1040 Quickfinder Handbook (2012 Tax Year) Updates for the American Taxpayer Relief Act of 2012

Transcription

1 Quickfinder 040 Quickfinder Handbook (202 Tax Year) Updates for the American Taxpayer Relief Act of 202 Instructions: This packet contains marked up changes to the pages in the 040 Quickfinder Handbook that were affected by the American Taxpayer Relief Act of 202, which was enacted after the handbook was published. To update your handbook, you can make the same changes in your handbook or print the revised page and paste over the original page. Note: For many pages, the change is simply a matter of crossing out a paragraph and/ or inserting an amount or date.

2 040 Quickfinder Handbook TAX PREPARATION Form Tax Year 202 Key Amounts Standard Deduction Earned Income Credit (Maximum) MFJ or QW... $,900 No children... $ 475 Single ,950 child... 3,69 HOH ,700 2 children... 5,236 MFS... 5,950 >2 children... 5,89 Dependent Investment income limit... 3,200 Personal Exemption Kiddie Tax Threshold $3,800 $,900 Gift Tax Annual Exclusion Elective Deferral Limits $3,000 SIMPLE IRA Plan Estate and Gift Tax Exclusion Amount < age $,500 $5,20,000 age ,000 Standard Mileage Rates Business (k), 403(b) and 457 Plans Medical/moving < age $ 7,000 Charitable... 4 age ,500 Profit-Sharing Plan/SEP Contribution limit... $ 50,000 Compensation limit 4... $250,000 Health Savings Accounts (HSAs) Self-only coverage Contribution (deduction) limit... $ 3,00 Plan minimum deductible...,200 Plan out-of-pocket limit... 6,050 Family coverage Contribution (deduction) limit... $ 6,250 Plan minimum deductible... 2,400 Plan out-of-pocket limit... 2,00 Additional contribution amount if age 55 or older... $,000 Add $,50 for age 65 or older or blind, each. 2 Add $,450 for age 65 or older or blind, each. 3 If greater, amount of earned income plus $300 (but not to exceed $5,950). 4 For computing employer contributions. 202 Quick Tax Method MFJ or QW Taxable Income $ 0 $ 7,400 0% minus $ 0.00 = Tax 7,40 70,700 5 minus = Tax 70,70 42, minus 7, = Tax 42,70 27, minus 2,22.00 = Tax 27,45 388, minus 23, = Tax 388,35 and over 35 minus 30, = Tax Single Taxable Income $ 0 $ 8,700 0% minus $ 0.00 = Tax 8,70 35,350 5 minus = Tax 35,35 85, minus 3, = Tax 85,65 78, minus 6, = Tax 78,65 388, minus 5, = Tax 388,35 and over 35 minus 23, = Tax HOH Taxable Income $ 0 $ 2,400 0% minus $ 0.00 = Tax 2,40 47,350 5 minus = Tax 47,35 22, minus 5, = Tax 22,30 98, minus 9, = Tax 98,05 388, minus 8, = Tax 388,35 and over 35 minus 26, = Tax MFS Taxable Income $ 0 $ 8,700 0% minus $ 0.00 = Tax 8,70 35,350 5 minus = Tax 35,35 7, minus 3, = Tax 7,35 08, minus 6,0.50 = Tax 08,726 94,75 33 minus, = Tax 94,76 and over 35 minus 5, = Tax Assumes taxable income is all ordinary income. Multiply taxable income by the applicable tax rate and subtract the amount shown. Caution: IRS Tax Tables must be used for taxable income under $00,000. To calculate the exact tax using the Quick Tax Method for taxable income under $00,000, round taxable income to the nearest $25 or $75 increment before using the formula. Round $50 or $00 increments up. 202 AGI Phase-Out Amounts/Ranges Filing Tuition and Fees Student Loan Interest Education Savings Lifetime Learning American Opportunity Education Savings Status Deduction Deduction Bond Interest Exclusion Credit Credit Account (ESA) MFJ $30,000 / $60,000 $25,000 $55,000 $09,250 $39,250 $04,000 $24,000 $60,000 $80,000 $90,000 $220,000 QW 65,000 / 80,000 60,000 75,000 09,250 39,250 52,000 62,000 80,000 90,000 95,000 0,000 Single 65,000 / 80,000 60,000 75,000 72,850 87,850 52,000 62,000 80,000 90,000 95,000 0,000 HOH 65,000 / 80,000 60,000 75,000 72,850 87,850 52,000 62,000 80,000 90,000 95,000 0,000 MFS Do Not Qualify Do Not Qualify Do Not Qualify Do Not Qualify Do Not Qualify 95,000 0,000 Child Tax Credit 2 Saver s Earned Income Credit 3 Traditional IRA Credit 3 No Child Child 2 Children >2 Children Deduction 4 Roth IRA Contribution Passive Loss in Active Rental Real Estate MFJ $ 0,000 $ 57,500 $ 9,90 $ 42,30 $ 47,62 $ 50,270 $ 92,000 $2,000 $73,000 $83,000 $00,000 $50,000 QW 75,000 28,750 3,980 36,920 4,952 45,060 92,000 2,000 73,000 83,000 00,000 50,000 Single 75,000 28,750 3,980 36,920 4,952 45,060 58,000 68,000 0,000 25,000 00,000 50,000 HOH 75,000 43,25 3,980 36,920 4,952 45,060 58,000 68,000 0,000 25,000 00,000 50,000 MFS 55,000 28,750 Do Not Qualify 0 5 0, ,000 50,000 75,000 Caution: Deduction expired 2/3/, but has been reinstated in the past. Amounts shown are thresholds for $4,000 and $2,000 deduction, respectively. 2 Amount at which phase-out begins. 3 Amount at which phase-out is complete. 4 Phase-out only applies if taxpayer is covered by an employer retirement plan. For MFJ, phase-out range for non-covered spouse is $73,000 $83, Married individuals filing MFS who live apart at all times during the year are treated as single. Replacement Page 0/203

3 Quick Facts, Worksheets, Where to File All worksheets included in Tab 3 may be copied and used in your tax practice. Quick Facts Data Sheet... Page 3- Business Use of Home Worksheet... Page 3-4 Capital Loss Carryover Worksheet (202)... Page 3-5 Child Tax Credit Worksheet (202)... Page 3-5 Donations Noncash... Page 3-6 Donated Goods Valuation Guide... Page 3-6 Donations Substantiation Guide... Page 3-7 Earned Income Credit (EIC) Worksheet (202)... Page 3-8 Forms 098 and 099 What s Reported... Page 3-9 Net Operating Loss Worksheet #... Page 3-0 Net Operating Loss Worksheet #2 Computation of NOL... Page 3- Tab 3 Topics Net Operating Loss Worksheet #3 NOL Carryback... Page 3- Social Security Benefits Worksheet (202)... Page 3-2 Reporting Capital Gains and Losses Form Page 3-3 State and Local General Sales Tax Deduction Worksheet... Page 3-3 Student Loan Interest Deduction Worksheet... Page 3-3 Where to File 202 Form 040, 040A, 040EZ... Page 3-4 Where to File Form 040-ES for Page 3-4 Where to File Form 4868 for 202 Return... Page 3-4 Quick Facts Data Sheet General Deductions and Credits Standard deduction: MFJ or QW $ 2,200 $,900 $,600 $,400 $,400 Single 6,00 5,950 5,800 5,700 5,700 HOH 8,950 8,700 8,500 8,400 8,350 MFS 6,00 5,950 5,800 5,700 5,700 Additional for age 65 or older or blind each (MFJ, QW, MFS),200,50,50,00,00 Additional for age 65 or older or blind each (Single, HOH),500,450,450,400,400 Itemized deduction phase-out begins at AGI of: MFJ, QW, Single or HOH $ * N/A N/A N/A $ 66,800 MFS 50,000 N/A N/A N/A 83,400 Personal/dependent exemption $ 3,900 $ 3,800 $ 3,700 $ 3,650 $ 3,650 Personal exemption phase-out begins at AGI of: 2 MFJ or QW $ 300,000 N/A N/A N/A $ 250,200 Single 250,000 N/A N/A N/A 66,800 HOH 275,000 N/A N/A N/A 208,500 MFS 50,000 N/A N/A N/A 25,00 Earned income credit: Earned income and AGI must be less than (MFJ): 3 No qualifying children $ 9,680 $ 9,90 $ 8,740 $ 8,470 $ 8,440 One qualifying child 43,20 42,30 4,32 40,545 40,463 Two qualifying children 48,378 47,62 46,044 45,373 45,295 Three or more qualifying children 5,567 50,270 49,078 48,362 48,279 Maximum amount of credit (all filers except MFS): No qualifying children $ 487 $ 475 $ 464 $ 457 $ 457 One qualifying child 3,250 3,69 3,094 3,050 3,043 Two qualifying children 5,372 5,236 5,2 5,036 5,028 Three or more qualifying children 6,044 5,89 5,75 5,666 5,657 Investment income limit 3,300 3,200 3,50 3,00 3,00 Child tax credit: Credit per child $,000 $,000 $,000 $,000 $,000 Additional (refundable) credit earned income floor 3,000 3,000 3,000 3,000 3,000 Adoption credit/exclusion: Maximum credit/exclusion (and amount allowed for adoption of special needs child) $ 2,970 $ 2,650 $ 3,360 $ 3,70 $ 2,50 Credit/exclusion phase-out begins at AGI of: All taxpayers except MFS $ 94,580 $ 89,70 $ 85,20 $ 82,520 $ 82,80 MFS Not Allowed Not Allowed Not Allowed Not Allowed Not Allowed Kiddie tax unearned income threshold $ 2,000 $,900 $,900 $,900 $,900 Foreign earned income exclusion $ 97,600 $ 95,00 $ 92,900 $ 9,500 $ 9,400 * $300,000 (MFJ, QW); $250,000 (Single); $275,000 (HOH). Table continued on the next page Replacement Page 0/ Tax Year 040 Quickfinder Handbook 3-

