a rental property she will not be able to deduct the expense under 163 because a rental property is not a qualified residence.

Hallie has a tough argument to be able to deduct the interest under a 212 theory because the loan was taken to finance a dream vacation for her and her husband. As such the interest she pays is not an necessary or ordinary expense incurred for the management, conservation, or maintenance of property held for the production of income, even if the loan is secured by property used for the production of income.

Involuntary Conversion.

When the government condemned Hallie’s property she could have elected to use 1033 to keep the payment she received from being recognized. Since her property was condemned and thus involuntarily converted to cash she could avoid recognition by buying property of a related service or use. It is not clear under the facts whether she did this. While stocks themselves are not of a similar service and use if the stocks of in a corporation which owns rental property then she still may be able to qualify for 1033. If the stocks she did buy are in a corporation which owns rental properties she will be able to avoid paying any taxes on the 425,000 cash she received from the involuntary conversion. In that case her basis from the rental property would carry over into the stock, which is at least 170,000. (carry over basis from the gift 200,000 minus (10,000 straight line depreciation/3 years she owned the property)).

If the stock does not qualify for an involuntary conversion Hallie will pay gains on at least 255,000 of gain as per 1001 her gain is calculated as amount received minus adjusted basis. While a rental property is not a capital asset, any gain from depreciable property is subject to capital gains of 25%.

If the purchase of the stock does not qualify for an involuntary conversion her basis in the stock is the full amount she paid for it.

Possible AMT complication

It is possible that has less gain, if she was subject to AMT. If she is subject to AMT she will have a slower depreciation schedule on the property and will thus have a higher basis at the point of sale.

Repayment of the Loan.

She does not get to deduct the amount used to repay the principle of her loan. Again subject tot he argument above regarding interest payments it is unlikely as well that she will be able to deduct the interest payed on the equity loan.

Whatever the tax result, Hallie has had a good year.

Exam No. 9348

1. House - Transfer from Dad

Hallie receives a rental house from her dad for no consideration with an AB of $200k and an FMV of $400k and no outstanding loans. This is likely a gift because it was from father to daughter on an important anniversary date, there was no consideration, because the father owned it free and clear (so was not trying to get out of a mortgage, e.g.), and because it shows the kind of "detached generosity" the IRS and Courts look for (see Duberstein). This means that the father doesn’t need to recognize a gain, and neither does Hallie because gifts are not realization events. Under 1015, when you give someone property, the basis goes with them, as does the potential tax liability. This means that Hallie’s basis in the new property is the father’s AB of $200k, which means that if she sells it, anything above $200k will be a gain. Hallie will need to start paying state and local property taxes on the property, however, which she can deduct. But because there is no mortgage, she will not be able to deduct any mortgage interest. She will also be able to continue depreciating the property at $10k per year.

There are no possible elections at play for Hallie in this exchange, unless she were to try to offer up something in consideration, which might help her increase her own basis if she plans to sell it soon.

2. Enrolling in local College

Hallie enrolls in a local college to take a class on owning a rental property, which costs her $2,000 in tuition. Owning and operating rental homes is considered a "passive activity." Further, Hallie does not run or maintain a rental business and so likely cannot count her tuition as an "ordinary and necessary business expense" insofar as it potentially helps qualify her for the business of owning and operating rental homes. Under 162, employees can deduct their education expenses either to maintain/improve their skills, or to meet express requirements of an employer, but not to meet minimum entry level requirements. It is likely that Hallie’s $2k in tuition would be seen as going towards entry-level requirements and so is not deductible under $162. However, it is possible that Hallie might qualify for a section 25 lifetime learning credit (not a deduction), specifically Hope, because she is enrolling at a 4-year college and not in grad school. This credit is worth up to $2k per year. However, she would need to be a half-time student to qualify and just taking one class might not be sufficient. However, under section 222, qualified student tuition and related expenses can be deducted up to $4k per year as long as the student’s AGI is not over $65k, at which point it gets phased down to $2k (up to $80k of AGI, at which point it becomes 0). It is not clear from the facts what Hallie’s AGI is.

Hallie might be able to deduct the cost of tuition as a part of her start-up costs of getting her rental business off the ground, which allows for up to $5k.

Elections: If H qualifies for both the lifetime learning credit and the section 222 deduction, she does not need to choose one or the other because one is a below the line deduction while the other is a credit.