4 Quick Facts Data Sheet (Continued) FICA/SE Taxes Maximum earnings subject to tax: Social Security tax $ 3,700 $ 0,00 $ 06,800 $ 06,800 $ 06,800 Medicare tax No Limit No Limit No Limit No Limit No Limit Maximum tax paid by: Employee Social Security $ 7, $ 4, $ 4, $ 6,62.60 $ 6,62.60 Self-employed Social Security 4,098.80,450.40, , , Employee or self-employed Medicare No Limit No Limit No Limit No Limit No Limit Business Deductions Section 79 deduction limit $ 500,000 $ 500,000 $ 500,000 $ 500,000 $ 250,000 Section 79 deduction SUV limit (per vehicle) 25,000 25,000 25,000 25,000 25,000 Section 79 deduction qualified real property limit 250, , , ,000 N/A Section 79 deduction qualifying property phase-out threshold 2,000,000 2,000,000 2,000,000 2,000, ,000 Depreciation limit autos (st year) 3,60 5 3, , ,960 5 Depreciation limit trucks and vans (st year) 3, , ,60 5 3,060 5 Standard mileage allowances: Business / Charity work Medical/moving / Health Care Deductions Health savings accounts (HSAs): Self-only coverage: Contribution limit $ 3,250 $ 3,00 $ 3,050 $ 3,050 $ 3,000 Plan minimum deductible,250,200,200,200,50 Plan out-of-pocket limit 6,250 6,050 5,950 5,950 5,800 Family coverage: Contribution limit 6,450 6,250 6,50 6,50 5,950 Plan minimum deductible 2,500 2,400 2,400 2,400 2,300 Plan out-of-pocket limit 2,500 2,00,900,900,600 Additional contribution limit age 55 or older,000,000,000,000,000 Long-term care insurance deduction limits: Age 40 and under $ 360 $ 350 $ 340 $ 330 $ 320 Age Age 5 60,360,30,270,230,90 Age ,640 3,500 3,390 3,290 3,80 Age 7 and older 4,550 4,370 4,240 4,0 3,980 Long-term care excludible per diem $ 320 $ 30 $ 300 $ 290 $ 280 Medical savings accounts (MSAs): Self-only coverage: Plan minimum deductible $ 2,50 $ 2,00 $ 2,050 $ 2,000 $ 2,000 Plan maximum deductible 3,200 3,50 3,050 3,000 3,000 Plan out-of-pocket limit 4,300 4,200 4,00 4,050 4,000 Family coverage: Plan minimum deductible 4,300 4,200 4,00 4,050 4,000 Plan maximum deductible 6,450 6,300 6,50 6,050 6,050 Plan out-of-pocket limit 7,850 7,650 7,500 7,400 7,350 Education Tax Incentives Education savings accounts (ESAs) phase-out begins at AGI of: MFJ $ 90,000 $ 90,000 $ 90,000 $ 90,000 $ 90,000 Single, HOH, QW and MFS 95,000 95,000 95,000 95,000 95,000 Hope/American Opportunity Credit maximum credit (per student) $ 2,500 $ 2,500 $ 2,500 $ 2,500 $ 2,500 Lifetime learning credit (LLC) maximum credit (per return) $ 2,000 $ 2,000 $ 2,000 $ 2,000 $ 2,000 Education credit phase-out begins at AGI of: MFJ: Hope/American Opportunity $ 60,000 $ 60,000 $ 60,000 $ 60,000 $ 60,000 LLC 07,000 04,000 02,000 00,000 00,000 Single, HOH and QW: Hope/American Opportunity 80,000 80,000 80,000 80,000 80,000 LLC 53,000 52,000 5,000 50,000 50,000 MFS Not Allowed Not Allowed Not Allowed Not Allowed Not Allowed Student loan interest deduction limit $ 2,500 $ 2,500 $ 2,500 $ 2,500 $ 2,500 Student loan interest deduction phase-out begins at AGI of: MFJ $ 25,000 $ 25,000 $ 20,000 $ 20,000 $ 20,000 Single, HOH and QW 60,000 60,000 60,000 60,000 60,000 MFS Not Allowed Not Allowed Not Allowed Not Allowed Not Allowed Tax Year 040 Quickfinder Handbook Replacement Page 0/203

5 Quick Facts Data Sheet (Continued) Savings bonds income exclusion phase-out begins at AGI of: MFJ and QW $ 2,050 $ 09,250 $ 06,650 $ 05,00 $ 04,900 Single and HOH 74,700 72,850 7,00 70,00 69,950 MFS Not Allowed Not Allowed Not Allowed Not Allowed Not Allowed Tuition deduction phase-out begins at AGI of: MFJ $ 30,000 $ 30,000 $ 30,000 $ 30,000 $ 30,000 Single, HOH and QW 65,000 65,000 65,000 65,000 65,000 MFS Not Allowed Not Allowed Not Allowed Not Allowed Not Allowed Alternative Minimum Tax (AMT) AMT exemption: MFJ or QW $ 80,800 $ 78,750 $ 74,450 $ 72,450 $ 70,950 Single or HOH 5,900 50,600 48,450 47,450 46,700 MFS 40,400 39,375 37,225 36,225 35,475 Child subject to kiddie tax earned income plus $ 7,50 $ 6,950 6,800 6,700 6,700 Retirement Plans IRA contribution limits: Under age 50 at year end $ 5,500 $ 5,000 $ 5,000 $ 5,000 $ 5,000 Age 50 or older at year end 6,500 6,000 6,000 6,000 6,000 Traditional IRA deduction phase-out begins at AGI of (taxpayer or spouse covered by employer retirement plan): MFJ and QW (covered spouse) $ 95,000 $ 92,000 $ 90,000 $ 89,000 $ 89,000 MFJ (non-covered spouse) 78,000 73,000 69,000 67,000 66,000 Single and HOH 59,000 58,000 56,000 56,000 55,000 MFS Roth IRA contribution phase-out begins at AGI of: MFJ and QW $ 78,000 $ 73,000 $ 69,000 $ 67,000 $ 66,000 Single and HOH 2,000 0,000 07,000 05,000 05,000 MFS Roth IRA conversion AGI limit: MFJ, Single and HOH N/A N/A N/A N/A $ 00,000 MFS N/A N/A N/A N/A Not Allowed SIMPLE IRA plan elective deferral limits: Under age 50 at year end $ 2,000 $,500 $,500 $,500 $,500 Age 50 or older at year end 4,500 4,000 4,000 4,000 4,000 40(k), 403(b), 457 and SARSEP elective deferral limits: Under age 50 at year end $ 7,500 $ 7,000 $ 6,500 $ 6,500 $ 6,500 Age 50 or older at year end 23,000 22,500 22,000 22,000 22,000 Profit-sharing plan/sep contribution limits $ 5,000 $ 50,000 $ 49,000 $ 49,000 $ 49,000 Compensation limit (for employer contributions to profit sharing plans) $ 255,000 $ 250,000 $ 245,000 $ 245,000 $ 245,000 Defined benefit plans annual benefit limit $ 205,000 $ 200,000 $ 95,000 $ 95,000 $ 95,000 Retirement saver s credit phased-out when AGI exceeds: MFJ $ 59,000 $ 57,500 $ 56,500 $ 55,500 $ 55,500 HOH 44,250 43,25 42,375 4,625 4,625 Single, MFS and QW 29,500 28,750 28,250 27,750 27,750 Key employee compensation threshold $ 65,000 $ 65,000 $ 60,000 $ 60,000 $ 60,000 Highly compensated threshold $ 5,000 $ 5,000 $ 0,000 $ 0,000 $ 0,000 Social Security Maximum earnings and still receive full Social Security benefits: Under full retirement age (FRA) at year-end, benefits $ 5,20 $ 4,640 $ 4,60 $ 4,60 $ 4,60 reduced by $ for each $2 earned over Year FRA reached, benefits reduced $ for each $3 earned 40,080 38,880 37,680 37,680 37,680 over (months up to FRA only) Month FRA reached and later No Limit No Limit No Limit No Limit No Limit Estate and Gift Taxes Estate and gift tax exclusion $ 5,250,000 8 $ 5,20,000 8 $ 5,000,000 8 $ 5,000,000 9 $ 3,500,000 9 GST tax exemption $ 5,250,000 $ 5,20,000 $ 5,000,000 $ 5,000,000 $ 3,500,000 Gift tax annual exclusion $ 4,000 $ 3,000 $ 3,000 $ 3,000 $ 3,000 Amount not released by IRS at publication time. Tax professionals should watch for developments. 2 Regardless of AGI, the exemption cannot be reduced below $2,433 (2009). 3 To get earned income/agi phaseout amount for all other filers (except MFS), reduce amount shown by: $5,20 in 202; $5,080 in 20; $5,00 in 200; $5,000 in Amount could be affected by legislation. Watch for developments. $5,340 in 203; 5 Add $8,000 if special depreciation claimed. 6 Caution: Expired on 2/3/20 but has been reinstated in the past. Watch for developments. 7 Congress has consistently raised this amount in the past. When the 202 amount is available, an update will be posted at 8 Plus the amount, if any, of deceased spousal unused exclusion amount. 9 The lifetime gift tax exclusion was limited to $,000,000. Replacement Page 0/ Tax Year 040 Quickfinder Handbook 3-3

6 Reporting Capital Gains and Losses Form 8949 For 202, sales and exchanges of capital assets (if not reported on Form 4684, 4797, 678 or 8824) are reported on Form 8949, even if some or all of the gain or loss is not recognized. The totals from Form 8949 are carried to Schedule D. In some cases, an adjustment to the gain or loss will also be reported on Form 8949 along with a code indicating the type of adjustment. At the date of publication, the IRS had not released the final list of codes to be used. When available, the codes will be posted to the Updates section of Quickfinder.com. State and Local General Sales Tax Deduction Worksheet 202 can can For 20, taxpayers could elect to deduct state and local sales taxes instead of state and local income taxes (see Electing to Deduct Sales Tax on Page 5-5). Instead of deducting their actual expenses, taxpayers could use optional sales tax tables [based on the taxpayer s state(s) of residence] provided by the IRS. The deduction for state and local general sales taxes expired on December 3, 20 and, at the time of publication, had not been extended to 202. If the deduction is extended to 202, The tables and a worksheet to figure the state and local sales tax deduction for 202 will be posted to the Updates section of Quickfinder.com when they are available. Student Loan Interest Deduction Worksheet Caution: Do not use this worksheet if taxpayer filed Form 2555 or 2555-EZ (related to foreign earned income) or Form 4563 (income exclusion for residents of American Samoa) or if taxpayer is excluding income from sources within Puerto Rico. Use the worksheet in IRS Pub. 970 instead. ) Enter the total interest paid in 202 on qualified student loans. Do not enter more than $2, ) 2) Enter the amount from Form 040, line ) 3) Enter the total of the amounts from Form 040, lines 23 through 32, plus any write-in adjustments entered on the dotted line next to line ) 4) Subtract line 3 from line ) 5) Enter the amount shown below for taxpayer s filing status: Single, HOH or QW $60,000. MFJ $25, ) 6) Is the amount on line 4 more than the amount on line 5? No Skip lines 6 and 7, enter -0- on line 8 and go to line 9. Subtract line 5 from line ) 7) Divide line 6 by $5,000 ($30,000 if MFJ). Enter the result as a decimal (rounded to at least three places). If the result is.000 or more, enter ) 8) Multiply line by line ) 9) Student loan interest deduction. Subtract line 8 from line. Enter the result here and on Form 040, line 33. Do not include this amount in figuring any other deduction on taxpayer s return (such as on Schedules A, C, E, etc.)... 9) Replacement Page 0/ Tax Year 040 Quickfinder Handbook 3-3

7 Contributions: Can be made for the entire year if the individual is HSA-eligible on the first day of the last month of the year. The HSA contribution limit is the full-year amount (but see Recapture below). Must be made in cash or through a cafeteria plan. Can be made in one or more payments, but cannot be made before the beginning of the tax year. For 202, must be made by April 5, 203. [IRC 223(d)(4)] Example: Jennifer enrolls in a HDHP on December, 202, and is otherwise an eligible individual for that month. She was not an eligible individual in any other month in 202. Jennifer may make HSA contributions as if she had been enrolled in the HDHP for all of 202. If she ceases to be an eligible individual (for example, if she ceases to be covered under the HDHP) at any time during 203, an amount equal to the HSA deduction attributable to treating her as an eligible individual for January through November 202 is included in her income in 203. In addition, a 0% additional tax applies to the includible amount. (See Recapture below.) Excess contributions: Are not deductible if made by or for an individual, Are included in gross income of the employee if made by an employer and Are subject to a 6% excise tax imposed on the account beneficiary unless withdrawn (with earnings) by the return due date (including extensions). Reporting: Report HSA contributions on Form 8889, Health Savings Accounts (HSAs). The deductible amount of the contribution is carried to Form 040, line 25. Taxpayers should receive Form 5498-SA from the HSA trustee showing the HSA contributions during the year. An employer's contributions to an employee s HSA are shown in box 2 of Form W-2 with code W. Note: A more-than-2% shareholder is not treated as an employee for this purpose. See S corporation shareholders on Page 4-6. Rollovers. A rollover is a distribution of assets from one HSA or MSA that is deposited in another HSA. Generally, the rollover must be completed within 60 days. Amounts rolled over are not taxable (or deductible) and do not affect the annual limit on contributions or deductions. Only one rollover contribution can be make to an HSA during a one-year period. Exception: An unlimited number of trustee-to-trustee transfers between HSAs can be made. Recapture. All or part of a deductible HSA contribution or otherwise nontaxable transfer to an HSA (from an HRA, FSA or IRA) is included in income and subject to a 0% penalty tax if the taxpayer fails to remain HSA-eligible (for any reason other than death or disability) for a required length of time following the contribution or transfer. Report the income on line 2 and the penalty tax on line 60 of Form 040. Part-year HDHP coverage. An HSA contribution made by an individual who is not HSA-eligible the entire year is recaptured to the extent allocable to the ineligible months if the individual fails to qualify for an HSA anytime during the following year. Tax-free transfers from an HRA, FSA or IRA. Individual must remain HSA-eligible from the month the funds are transferred into the HSA until the last day of the 2th following month. High deductible health plan (HDHP). A HDHP is one with higher annual deductibles than typical health plans. Only HDHPs with the following deductibles qualify for HSA purposes. Replacement Page 0/ HSA High Deductible Health Plan (HDHP) Limits Type of Coverage Minimum Annual Deductible Maximum Annual Deductible and Out-of-Pocket Expenses (other than for premiums) Self-Only $,200 $ 6,050 Family 2,400 2,00 Only the deductible and out-of-pocket expenses for services within the network should be used to figure whether the limit applies. The limit does not apply to deductibles and expenses for out-of-network services if the plan uses a network of providers. Non-HDHP health insurance. An individual (or spouse if filing jointly) generally cannot have any other health plan that is not an HDHP. However, an individual may have additional insurance that only covers the following items: Accidents. Disability. Dental care. Vision care. Long-term care. Liabilities related to workers compensation laws, torts or ownership or use of property. Specific diseases or illnesses. A fixed amount per day (or other period) of hospitalization. Prescription drug benefits. In general, if an individual is covered by both an HDHP that does not cover prescription drugs and by a separate prescription drug plan that provides benefits before the minimum annual deductible of the HDHP has been satisfied, the individual is not eligible to contribute to an HSA. (Rev. Rul ) Preventive care. A plan that provides preventive care without a deductible or with a deductible below the HSA requirements can still be treated as a HDHP. Preventive care includes: (IRS Notice ) Periodic health evaluations, including tests and diagnostic procedures ordered in connection with routine examinations. Routine prenatal and well-child care. Child and adult immunizations. Tobacco cessation programs. Obesity weight-loss programs. Many screening services. State-mandated benefits. If a state requires health plans to provide certain benefits without a deductible or with a deductible below the HSA limitations, the plan will not be an HDHP. Other employee health plans. A taxpayer covered by his (or his spouse s) employer s medical expense reimbursement plan, a healthcare flexible spending account (FSA) plan or a health reimbursement arrangement (HRA) is generally ineligible to make HSA contributions. HRA or FSA Transfers Expired Provision Alert: The ability to transfer funds tax-free from an HRA or FSA to an HSA expired after 20. It s possible that Congress will extend this provision to 202, but it had not done so at the time of this publication. See Expired Tax Provisions on Page 7- for more information. Before 202, an employer could make a one-time direct transfer from an employee s HRA account or health FSA account to the employee s HSA. The maximum transfer is the smaller of the amount in those accounts on September 2, 2006, or the date of the transfer. For the employee, the amount transferred is not taxable, is not deductible as an HSA contribution and does not reduce his HSA contribution limit for the year. 202 Tax Year 040 Quickfinder Handbook 4-7

8 202 Insurance Reimbursements Deductible medical costs must be reduced by any insurance reimbursements received. Excess reimbursements are taxable only to the extent they were provided for under an employer plan and attributable to the employer s contribution that was not included in income. Over-the-Counter Drug Reimbursements From FSA Reimbursements for over-the-counter drugs through an employer health flexible-spending arrangement (FSA) or other employer health plan are not tax-free to the employee. Any distributions for non-prescribed drugs are treated as disqualified distributions subject to tax and penalty. Exceptions: Any over-the-counter drug prescribed by a doctor and insulin. Replacement Page 0/203 Taxes See also IRS Pubs. 523, 530 and 535 State and Local Income Taxes State and local income taxes are deductible on Schedule A in the year paid. The tax may be paid either through withholding, estimated payments or payments for prior year returns. The IRS may disallow deductions for large estimated state income tax payments made solely to increase itemized deductions (Rev. Rul ). The prepayment of estimated state income tax should be based on tax liability. Penalties and interest are not deductible. Court Case: A taxpayer claimed the standard deduction and deducted nonresident state income taxes from royalties on Schedule E. The court found that state income taxes are not expenses incurred in the production of royalty income. [Strange, 88 AFTR 2d (9th Cir. 200)] Electing to Deduct Sales Tax Expired Provision Alert: The election to deduct state and local sales tax expired at the end of 20. It s possible Congress will extend it to 202, but had not done so at the time of this publication. See Expired Tax Provisions on Page 7- for more information. For 20, taxpayers could elect to deduct state and local sales tax rather than state and local income taxes. Taxpayers who made this election could deduct either: can ) Actual sales tax amounts (based on their records) or 2) Predetermined deduction figures from IRS tables. To deduct actual amounts. Add up the nonbusiness general state and local sales taxes (including any compensating use taxes) paid during the year plus any selective sales taxes if the rate is the same as the general sales tax rate. Include selective sales taxes on food, clothing, medical supplies and motor vehicles even if the rate is lower than the general sales tax rate. If the selective sales tax rate on a motor vehicle is higher than the general rate, deduct only the amount that would have resulted from charging the lower general sales tax rate. To deduct amounts from IRS tables. The table amounts depend on the taxpayer s AGI plus nontaxable income (for example, taxexempt interest and nontaxable portion of Social Security benefits), the number of exemptions claimed on Form 040 and the state of residence. If the taxpayer lives in more than one state during the year, pro-rate the amount from the table for each state (based on the number of days spent there divided by 365), add up the prorated amounts and deduct the total. Note: In addition to the table amounts, the taxpayer can deduct additional actual sales tax amounts from purchases of motor vehicles (including leased vehicles). If the sales tax rate on a motor vehicle is higher than the general rate, deduct only the amount that would have resulted from charging the lower general sales tax rate. Also add sales taxes paid on boats, airplanes, homes (including mobile and prefabricated) or home building materials if the rate was the same as the general sales tax rate. See Page 3-3 for the State and Local General Sales Tax Deduction Worksheet. Also, a Sales Tax Deduction Calculator can be found at Real Estate Taxes A real estate tax is deductible in the year it is paid to the taxing authority. Prepaid real estate taxes can generally be deducted in the year of the prepayment if the taxpayer is on the cash basis and does not live in an area in which the prepayment would be considered a deposit by the taxing authority. How prepaid taxes are treated varies among local jurisdictions. Taxes placed in escrow are deductible when actually paid to the taxing authority, not when paid to the escrow agent. Penalties and interest on late payments are not deductible. Also, see Electing to Capitalize Taxes and Interest on Page 5-8. Generally, real estate taxes can be deducted only by the owner of the property upon which the tax is imposed. Regulation Section.64-3(b) defines real property taxes as taxes imposed on interests in real property and levied for the general public welfare Because of the lack of a detailed definition, the issue has been the subject of several court cases and IRS rulings. For example, the tax imposed on renters by the New York Real Property Tax Law is not deductible for federal tax purposes. Taxes paid under this law are considered rent, not property taxes. (Rev. Rul ) In contrast, Revenue Ruling 7-49 stated that certain payments made to an educational construction fund by a cooperative housing corporation did qualify as real property taxes, and were deductible by the tenant-shareholders. More than one property. Real estate taxes are deductible for all property owned by a taxpayer. Sale of real estate. The buyer and the seller must divide real estate taxes according to the number of days that each owned the property during the year. Both are considered to have paid their share of taxes, even if one or the other paid the entire amount. Buyer-paid taxes. Deductible by the buyer only for the period he owned the property. The buyer cannot deduct the real estate taxes of the seller. The buyer must add these taxes to the basis of the property. The seller treats this as additional sales proceeds. Seller-paid taxes. If the seller pays real estate tax owed by the buyer (beginning on the date of sale), the buyer is considered to have paid the tax. The tax is deductible by the buyer. The buyer must reduce the basis in the property by the tax paid. The seller treats this as a reduced selling price. Equitable owner. Taxpayers who do not have legal title to a property may still claim a Schedule A deduction for real estate taxes paid if they are equitable owners of the property. An equitable owner is a person who has the economic benefits and burdens of ownership, based on the facts. Occupying and maintaining the home and paying the mortgage and taxes on it are factors that might indicate equitable ownership. See Trans (TC Memo ), Uslu (TC Memo ) and Edosada (TC Summ. Op ) for situations where taxpayers were equitable owners. Cooperative Housing Corporations (Co-Ops) Mortgage interest and property taxes allocated to a tenant-shareholder in a co-op are generally treated the same as those paid by other homeowners, provided the following conditions are met. ) The corporation has only one class of stock outstanding. Continued on the next page 202 Tax Year 040 Quickfinder Handbook 5-5