3. Getting that Rent $$$

Hallie gets $8k more in rent than her out-of-pocket expenses on the rental property, not counting her depreciation, which is $10k per year. Hallie pays all the repair costs, but doesn’t make any improvements. Repairs that don’t increase the value are immediately deductible under 162, as long as they’re incidental and not long-term improvements, in which case they must be capitalized and included in the basis. Hallie’s are incidental and need not be capitalized. Her $8k in rental profits will count as ordinary income and be included under gross income unless she can deduct her expenses and use her depreciation against it. Under section 469, rentals are per se passive activities, and passive activity losses can only be deducted against passive activity profits. The exception is for mom and pop rental income of up to $25k, which can be deducted against ordinary income if need be. Hallies rental is a passive activity income generator, aka a Pig. This means that either Hallie can count her out-of-pocket expenses against her $8k in profit or against up to $25k of her other income (because she’s a "mom and pop"). However, in order for the $25k rule to apply Allie needs to be "actively involved" in the rental. On the basis of the facts, it’s not clear that she is or isn’t, except that she pays all the repair costs herself. As a rental property, Hallie’s rental property is subject to straight-line depreciation. This means that she can count that $10k against her $8k in profits. Either way, it looks like Hallie’s depreciation will alone allow her to take a loss on the rental property in year one. Hallie can use this loss in up to 20 years under section 172. However, this will likely only be usable against other passive activity losses. Additionally, Hallie can deduct her state and local taxes under section 164.

Elections: It is not clear that Hallie has any elections. If she does, it is to get involved in some other passive activity loss generators, so that if she has any such losses, she can use them against her Pig’s profits.

4. $20k Equity Loan

Hallie took out a $20k equity loan, secured by her mortgage, which she used to finance a dream vacation with her hubby, and which she paid interest to the bank. Loans are generally not income under the assumption that the $$$ we receive is commensurate with the obligation to repay it in the future with fully taxable income. This means that the loan itself will not count as income for Hallie. However, because she spends it on a vacation, which is a personal expense under 262, she will not get to take any deductions as a result. Instead, she should consider using the $$$ to make improvements to the rental property, which would go into her basis, and which would help her avoid potential tax liability in the future if/when she sells the property (or is forced to do so). And while 263 doesn’t allow for deductions for improvements to property, it does allow you to include those amounts in the basis.

5. Condemnation - Forced Transfer

The city condemns Hallie’s rental and pays her $425k, which Hallie uses to pay off the balance on the equity loan, and uses to invest in the stock market. This is arguably a forced transfer. Not a casualty loss under 165 because it is arguably not dramatic enough ala a fire, storm, or shipwreck. And last time I checked, condemnation doesn’t equal theft. It was, however, against Hallie’s will. Under section 1033, when a TPer loses their property via an involuntary conversion and receives property or $$$ in return, they have a realization event and, potentially, a gain. However, they can avoid recognizing the gains by reinvesting their money in similar property to the property lost within 2 years of the year they receive the $. More importantly, it doesn’t need to be the same exact cash, just the same amount. Here, the $425 Hallie receives 2 years later, which means more depreciation out of the basis, is a gain of $425k (AR, which is the amount the city paid her in cash) - $180k (adjusted basis of $200k - two more years of depreciation and no improvements), which equals $245k in gain. This will likely not be a capital gain for Hallie because rental property is not a capital asset under section 1221(a) because it defines capital assets as NOT including depreciable real estate. That said, because Hallie held it for more than a year, it will be considered a quasi-capital asset under 1231, which means that it will be treated as capital when it generates a gain, but ordinary when it generates a loss. This is GREAT for TPers generally, but specifically for Hallie here because it means that at least her gain will be a capital one, taxed at a lower % of probably 15-20%. That said, part of this gain will be considered a recapture on depreciation under code sections 1245 and 1250, which means that whatever amount of the gain is attributable to depreciation (at least $20k for Hallie after 2 years), that will be taxed at a higher rate of 25%. Further, because Hallie choses to pay off the principal of her equity loan and reinvest the $ in the stock market, she at least initially is not able to take an interest deduction or any deduction on the purchase of the stock.

Elections: Again, an important part of 1033 is that whatever gain you realize on an involuntary conversion can go unrecognized if you reinvest it in similar property within 2 years after the year you receive the $. Further, the money you use to reinvest need not be the identical money. So, here’s what Hallie should do (assuming she can’t pull out her choices to repay her loan and buy stock): If the stock goes up or down, either way, sell it in a year or so, then use that amount to purchase a new piece of real estate (preferably rental property to be used in Hallie’s burgeoning rental business). That way, Hallie can avoid recognizing at least part of her gain on the condemnation. Additionally, her new basis in whatever property she purchases will be equal to her old basis in the rental property, which would be $180k. This would be smart.