9 Amortizing Points Amortization is per month, not per year. Thus, if a taxpayer incurs $2,000 in points on a 30-year loan of 360 monthly payments and the first payment is for November of 202, only $.2 is deductible for 202 ($2, = $ months = $.2). Home equity line-of-credit points. Points paid initially for a line of credit of up to $00,000 secured by the home are deductible as home equity debt interest over the period of time until the credit line expires. However, if funds from a line of credit are used for home improvements for the principal residence, the points are fully deductible the first year. Business or investment property. Amortize the points over the life of the loan. Second Home Assuming the home is treated as the second home under the qualified residence interest expense rules, points are treated as follows. Personal use only. Points are amortized as mortgage interest expense over the entire loan period. Rental and personal use: ) If personal use is not more than the greater of 4 days or 0% of the days the home is rented, the second home is treated as a rental property. Amortize and deduct the rental portion of the points over the life of the loan. Points allocated to personal use are non-deductible. 2) If personal use exceeds the 4-day or 0% use rule, divide the points proportionately based on rental and personal use. Amortize and deduct the amount attributable to the rental activity against the rental income, and amortize and deduct the balance as qualified residence interest expense. Note: See Renting Out a Home on Page 8-. Other Mortgage Interest Deduction Rules Late Payment Charges Late payment charges are generally deductible as mortgage interest if they are not for a specific service such as a collection fee. Land Rent (Redeemable Ground Rent) Periodic lease payments made for the use of land on which a house is located can be deductible as mortgage interest. To be deductible, all of the following must be true. ) The land lease term is more than 5 years, including renewal periods, and is freely assignable by the lessee, 2) The lessee has the right to terminate the lease and purchase the lessor s land by paying a specific amount and 3) The lessor s interest in the land is a security interest to protect the entitlement to rental payment. Construction Loans Interest on construction loans or loans to buy a lot is qualified residence interest if the following requirements are met: ) A home under construction is treated as a qualifying home for up to 24 months provided that when ready for occupancy, the house is used as a main or second home. The deduction was allowed even when the home was never completed because the taxpayers could not obtain financing. [Rose, TC Summary Opinion 20-7 (20)] 2) If the construction period exceeds 24 months, the interest for the remaining months is considered personal interest. Replacement Page 0/203 3) Loan proceeds must be directly traceable to home construction expenses, including the purchase of a lot. 4) Before construction begins, the loan does not qualify as acquisition debt and interest incurred during that period is treated generally as personal interest. 5) 90-day rule. A loan incurred within 90 days after construction is complete may also qualify, provided the debt is secured by the home. Construction expenses made within the period starting 24 months before completion of the house and ending on the date of the loan qualify. Timeshares Homes owned under a time-sharing plan can be considered second homes for deducting interest expense. A time-sharing plan is an arrangement between two or more people that limits each person s interest in the home or right to use it to a certain part of the year. However, if any portion of the timeshare is rented to a third party, the ability to claim a deduction for the personal portion of the mortgage interest may be lost. Boats, Mobile Homes and House Trailers For the qualified residence mortgage interest deduction, a qualified home includes a boat, mobile home, house trailer or similar property that has sleeping, cooking and toilet facilities. However, local law must allow for such use. A houseboat would not qualify if moored at a marina where overnight sleeping is prohibited. Prepaid Mortgage Interest Mortgage interest prepaid in 202 that fully accrues by January 5, 203, may be included in Form 098, box. However, this prepaid interest is not deductible in 202; it should be deducted in 203. Note: Some lenders apply prepaid amounts to both interest and principal; others apply prepayments to principal only. Reverse Mortgages A reverse mortgage is used to convert home equity into cash. The homeowner receives payments (as a line of credit, a lump sum, monthly payments for a specified number of years, or payments over his life). The amount received is a loan, so it is tax-free and will not affect Social Security benefits. When a reverse mortgage comes due, the lender recovers the amount owed from the borrower (or the heirs). Mortgage interest deduction. Mortgage interest is added to the loan balance over the term of the loan, but is not deducted under the personal residence interest rules until the loan is repaid. Mortgage Insurance Premiums Expired Provision Alert: The deduction for mortgage insurance premiums expired at the end of 20. It s possible Congress will extend it to 202, but had not done so at the time of this publication. See Expired Tax Provisions on Page 7- for more information. 202 For 20, mortgage insurance premiums paid or accrued during the year in connection with acquisition debt on a taxpayer s primary or second home are deductible as residence interest. The deduction phases out ratably by 0% for each $,000 (or portion thereof) by which the taxpayer s AGI exceeds $00,000. Phase-out amounts are halved for married filing separately. Thus, it is not available for taxpayers with AGI greater than $09,000 ($54,500 for MFS). Only amounts paid on mortgage insurance contracts issued after 2006 qualify. 202 Tax Year 040 Quickfinder Handbook 5-

10 Deceased spouse. Carryovers allocable to the excess contributions of a deceased spouse may only be claimed on the final return of the deceased spouse, not by the surviving spouse. [Reg..70A-0(d)(4)(iii)] Qualified Conservation Contributions Expired Provision Alert: Special rules for qualified conservation contribution expired at the end of 20. It s possible Congress will extend them to 202, but had not done so at the time of this publication. See Expired Tax Provisions on Page 7- for more information. 202 For 20, the deduction for qualified conservation contributions is limited to 50% of AGI (00% of AGI for qualified farmers and ranchers) minus the deduction for all other charitable contributions. Any excess amount is carried forward 5 years. Absent these rules, a qualified conservation contribution is subject to the 30%-of-AGI limit and a five-year carryforward period. Contributions That Benefit the Taxpayer Contributions that are made partly for goods or services provided by the organization are deductible if: ) The amount of the payment exceeds the FMV of goods and services received, and 2) The donor intends to make a payment in excess of the FMV of goods and services. Example: Anita makes a large contribution to a charity that has a history of sponsoring a dinner-dance for donors making substantial contributions. The charitable deduction is limited to amount of the donation less the FMV of the anticipated dinner-dance even if the dance takes place in the following year. Refused benefits. A donor can claim a full deduction if all benefits are actively refused (such as checking off a refusal box on a form sent by the charity). (Rev. Rul ) Gifts of more than $75. If the donor receives some benefit, the charity must provide a statement as to the deductible amount of the contribution. The charity must make a good faith estimate of the FMV of goods/services provided to the donor. Token benefits. A donor can disregard benefits if either: The benefits received do not exceed the lesser of 2% of the contribution or $99 (for 202) or The gift is $49.50 of more and the benefit received bears the charity s name or logo and has an aggregate cost not more than $9.90 (for 202). Membership benefits. Certain benefits can be disregarded if the annual payment is $75 or less. A payment of more than $75 can be made if the organization does not require a larger payment to receive these benefits. Benefits may include rights or privileges that members can exercise frequently (such as free or discounted admission and parking) or admission to member-only events if the cost is $9.90 (for 202) or less per person. Tickets to college games. A payment made to a college or university in exchange for a right to buy tickets to a sporting event qualifies for a charitable deduction of 80% of the amount paid. Any amount actually paid for tickets is not deductible. [Reg..70A-3(f)(4)] Cash Donations Substantiation No deduction is allowed unless the taxpayer has either () bank records (for example, a canceled check or account statement) or (2) written acknowledgment from the charity documenting the contribution s amount and date. [IRC 70(f)(7)]. This means that donors who give cash will need to get written acknowledgement from the charity to claim a deduction. Using a check for small donations, rather than cash, may be preferable. Replacement Page 0/203 $250 or more. Charitable contributions of $250 or more in any one day to any one organization must have written acknowledgment from the organization [IRC 70(f)(8)]. The acknowledgment must be received by the earlier of the date the tax return is filed for the contribution year or the extended due date for filing. It must state whether the charitable organization provided any goods or services in exchange for the contribution (and if so, an estimate of the FMV of the goods or services provided). Payroll deduction contributions: Employees can substantiate a payroll deduction of $250 or more with () a Form W-2 or other document from the employer showing payroll deduction and (2) a pledge card or other document prepared by the charity. Noncash Donations Substantiation General recordkeeping requirements for noncash contributions: ) Name of charitable organization. 2) Date and location of contribution. 3) Reasonably detailed description of contributed property. 4) Fair market value and method of valuing the property. 5) Cost or other basis of the property if FMV must be reduced. See Required Reductions in FMV Donating Appreciated Property on Page 5-4. Specific requirements. See the Donations Substantiation Guide on Page 3-7 for specific requirements based on the type and amount of the donation. Form 8283, Noncash Charitable Contributions. Must be filed if noncash property donations are in excess of $500. Note: Special rules apply to donations of less than a taxpayer s entire interest in a property. See Pub. 526, Charitable Contributions. Out-of-pocket expenses. Acknowledgment from the charity is required if a volunteer claims a deduction for a single contribution of $250 or more in the form of out-of-pocket expenses. The acknowledgement must contain a description of the service provided and a statement about whether goods or services were provided by the charity to reimburse the taxpayer for the expenses incurred (including an estimate of the FMV of any goods or services provided). The charity must substantiate the type of services performed (not dates or amounts of expenses). Clothing and household items. No deduction is allowed for donating clothing or household items unless they are in good used condition or better. Exception: Deduction is allowed for an item of clothing or a household item that is not in good used condition or better if the deduction is more than $500 and a qualified appraisal of it is included with the tax return. Household items include furniture and furnishings, electronics, appliances, linens and other similar items. Valuation For guidelines on the value of donated goods, see the Donated Goods Valuation Guide table on Page 3-6. Appraisals A written appraisal is required for charitable contributions of property for which the claimed value exceeds $5,000 if an income tax deduction is claimed. Also, the recipient organization must file an information return if it disposes of the property within two years of receipt. See Notice for guidance on qualified appraisals and qualified appraisers. Exception: Publicly traded securities do not require written appraisal. (Nonpublicly traded securities must be appraised if the claimed value is more than $0,000.) Fees paid to determine the FMV of donated property are not deductible as contributions. Claim them on Schedule A as miscellaneous deductions subject to 2% of the AGI limitation. 202 Tax Year 040 Quickfinder Handbook 5-3

11 Sale or exchange of timber: Timber sold primarily for sale to customer. Gain or loss is treated as ordinary income subject to SE tax. Farmers who cut and sell timber on their land in the form of logs, firewood or pulpwood report income and expenses as ordinary income and expenses on Schedule F. Standing timber sold from investment property. Treated as a capital gain or loss, reported on Form Outright sales of timber. Outright sales of timber by landowners qualify for capital gains treatment if the timber was held for more than one year before the date of disposal. Generally, cutting of timber results in no gain or loss until sold or exchanged. Exception: Under Section 63(a) taxpayers can elect to treat the cutting of timber as a sale under Section 23 in the year it is cut. To qualify for the Section 63(a) election, the timber must be cut for sale or for use in the taxpayer s trade or business, and the taxpayer must own or hold a right to cut timber for more than one year before the timber is cut. Timber depletion. The depletion deduction for timber must be calculated using cost depletion. The depletion is taken in the year of sale or other disposition of the products cut from the timber, unless the taxpayer elects to treat the cutting of timber as a sale or exchange. The depletion deduction is limited by the adjusted basis of the timber. The adjusted basis for depletion cannot include the residual value of land and improvements at the end of operations. [Reg..62-(b)()] Example: Samuel purchases a timber tract for $60,000. The residual value of the land at the time of purchase, assuming all timber has been cut, equals $00,000. The depletable basis of the timber for cost depletion is $60,000 ($60,000 $00,000). Samuel determines that the standing timber will produce,000 units when cut. Samuel s depletion per unit equals $60 ($60,000,000). If Samuel sold 300 units during the year, his depletion allowance would be $8,000 (300 $60). Domestic Producer Deduction (DPD) Form 8903 For 202, the DPD is 9% of the lesser of the business s: ) Qualified production activities income or 2) Taxable income (AGI for individual taxpayers) determined without regard to the DPD. The DPD cannot exceed 50% of the wages paid and reported on Form W-2 by the business for the year (and allocable to domestic production gross receipts). Oil and gas activities. Individuals with oil-related qualified production activities income must reduce their DPD by 3% of the least of their () oil-related qualified production activities income, (2) qualified production activities income or (3) AGI (determined without regard to the DPD). [IRC 99(d)(9)] Oil-related qualified production activities income is qualified production activities income attributable to the production, refining, processing, transportation or distribution of oil, gas or any primary product thereof. Qualified Production Activities Income To determine the net income that qualifies for the 9% deduction, the taxpayer s receipts must be divided into those from eligible activities (domestic production gross receipts or DPGR) and non- DPGR. Then, the taxpayer s expenses are allocated between the two categories of income. The DPGR less allocable expenses equals qualified production activities income. Eligible activities. The following activities generate DPGR if performed in the U.S.: [IRC 99(c)(4)] Manufacture, production, growth or extraction of: Tangible personal property (for example, clothing, goods, food, agricultural products). Computer software. Sound recordings. Certain film production. Production of electricity, natural gas or potable water. Construction or substantial renovation of residential and commercial buildings and infrastructure by taxpayers engaged in the construction business. Engineering and architectural services performed by a taxpayer engaged in the business of performing engineering or architecture. N Observation: While most U.S. farming activities will generate DPGR, income from custom farming if the farmer does not have the benefits and burden of ownership of the property is not DPGR. Expired Provision Alert: For , qualified production activities performed in Puerto Rico was included in the domestic production gross receipts calculation as long as the activity in Puerto Rico was subject to U.S. tax. It s arepossible Congress will extend this provision to 202, but had not done so at the time of this publication. See Expired Tax Provisions on Page 7- for more information. Allocating costs. There are three methods for allocating costs to DPGR (that is, income that qualifies for the DPD) and non-dpgr. [Reg..99-4] Small business simplified overall method. Allocate all deductions (including cost of goods sold) and losses between DPGR and non-dpgr based on relative gross receipts. Available to: Taxpayers with average gross receipts under $5 million. Taxpayers with average gross receipts of $0 million or less, if they qualify to use the cash method under Revenue Procedure Farmers not required to use the accrual method. Simplified deduction method. Use gross receipts to allocate all costs and expenses except cost of goods sold. Cost of goods sold must be specifically traced to DPGR and non-dpgr. Available to taxpayers with average annual gross receipts of $00 million or less or total assets of $0 million or less at the end of the year. Section 86 Method. Deductions are allocated to DPGR using the rules under Section 86 for allocating deductions to foreign income. This is the most complex method because it requires tracing each cost to income. S Shareholders and Partners The DPD is determined at the shareholder or partner level so taxpayers should get the information from the S corporation or partnership Schedule K-. Eligible small S corporations and partnerships can choose to compute qualified production activities income and Form W-2 wages at the entity level and allocate those amounts to the shareholders or partners, who then report the amounts on lines 7 and 7 of Form End of Tab Tax Year 040 Quickfinder Handbook Replacement Page 0/203

12 Reporting Different Long-Term Rates All long-term capital gains and losses are entered on Part II of Form 8949, regardless of whether they are subject to the 0%, 5%, 25% or 28% rates. The totals from Form 8949 carry to Schedule D, where long-term and short-term gains and losses are combined or netted. If the taxpayer has a net capital gain (that is, net long-term capital gain exceeds net short-term capital loss): Unrecaptured Section 250 gains are carried to the Unrecaptured Section 250 Gain Worksheet in the Schedule D (and Form 8949) instructions to calculate the net gain subject to the 25% rate. This amount is then carried to Line 9 of Schedule D. Gains subject to the 28% rate are carried to the 28% Rate Gain Worksheet in the Schedule D (and Form 8949) instructions to calculate the net gain subject to the 28% rate. This amount is then carried to Line 8 of Schedule D. Taxpayers with any net capital gains subject to the 25% or the 28% rates must use the Schedule D Tax Worksheet in the Schedule D (and Form 8949) instructions. Partnerships and S corporations. Pass-through entities must provide the necessary information on Schedule K- to determine gains eligible for the different maximum tax rates. Unrecaptured Section 250 Gain For sales of Section 250 property (most depreciable real property), any long-term capital gain attributable to depreciation (other than depreciation recaptured as ordinary income) is taxed at a maximum rate of 25%. In general, unrecaptured Section 250 gain is the gain to the extent of straight-line (SL) depreciation allowed. Calculation. Generally, the unrecaptured Section 250 gain is the smaller of () depreciation claimed or (2) total gain less any recaptured depreciation that is taxed at ordinary rates (that is, accelerated depreciation in excess of SL). This amount is then limited to the net Section 23 gain. Finally, any net 28% rate loss is used to offset the unrecaptured Section 250 gain. Example: Harry sold rental property for $50,000. He paid $00,000 for the property several years ago and had depreciated $20,000 under MACRS (SL depreciation). Of his total $70,000 gain ($50,000 proceeds $80,000 adjusted basis), $50,000 is attributable to appreciation (which is taxed at a maximum rate of 5%), and $20,000 is attributable to depreciation (which is taxed as unrecaptured Section 250 gain at a maximum rate of 25%). 28% Rate Gain Collectibles gain or loss. A collectibles gain (loss) is any longterm gain or deductible long-term loss from the sale or exchange of a collectible that is a capital asset. Collectibles include works of art, rugs, antiques, metals (such as gold, silver and platinum bullion), gems, stamps, coins, alcoholic beverages and certain other tangible property. Also include any gain (but not loss) from the sale or exchange of an interest in a partnership, S corporation or trust held for more than one year and attributable to unrealized appreciation of collectibles. Qualified small business stock. Up to 50% (60% for certain empowerment zone business stock) of the gain from the sale of Section 202 qualified small business stock (QSBS) is excluded from gross income if held for more than five years. The taxable portion of the gain is included in income as long-term capital gain subject to the 28% rate. Note: A 75% gain exclusion rate applies to QSBS (including QSBS stock in certain empowerment zone businesses) acquired from February 8, 2009 September 27, 200. A 00% gain exclusion applies to QSBS acquired from September 28, 200 December 3, 20. However, the 75% and 00% gain exclusions will not apply to 202 sales since the five-year holding period will not be met. 203 Under Section 045, gain from the sale of QSBS held over six months may be rolled over by acquiring the stock of another qualified small business within 60 days. If a partnership or S corporation sells such stock and does not elect to defer the gain on the sale, a non-corporate partner or shareholder can purchase replacement stock within 60 days of the date of the sale and elect to defer his distributive share of the pass-through entity s gain. See AMT for Individuals Adjustments and Preferences on Page 2-4 for AMT rules on QSBS. Also see Small Business Stock in Tab C in the Small Business Quickfinder Handbook. Related-Party Transactions In general, a loss on the sale of property between related parties is not deductible (IRC 267). If the property is later sold to an unrelated party, gain is recognized only to the extent that it is more than the loss not allowed from the previous transfer. Example: Colin sells stock with a cost basis of $0,000 to his brother Finn for $7,600. Colin s $2,400 loss is not deductible. Finn later sells the same stock to an unrelated person for $0,500. Although Finn has a gain of $2,900, his taxable gain is only $500, the amount the gain exceeds Colin s unallowed loss. If the property is later sold to an unrelated party at a loss, the loss disallowed to the related party cannot be recognized. Definition. A related party is a family member who is a brother or sister (whether by whole or half blood), spouse, ancestor (parent, grandparent, etc.) or lineal descendant (child, grandchild, etc.) of a taxpayer. A cousin, aunt, uncle, nephew, niece, stepchild, stepparent or in-law is not a related party for this purpose. For related party rules between individuals, corporations, trusts, fiduciaries and other organizations, see Related-Party Transactions in Tab O in the Small Business Quickfinder Handbook. Deceased Spouse s Capital Loss Carryover A surviving spouse cannot claim a deceased spouse s capital loss carryover from joint return years (Ltr. Rul ). The annual $3,000 net capital loss limitation applies to the final Form 040 of the deceased taxpayer (if a joint return is filed). Any remaining capital losses allocable to the deceased spouse are lost and cannot be carried over to the surviving spouse s Form 040, the Form 04 filed by the decedent s estate or to any other beneficiary s return. Strategy: In Letter Ruling , the property sold was the decedent spouse s separate property. If the property was owned jointly by decedent and surviving spouse or owned by a decedent and surviving spouse residing in a community property state at the time of decedent s death, the survivor would be entitled to half the loss carryforward. Schedule D/Form 8949 Reporting Tips Gains and losses are reported on Form 8949 and totals are carried to Schedule D. Separate Forms 8949 are completed for () transactions reported on Form 099-B with basis reported to the IRS (amount in box 3 and box 6b checked), (2) transactions reported on Form 099-B but basis not reported to the IRS (box 6a checked) and (3) transactions for which a Form 099-B was not received. Report a sale of a principal residence only if required (see Tax Reporting Rules on Page 7-6) Tax Year 040 Quickfinder Handbook Replacement Page 0/203