Exam No. 9100

Rental House Gift from Drew to Hallie

H’s primary employment is that of a physician, her salary will be taxed as ordinary income. The transfer on her wedding (that definitely was not that case at my wedding) of property from her Father is likely a gift b/c it was given with detached and disinterested generosity out of respect, admiration, or charity. It could be argued that the transfer gave the Father some kind of return benefit and was not given out of detached and disinterested generosity, maybe he was trying to curry favor with the son in law, or show the son in law who is really wearing the big boys pants. If it was not a gift, then the transfer would be a sale with gain recognized, but there would be serious valuation issues with regard to the return benefit to the father.. Here, b/c a gift, this is not a realizing event and the father’s basis carries over to H. §1015. H now owns the property free and clear with a basis of 200k and current FMV of 400k. The property is per se not a capital asset, and a rental will generate ordinary income b/c there is no sale, just collecting. H will likely want to itemize her deductions at this point if she already does not because there are deduction she can take advantage of related to the rental property.

Business Course at Local College

To be able to deduct the expense, H could try to classify it as a necessary and ordinary business expense, but this would take both convincing the IRS that the rental constituted a business, and that it was necessary and ordinary under the circumstances. If H is considered to be running a business, then to qualify the education must be aimed at maintaining or improving required skills in an existing trade or business, here she is not gaining any additional skill or improving such skills within the medical field. The education cannot be entry-level, which a course for those with no experience in real estate likely is, and it cannot qualify H for a new trade or business. The class probably satisfies the last requirement unless it lead to some kind of certification or license, though I would hope a real-estate license is not that easy to get. In H’s personal capacity, she may be able to get the hope or lifetime learning credit to cover the amounts, although her high salary probably phases those out considerably. Likewise, if she had taken out a loan to pay for it some of that interest was be deductible above the line.

The Rental, Rents and Deductions

H’s ability to take deductions for costs associated with the rental will likely have to be offset against rental income. Annual rent income is $8,000 above the annual out-of-pocket expenses (taxes, maintenance, repairs, insurance, and utilities), not counting depreciation deduction. This means that the 10k annual depreciation deductions can only be used against the 8k excess above, leaving 2k of passive loss deductions available to carry forward to subsequent years. H probably does not qualify for the "mom and pop" exception where up to 25k of any loss can be applied towards ordinary income (H’s salary), the phase out for this exception is quite low. However, if H could show that she materially participated in the business, typically 500 hours a year, then the income would be active and deductions from the rental could go against ordinary income. H will be able to continue to take annual depreciation for a number of years, residential rental property allows for 27.5 years of deductions.

If H is able to convince the IRS that this is part of her business, or a business she has started, then she will be able to deduct plenty more costs.

Home Equity Loan of 20k

Can use home equity loan for whatever, acquisition loan has to be used for improvements to the property. Can borrow up to 100k of home equity. The principal is not deductible, but the interest is deductible above the line. B/c loan not made during acquisition does not go into the basis of the property, merely secured by the property.

Must be for qualified residence, which can include a vacation home (insert vacation home discussion)

The 20k equity loan secured by the property does not increase H’s basis in the property b/c it was entered into after the property was acquired. If the property can qualify as a qualified residence of H, which you can have up to 2 (principal residence and vacation home), then the interest on the equity loan will be deducted above the line. The loan can be used for vacation costs, however, if H had gotten an acquisition loan, which would require her to have acquired the property in the first place (ignoring the gift), she would not be able to use the money from that type of loan for a vacation.

City Condemnation and Subsequent Reinvestment

The condemnation of H’s houses is an involuntary conversion and is treated as a sale. The FMV at the time of sale is $425,000 b/c we have no additional facts to indicate otherwise and it is the amount received by H. The basis in the house at the time of the conversion is probably 180k b/c it is 2 years later and 10k of depreciation has been taken annually. H’s realized gain in this transaction will be the amount realized 425k minus her adjusted basis 180k, producing a gain of 245k. This transaction may qualify for non-recognition under 1033 b/c H is being paid in damages that are replacing property. If H acts within 2 years to reinvest then she will only be taxed on the difference between the what she was paid 425k, and what she reinvested (if it is less). Here, she reinvested the 408k into the stock market, which may or may not qualify as being the same type of property b/c they are different kinds of assets. If H is able to utilize 1033 then only 18k will be recognized (treated as boot, taxed as ordinary) as gain and her basis in the old property would carry over. The more likely outcome is that H pays the 245k gain, which will be taxed as a long term capital asset, but subject to 1250 depreciation recapture wherein the capital rate is higher as a result of taking depreciation over the year. If H pays on the gain from the conversion, then her subsequent purchase of stock will give her a cost basis in the stock equal to 408k.

There are probably some other nuances and permutations related to determining if she qualified for business activity with regard to the conversion, but no time.