13 Reimbursements When an employer reimburses an employee for travel, meals or entertainment expenses, the reimbursement is excluded from the employee s income if the reimbursement arrangement is an accountable plan. Similar rules apply to independent contractors [Temp. Reg T(h)(2)]. Employees cannot deduct meal and entertainment expenses if the employer reimburses the expenses under an accountable plan and does not treat the reimbursement as wages. See Accountable Plan/Nonaccountable Plan below. Independent contractors cannot deduct meals and entertainment expenses if the customer or client makes direct reimbursement for the expenses and adequate records are submitted to the customer or client. See Elements to Prove Certain Business Expenses on Page 9-6. Note: If reimbursements for meals are excluded from the income of the employee or independent contractor, the employer (or customer/client) is generally subject to the 50% deduction limit. See 50% Limit on Page 9-2. Failure to claim reimbursement. Employees may not deduct business expenses that are eligible for reimbursement from the employer. Accountable Plan/Nonaccountable Plan Accountable plan. Reimbursements made to an employee under an accountable plan are not included in the employee s income, and the employee does not deduct the expenses. Nonaccountable plan. Reimbursements made to an employee under a nonaccountable plan are treated as taxable wages and reported in box of Form W-2. The employee deducts the expenses on Form 206, subject to the 2%-of-AGI limitation on Schedule A. An employee who receives payments under a nonaccountable plan cannot convert the payments to an accountable plan by voluntarily accounting to the employer or returning excess payment. Accountable plan requirements: [IRC 62(c)] ) Business Connection. The reimbursement must be for jobrelated expenses the employee would reasonably be expected to incur. A plan that reimburses personal expenses does not qualify as an accountable plan. Caution: An arrangement that recharacterizes wages as nontaxable reimbursements or allowances does not satisfy the business connection requirement. (Rev. Rul ) 2) Substantiation. The employee must substantiate the expense by providing receipts or other documentation to the employer within a reasonable period of time. 3) Return of Excess Reimbursement. The employee must be required to return any excess reimbursement to the employer within a reasonable period of time. Reasonable period of time. The following situations will be considered within a reasonable period of time for purposes of accountable plans. ) The employee receives an advance within 30 days of the time the expense is incurred. 2) The employee adequately accounts for the expense within 60 days of the time the expense was paid or incurred. 3) Any excess reimbursement is returned to the employer within 20 days after the expense was paid or incurred. 4) The employer provides a statement to the employee (at least quarterly) asking the employee to either return or adequately account for outstanding advances, and the employee complies within 20 days of the statement. If the above requirements are not met, the plan is considered a nonaccountable plan. Part accountable plan or part nonaccountable plan. If an employer makes reimbursements to an employee under an accountable plan, but some reimbursements do not qualify under accountable plan rules, only the reimbursements falling under the nonaccountable plan are considered taxable wages. Each plan is viewed separately, and the employer treats the employee as having received reimbursements under two different plans. Replacement Page 0/203 Above-the-Line Deduction for Certain Employees Government officials paid on a fee basis, qualified performing artists, Armed Forces reservists and educators can claim business expenses as an adjustment to income. [IRC 62(a)(2) and 62] Government fee basis officials (FBOs). Individuals who are employed by a state or local government and paid in whole or in part on a fee basis. Qualified performing artists (QPAs): ) Perform services as an employee in performing arts for at least two employers during the tax year and receive at least $200 from any two of the employers, 2) Incur performing arts-related business expenses of more than 0% of the gross income from performing arts and 3) Have AGI of $6,000 or less before deducting performing arts expenses. To qualify, married individuals must file a joint return unless they lived apart for all of the tax year. Armed Forces reservists. National Guard members and Armed Forces reservists who must travel more than 00 miles away from home and stay overnight to fulfill their training and service commitments can claim an above-the-line deduction for the cost of transportation, meals (subject to the 50% disallowance rule) and lodging. The deductible amounts are limited to general federal government per diem amounts for the applicable locale. Form 206 is completed to report eligible expenses for FBOs, QPAs and reservists. The expenses are then entered on line 24 of Form Educators. For 20 grades K 2 teachers, instructors, counselors, principals and aides can deduct up to $250 of unreimbursed expenses on line 23 of Form 040 (up to $500 if MFJ and both spouses are educators). Only expenses in excess of excludable U.S. bond interest, nontaxable qualified tuition plan distributions and nontaxable Coverdell ESA distributions are allowable. The taxpayer must spend at least 900 hours during a school year as an educator. Qualified expenses include amounts paid for books, supplies (other than nonathletic supplies for courses of instruction in health and PE), computer software and equipment, and other equipment and materials used in the classroom. Amounts that cannot be deducted above the line can be deducted as unreimbursed employee business expenses, subject to the 2%-of-AGI limit. Expired Provision Alert: The educator s expense deduction expired at the end of 20. It s possible Congress will extend it to 202, but had not done so at the time of this publication. See Expired Tax Provisions on Page 7- for more information. Per Diem Rates See also IRS Pub. 542 Per Diem Substantiation Methods The federal per diem rates accepted by the IRS for meals, lodging and other incidental expenses vary depending on the travel location. The per diem rates for travel are revised each year on October. For the last three months of the year, taxpayers use either the per diem rates effective October of the preceding year or the revised rates effective October of the current year. They must use either the current rates or the revised rates consistently for all travel during that period. Meals and incidental expenses (M&IE) rate. Instead of deducting actual expenses incurred for M&IE while traveling for business, employees and self-employed individuals may deduct the per diem amounts, if they document the time, place and business purpose for the travel. Also, employees and self-employed individuals who are reimbursed for their meals and incidental expenses are treated as substantiating the amount of those expenses up to the IRS per 202 Tax Year 040 Quickfinder Handbook 9-7

14 Depreciation Tab 0 Topics Depreciation Rules... Page 0- MACRS Recovery Periods (202)... Page 0-2 MACRS Optional Tables (Various)... Page 0-4 Special Depreciation Allowance... Page 0-8 Alternative Minimum Tax Adjustments... Page 0-8 Alternative Depreciation System... Page 0-9 Section 79 Deduction... Page 0-9 Section 79 Recapture... Page 0- Change of Use of MACRS Property... Page 0-2 Dispositions of MACRS Property... Page 0-2 Depreciation Recapture... Page 0-2 Like-Kind Exchanges Depreciation Rules... Page 0-2 Computer Software... Page 0-3 Leasehold Improvements... Page 0-3 Qualified Real Property... Page 0-3 Correcting Depreciation Errors... Page 0-4 Intangible Assets Amortization Rules... Page 0-4 Depreciation Rules Form 4562; See also IRC 68 and IRS Pub. 946 What Property Can Be Depreciated? Depreciable property must meet all these requirements: ) It is owned by the taxpayer. 2) It is used in the taxpayer s business or income-producing activity. 3) It has a determinable useful life (it must be something that wears out, decays, gets used up, becomes obsolete or loses its value from natural causes). 4) It is expected to last more than one year. 5) It is not excepted property. Excepted property includes: Property placed in service and disposed of in the same year. Equipment used to build capital improvements. Section 97 intangibles. Certain term interests. MACRS Depreciation Systems MACRS applies to assets placed in service after 986. See IRS Pub. 534 for assets placed in service before 987. MACRS provides two depreciation systems: ) General depreciation system (GDS). 200% declining balance (DB), 50% DB or straight-line (SL), depending on the type of property and the method elected. 2) Alternative depreciation system (ADS). SL over a longer recovery period. ADS may be elected instead of GDS. However, in some cases, ADS is required. See Alternative Depreciation System on Page 0-9. The depreciation method is elected on Form 4562 the year the property is placed in service. An election applies to all assets in a property class (for example, three-year, five-year, etc.) placed in service that year. Exception: The election is made on a property-by-property basis for nonresidential real and residential rental property. MACRS Depreciation Methods (202) Type of property Nonfarm 3-, 5-, 7- and 0-year property. All farm property (except real property). 5- and 20-year property. Residential rental property. Nonresidential real property. Trees or vines bearing fruit or nuts. Water utility property. GDS 200% DB GDS 50% DB GDS 50% DB GDS SL Available methods GDS SL ADS SL ADS SL GDS SL ADS SL Property for which ADS is required (see ADS SL When ADS Must Be Used on Page 0-9). For 202 Expired Provision Alert: For 20, qualified leasehold improvements, retail improvements and restaurant property were 5-year property, but were depreciated SL. See Qualified Real Property on Page 0-3. must be Date Placed in Service Depreciation begins when property is placed in service (ready and available for use in a trade or business or income-producing activity, regardless of when it was purchased). First-year depreciation is determined by applying the appropriate convention. are Reporting Depreciation and Amortization File Form 4562 if any of the following are claimed: Depreciation for property placed in service during the current year. Section 79 deduction or carryover. Depreciation for listed property. Deduction for a vehicle reported on forms other than Schedule C or Form 206 (such as Schedules E and F). Amortization of costs beginning in the current year. File a separate Form 4562 for each business activity. However, complete only one Form 4562, Part I, for the Section 79 expense deduction claimed for all business activities. Conventions Half-year convention. Treats all property placed in service or disposed of during a tax year as placed in service, or disposed of, on the midpoint of that tax year. The half-year convention applies to all property except: ) Residential rental and nonresidential real property and 2) Property subject to the mid-quarter convention. Mid-quarter convention. If the depreciable basis of property placed in service in the last three months of the year is more than 40% of the total depreciable basis of property placed in service during the entire year, the mid-quarter convention applies to assets placed in service that year. All property placed in service during that tax year is treated as placed in service, or disposed of, at the midpoint of the quarter it is placed in service or disposed of. Replacement Page 0/ Tax Year 040 Quickfinder Handbook 0-

15 Mid-Quarter Percentages Quarter Acquisition Year Disposition Year First 87.5% 2.5% Second Third Fourth Note: Figure the deduction for the year the asset is placed in service (disposed of) by multiplying full-year depreciation by the applicable percentage, based on the quarter in which the asset was placed in service (disposed of). Excluded items. To determine if the mid-quarter convention applies, the following items are not counted: ) Property depreciated under a method other than MACRS, 2) Residential rental property, 3) Nonresidential real property, 4) Property placed in service and disposed of in the same tax year and 5) Property expensed under Section 79. Mid-month convention. Treats all property placed in service or disposed of during any month as placed in service or disposed of on the midpoint of that month. This convention applies to residential rental and nonresidential real property. Computing Depreciation Optional tables. The IRS provides optional tables that incorporate the applicable convention and depreciation method. These tables, based on the property s recovery period, begin on Page 0-4. Depreciation is calculated by multiplying the property s unadjusted depreciable basis by the applicable percentage from the table each year. Once the optional table is used for an asset, it generally must be used for that asset s entire recovery period. Exception: The tables cannot be used after the property s basis is adjusted for a reason other than depreciation or an addition or improvement to that property that is depreciated as a separate item of property. For example, the optional table cannot be used after a basis reduction for a casualty loss. Note: The optional tables cannot be used for a short tax year. See Tab J in the Small Business Quickfinder Handbook for calculating depreciation in a short tax year. If the optional tables are not used, depreciation is computed either using the declining balance or the straight-line method. Declining balance (DB) method. This method applies the same depreciation rate each year to the property s adjusted basis, switching to straight line (SL) in the year that SL gives an equal or greater deduction. Declining Balance Rates Recovery Period DB Percentage DB Rate Year SL begins 3-year 200% % 3rd 5-year th 7-year th 0-year th 5-year th 20-year th Note: Compute the DB rate by dividing the DB percentage (50% or 200%) by the number of years in the property s recovery period. MACRS Recovery Periods (202) See IRS Pub. 946 for more recovery periods. Note the recovery periods assigned to certain assets used in specific activities. Recovery Period (Years) GDS ADS Agriculture Agricultural machinery and equipment 7 0 Breeding or dairy cattle 5 7 Breeding or work horses (2 years old or less) 7 0 Breeding or work horses (more than 2 years old) 3 0 Race horses 3 2 Breeding hogs 3 3 Breeding sheep and goats 5 5 Farm buildings, other than single purpose Fences (agricultural) 7 0 Grain bins 7 0 Single-purpose agricultural or horticultural structures 0 5 Trees and vines bearing fruit 0 20 Drainage facilities 5 20 Distributive Trades and Services Assets used in wholesale and retail trade and personal and professional services Minerals Assets used in drilling for oil and gas wells (onshore) 5 6 Assets used in exploration and production of oil and gas 7 4 Office Related Office furniture and fixtures (such as desks, files, safes) 7 0 Computers and peripheral equipment 5 5 Typewriters, calculators, copiers 5 6 Computer software. See Computer Software on Page 0-3. Real Property Land improvements (sidewalks, roads, fences, etc.) 5 20 Qualified leasehold improvements 5 39 Qualified restaurant property 5 39 Qualified retail improvement property 5 39 Residential rental property including mobile homes Retail motor fuel outlet 5 20 Nonresidential real property Transportation Airplanes (noncommercial) and helicopters 5 6 Automobiles, taxis 5 5 Buses 5 9 Light general purpose trucks (less than 3,000 lbs.) 5 5 Heavy general purpose trucks (3,000 lbs. or more) 5 6 Tractor units (for over-the-road use) 3 4 Trailers (for over-the-road use) 5 6 Water transportation equipment 0 8 Other Appliances, carpets and furniture used in residential rental property 5 9 Personal property with no class life 7 2 Must use SL. 2 Five years for high technology medical equipment. 3 Expired Provision Alert: For 20, qualified leasehold improvements, retail improvements and restaurant property had a 5-year (39-year for ADS) recovery period. See Qualified Real Property on Page Tax Year 040 Quickfinder Handbook Replacement Page 0/203

16 Straight-Line Percentages See Optional Tables on Page 0-2. Alternative depreciation system (use ADS recovery period for regular tax and AMT). See When ADS Must Be Used on Page 0-9. SL MACRS depreciation (use GDS recovery period for regular tax and AMT). Year Half-Year Convention Mid-Quarter Convention Quarter in Which Acquired Year Property % 29.7% 20.83% 2.50% 4.7% Year Property % 7.50% 2.50% 7.50% 2.50% Year Property % 2.50% 8.93% 5.36%.79% Year Property % 8.75% 6.25% 3.75%.25% Special Depreciation Allowance IRC 68(k) A special (bonus) depreciation allowance equal to 50% of the depreciable basis of qualified property is claimed in Part II of Form 4562 for assets placed in service during 202. Expired Provision Alert: For assets acquired and placed in service September 9, 200 December 3, 20, the special depreciation allowance was 00% (rather than 50%). It s possible that Congress will extend the 00% rate to 202, but it had not done so at the time of this publication. See Expired Tax Provisions on Page 7-. The special depreciation allowance equals 50% of the asset s depreciable basis (cost or other basis less Section 79 deduction and credits). Exception: 00% special depreciation applies to certain long-production period property and noncommercial aircraft placed in service in 202. The amount of the special depreciation allowance is not affected by a short taxable year or by the applicable convention. (See Conventions on Page 0-.) But, assets for which the special depreciation allowance is claimed are still counted for determining whether the mid-quarter convention applies for the normal MACRS Strategy: If the special depreciation allowance is taken, there are no AMT adjustments for depreciation for that asset for the year placed in service or any later year. Qualified Property To qualify for the special depreciation allowance, the property must be a new asset (see Original use below) that is either: MACRS property with a recovery period of 20 years or less, Computer software (other than computer software covered by Section 97), Water utility property or Qualified leasehold improvement property. See Qualified leasehold improvement property Page 0-3. Business vehicles. The Section 280F limit on depreciation that applies to many vehicles is increased in 202 by $8,000 for vehicles for which special depreciation is allowed. See the Business Vehicles Quick Facts table on Page -. Original use. To qualify for special depreciation, the asset must generally be new, rather than used. However, new property that a taxpayer acquired for personal use and later converted to business use meets the original-use requirement. [Reg..68(k)-(b)(3)] Electing Out Taxpayers can elect not to claim special depreciation for any class of property by attaching a statement to the tax return. The election out applies to all additions to an asset class (for example, five-year property) for the year. [IRC 68(k)(2)(D)] Election Out of Special Depreciation Allowance Taxpayer elects under IRC Sec. 68(k)(2)(D)(iii) not to claim the special depreciation allowance for the following classes of property placed in service during the tax year ended [insert year-end] : [List property classes for which election is made.] Alternative Minimum Tax Adjustments For alternative minimum tax (AMT), depreciation must be computed using the AMT method. For assets placed in service after 998, the GDS recovery period is used for both regular tax and AMT. So for these assets, there is an AMT depreciation adjustment only if the AMT and regular tax depreciation methods differ. AMT Depreciation Adjustment Required Depreciation Method Type of Property Regular Tax AMT 3-, 5-, 7- and 0-yr property 200% DB 50% DB Section 250 property 50% DB SL Note: For property place in service after 986 and before 999, the ADS recovery period generally applied for AMT. Then, the AMT adjustment is the result of differences in both the depreciation method and recovery period. See MACRS Recovery Periods (202) on Page 0-2 for ADS recovery periods. N Observation: For assets placed in service after 998, no AMT adjustment is required for assets depreciated SL for regular tax. Common examples are: [IRC 68(b)(3)] Nonresidential real property with a class life of 27.5 years or more. Residential rental property. Qualified leasehold improvement, restaurant and retail improvement property. Trees and vines bearing fruit Tax Year 040 Quickfinder Handbook Replacement Page 0/203

17 Property Not Eligible for Section 79 Expense (202) Not an Exhaustive List Air conditioning units. Barns. Billboards (if not movable). Bridges. Buildings. Car washes. Docks. Elevators. Escalators. Fences. Heating units. Land. Landscaping. Roads. Shrubbery. Sidewalks. Stables. Swimming pools. Trailers (nonmobile). Warehouses. Wharves. Property eligible for the Section 79 deduction does not include that part of the property s basis that is determined by reference to the basis of other property held at any time by the person acquiring the property. [Reg..79-4(d)] $2,000,000 Example: Arnold trades a copier (used in his business) for a new copier that costs $20,000. Arnold is granted a trade-in allowance of $2,000 on his old copier. Arnold s adjusted basis in his old copier was $,200. The basis of the new copier is $9,200 ($,200 basis of old copier plus $8,000 cash expended). Only $8,000 of the basis of the new copier qualifies for Section 79 deduction; the remaining $,200 is basis determined by reference to other property. 203 Election The Section 79 election is made on an item-by-item basis for qualifying property by completing Part I of Form A taxpayer can make or revoke (for ) the expensing election on a timely filed amended return. Once the election is revoked, however, it cannot be remade. $50,000 is Example: In 202, Ryan placed two machines (each cost $50,000) in service for his sole proprietorship. One of the machines was new and one was used. He elects a $39,000 Section 79 deduction for the new machine. After filing his 202 return, he realizes he would have been better off electing the Section 79 deduction for the used machine since it did not qualify for special depreciation (and the new machine did). Ryan can file an amended return for 202, revoking the Section 79 election for the new machine and making the election for the used machine. Although the total Section 79 expense would not change, Ryan would also refigure depreciation on the assets, claiming special depreciation on the new machine. No IRS consent is required, but the revocation is irrevocable, so Ryan could not later amend his return to elect a Section 79 deduction for the new machine. A Section 79 election made on an amended return must specify the item of Section 79 property to which the election applies and the portion of the cost of each item to be expensed. If a taxpayer elected to expense only a portion of the cost of an item for a particular taxable year (or did not elect to expense any portion of the item), he may file an amended return and expense any portion of the item that was not previously expensed. Any increase in the amount expensed under Section 79 is not treated as a revocation of the prior election for that year. [Reg..79-5(c)(2)] Dollar Limit on Section 79 Deduction The total cost of property that can be expensed any year is limited to a maximum deduction. In addition, for each dollar of Section 79 property placed in service during the year over the qualifying property threshold, the maximum deduction is reduced (but not below zero) by one dollar. A husband and wife, whether filing joint or separate returns, are treated as one taxpayer for the maximum deduction and the qualifying property threshold. The maximum deduction (after any reduction for qualifying property additions over the threshold) is divided equally between the spouses, unless they agree to a different allocation Year Section 79 Annual Limits Maximum Deduction Qualifying Property Threshold $ 39, $ 560, and , ,000, and , ,000 Expired Provision Alert: For 20, the maximum deduction and qualifying property threshold were $500,000 and $2,000,000, respectively. It s possible that Congress will extend these higher amounts to 202, but it had not done so at the time of this publication. See Expired Tax Provisions on Page 7- for more information. $2,040,000 Example: James placed $600,000 of Section 79-eligible property in service in his business in 202. The maximum amount he can elect to expense under Section 79 is $99,000 ($39,000 $40,000 qualifying property over the $560,000 threshold). $460,000 ($500,000 U Caution: Most vehicles that aren t subject to the Section 280F depreciation limit are subject to a $25,000 (per vehicle) Section 79 expensing limit. See Section 79 Limit for Heavy Vehicles on Page -3. Section 79 Expensing Qualified Real Property Expired Provision Alert: For 20, qualified real property was eligible for Section 79 expensing. It s possible that Congress will extend this provision to 202, but had not done so at the time of this publication. See Expired Tax Provisions on Page 7- for more information For tax years beginning in 200 and 20, qualified real property, which is () qualified leasehold improvement property, (2) qualified restaurant property and (3) qualified retail improvement property is eligible for Section 79 expensing. See Qualified Real Property on Page 0-3 for definitions. Taxpayers elect to treat qualified real property as Section 79 property by attaching a statement to their original or amended return. The total Section 79 election for qualified real property is limited to $250,000 per year. Any Section 79 deduction for qualified real property that is unused due to the business taxable income limit (see Business Taxable Income Limit below) cannot be carried to a year after 20. Any carryforward remaining at the end of the tax year beginning in 20 is treated as placed in service in that year. [IRC 79(f)] For 202, Business Taxable Income Limit The Section 79 deduction is limited to the taxpayer s total taxable income from the active conduct of any trade or business. Taxable income is computed without regard to any Section 79 deduction, net operating losses (NOLs), the deduction for self-employment (SE) taxes or any unreimbursed employee business expenses. Active trade or business income includes: (Reg..79-2) Wages, salaries, tips and other compensation; Proprietorship (Schedule C or F) net income; A partner s or S corporation shareholder s pass-through share of entity business income or loss (if the taxpayer is engaged in the active conduct of at least one of the entity s trades or businesses); Section 23 business asset gains (or losses) from a trade or business and Section 245 and 250 depreciation recapture income from a trade or business Tax Year 040 Quickfinder Handbook Replacement Page 0/203

18 The active conduct of a trade or business for the Section 79 taxable income limit is not the same as material participation under the Section 469 passive activity rules. Income is derived from an active trade or business for the Section 79 test if the taxpayer meaningfully participates in the business s management or operations. Strategy: Business taxable income does not have to be generated by the business in which the Section 79 property is used to count toward the business taxable income limit. In fact, the trade or business in which the Section 79 property is used can generate a loss, as long as the taxpayer s net business taxable income from all sources is positive. Example: In 202, Anne received wages of $30,000. She purchased $25,000 worth of equipment to begin a sole proprietorship. Even though she received only $5,500 of net income from her Schedule C operations, she may claim a full $25,000 Section 79 deduction since her business taxable income was $35,500 ($30,000 + $5,500). Joint return. If a joint return is filed, the business taxable incomes (or losses) of both spouses are aggregated, even though the Section 79 deduction may be related to the activities of only one spouse. Section 79 Carryover If the cost of property for which a current year Section 79 election is made exceeds the taxable income limitation, the taxpayer may select the properties for which all or a part of the cost will be carried forward. The selections must be supported in the recordkeeping. If a selection is not made, the total carryover will be allocated equally among the properties for which Section 79 was elected (Reg..79-3). The Section 79 costs carried forward are added to the cost of qualifying property placed in service in that tax year. Amounts carried over must be applied on a first-in first-out (FIFO) basis. The maximum deduction limit ($39,000 for 202) applies to the carryover amount plus any new amounts elected in the carryover year. $2,000,000 $500,000 $500,000 However, there is no carryover of deductions lost due to the $39,000 (for 202) deduction limit [reduced, if applicable, by asset additions over the $560,000 (for 202) qualifying property threshold]. This may occur, for example, if a taxpayer claims Section 79 expense from multiple pass-through entities and the aggregate amounts exceed the maximum deduction limit. U Caution: Special rules apply to carryovers attributable to qualified real property. See Qualified Real Property on Page 0-3. Maximize Benefits of Section 79 Planning Use one of the methods shown below when the Section 79 deduction is reduced by the taxable income limit. Either method will result in net income of zero for the current year, but will provide different rates of cost recovery in future years. Projections are necessary to determine the best method to use. Method #: Determine the amount of Section 79 expense that will result in a taxable income of zero when combined with depreciation. Remaining basis is recovered using normal depreciation over future years. This will avoid the possibility that Section 79 carryovers are locked up by income limitations in future years. This formula works if the regular MACRS method is used, special depreciation is not claimed and the mid-quarter convention does not apply. Replacement Page 0/203 Formula for Section 79 deduction (Method #) [ (M N) A ] [ M ] = D M = MACRS Recovery Period D = Section 79 Deduction N = Net Income Before Depreciation A = Asset Cost Example: Martha purchased a previously used five-year MACRS asset on March, 202 for $05,000. Her business taxable income was $23,700 before the Section 79 deduction and depreciation. Maximum Section 79 deduction calculation is: (5 $23,700) $05,000 $3,500 = 5 <4> = < $ 3,375> Net income before depreciation... $ 23,700 Section 79 deduction... < 3,375> MACRS depreciation [($05,000 $3,375) 20.00%]... < 20,325> Net taxable income... $ 0 Method #2: Elect the maximum Section 79 expense available for the tax year. The amount disallowed because of the taxable income limit is reported as a Section 79 carryover in the following year. This method is beneficial if income increases enough in the next year to absorb most or all of the carried forward Section 79 expense. Example: Using method #2 for the above example, a Section 79 election is made for the entire $05,000 of the asset placed in service. Only $23,700 is deductible in 202. The remaining $8,300 ($05,000 $23,700) carries over and may be deductible as a Section 79 expense in 203, subject to the business taxable income and maximum deduction limits. Section 79 Recapture The tax benefit derived from a Section 79 election must be recaptured as ordinary income if business use of the property falls to 50% or less during its MACRS recovery period. The basis of the asset is increased by the recaptured amount, which is computed as follows: ) The amount originally deducted as Section 79 expense, 2) Minus: MACRS depreciation (from the year the property was placed in service through the current year) that would have been allowed on the portion of the asset for which the Section 79 deduction was claimed. U Caution: If the business use of listed property drops to 50% or less, do not figure recapture under these rules. Instead, use the rules for listed property at Depreciation Recapture on Page -5. Where to Report When the business use of an asset decreases to 50% or less, the Section 79 recapture amount is first entered on Form 4797, Part IV, column (a). This amount is then reported as income on the form where the deductions were originally claimed. Notes: If the expense was originally claimed on Schedule C or F, the recaptured amount is subject to SE tax. Recapture on Form 4797, Part IV, only applies when businessuse drops to 50% or less [IRC 280F(b)(2)] and may be subject to SE tax. Depreciation recapture [under Section 245(a)] triggered by the sale (or other dispositions) of Section 79 property before the end of its MACRS recovery period results in ordinary income, but not SE income. [Reg..79-(e)] 202 Tax Year 040 Quickfinder Handbook 0-

19 a) Exchanged basis recovery period: i) If the replacement property has the same or a shorter Leasehold Improvements recovery period than the relinquished property, use the Generally, any improvement to depreciable property has the remaining recovery period of the relinquished property. same recovery period and method as the improved property (but ii) If the replacement property has a longer recovery period than the relinquished property, use the remaining So an improvement to a commercial building [whether made by is treated as placed in service when the improvement is made). recovery period of the replacement property as if it had the lessor (landlord) or the lessee (tenant)] generally would be depreciated straight-line over 39 years. But, see Qualified leasehold originally been placed in service in the same taxable year as the relinquished property. improvement property below for special rules. b) Exchanged basis depreciation method: Lessee (tenant). Any remaining undepreciated basis is deductible i) If the replacement property has the same or a more accelerated depreciation method than the relinquished property, Lessor (landlord). The lessor can deduct the undepreciated basis by the lessee when the lease terminates. use the depreciation method of the relinquished property. of the improvement at the end of the lease term only if the actual ii) If the replacement property has a slower depreciation improvement is irrevocably disposed of or abandoned by the lessor method than the relinquished property, use the depreciation method of the replacement property as if it had at the termination of the lease. [IRC 68(i)(8)] originally been placed in service in the same taxable year as the relinquished property. Qualified Real Property 2) Excess basis is any excess of the basis in the replacement Qualified real property is any of the following: property over the exchanged basis (this is normally boot paid). Determine the recovery period and depreciation method for the Qualified leasehold improvement property. excess basis of the replacement property using the applicable Qualified restaurant property. recovery period and depreciation method for the property at the Qualified retail improvement property. time of the exchange. Section 79 deduction can be claimed. 202 is Expired Provision Alert: Qualified real property placed in service Electing out. Taxpayers may elect out of these depreciation rules in 20 was assigned a 5-year recovery period (SL depreciation required). It was also eligible for Section 79 expensing if placed in service for like-kind exchanges. Then, the exchanged basis and excess basis, if any, in the replacement property are treated as placed in is in a tax year beginning in 20. It s possible that Congress will extend service on the date acquired (or if later, the date the relinquished these provisions to 202, but had 202 not done so at the time of this publication. See Expired Tax Provisions on Page 7- for more information. property was given up) and the adjusted depreciable basis of the relinquished property is treated as being disposed of by the taxpayer Qualified leasehold improvement property. Qualified leasehold at the time of the exchange. The election must be made by the due improvement property is generally any improvement to an interior date (including extensions) of the tax return for the year of replacement, and is made by reporting the depreciation for the replacement part of a building that is nonresidential real property if: ) The improvement was made pursuant to a lease by the tenant, sub-tenant or the landlord to a part of the property to be property (computed as described above) in Part III of the Form Also, attach a statement indicating Election made under Section occupied exclusively by the tenant (or sub-tenant)..68(i)-6(i) for each property involved in the exchange. The election may be revoked only with the consent of the IRS. 2) The improvement is placed in service more than three years after the date the building was first placed in service (by any taxpayer). 3) The expenses are not for the enlargement of the building, any elevator or escalator, any structural components benefiting a Computer Software common area or the internal structural framework of the building. U Caution: Leases between related parties are not treated as leases for purposes of qualified leasehold improvement property [IRC 68(k)(3)]. Related parties include taxpayers and their spouses, parents, grandparents, children, grandchildren and siblings. Taxpayers are also considered related to certain entities that they own (directly or indirectly) 80% or more. Cost of purchased computer software: Software included in the purchase price of a computer (not separately stated) is added to the basis of the computer and depreciated over five years, or expensed under Section 79. Software readily available for purchase by the general public is depreciable as intangible property over 36 months using the SL method beginning with the month the software is placed in service [IRC 67(f)()]. Include depreciation on line 6 of Form 4562, as other depreciation. Can also claim special depreciation if all other requirements met. For tax years beginning after 2002 and before 203, off-the-shelf computer software is eligible for the Section 79 deduction. 204 Purchased software with a useful life of less than one year is deductible as a current expense. Cost of developing computer software: (Rev. Proc ) Deduct in accordance with the rules for research and experimental expenditures or Capitalize and amortize ratably over 60 months from the date development is completed or 36 months from the date the software is placed in service. Leased or licensed software. Deduct as a rental expense. Software included in purchase price of a trade or business. Amortize over 5 years beginning with the month acquired. (IRC 97) Replacement Page 0/203 If a landlord transfers ownership of qualified leasehold improvement property, the improvement will not be qualified property to any subsequent owner. (Exceptions exist for transfers because of death, corporate merger, formations of business entities where the taxpayer retains significant control, like-kind exchanges and involuntary conversions.) [IRC 68(e)(6)] Qualified restaurant property. This is any Section 250 property that is a building or an improvement to a building if more than 50% of the building s square footage is devoted to preparation of, and seating for on-premises consumption of, prepared meals. [IRC 68(e)(7)] Qualified retail improvement property. This is generally any improvement to an interior portion of a building that is nonresidential real property if: [IRC 68(e)(8)] ) Such portion is open to the general public and is used in the retail business of selling tangible personal property to the general public and Continued on the next page 202 Tax Year 040 Quickfinder Handbook 0-3

20 2) Such improvement is placed in service more than three years after the date the building was first placed in service. 3) The expenses are not for the enlargement of the building, any elevator or escalator, any structural components benefiting a common area or the internal structural framework of the building. If an owner transfers ownership of qualified retail improvement property, the improvement will not be qualified retail improvement property to any subsequent owner. (Exceptions exist for transfers because of death, corporate merger, formations of business entities where the taxpayer retains significant control, like-kind exchanges and involuntary conversions.) Qualified Real Property Special Rules (202) Qualified Leasehold Improvement Property Qualified Restaurant Property Qualified Retail Improvement Property MACRS recovery period Eligible for special (bonus) depreciation? No No Eligible for Section 79 deduction? Must be placed in service more than three years after building placed in service? No Must be made pursuant to a lease? No No Expired Provision Alert: For 20, the recovery period was 5 years (SL) and property was eligible for Section 79 expensing (heating and air conditioning units were not eligible). See Expired Tax Provisions on Page Exception: If property also meets the definition of qualified leasehold improvements, it qualifies for special depreciation allowance. 2 Heating and air conditioning units are not eligible. Correcting Depreciation Errors File Form 35, Application for Change in Accounting Method, to report depreciation changes that qualify as accounting method changes. Changes that are not accounting method changes are reported on amended returns. Depreciation corrections made on From 35. The treatment of an asset from nondepreciable to depreciable or vice versa. Change to the depreciation method, recovery period or convention of a MACRS asset. Changing from an incorrect to the correct amount of special (bonus) depreciation. Change from improperly expensing to capitalizing an asset. Depreciation corrections made on an amended return. Correcting mathematical or posting errors. A change in useful life (non-macrs assets). A change in salvage value (other than to zero). A change in the placed-in-service date. Note: Generally, an accounting method is not established until the taxpayer uses it for two consecutive tax years. Thus, an accounting method used on only one return would generally be corrected on an amended return. However, taxpayers can change a depreciation accounting method used on a single return either by filing an amended return or by filing a Form 35. (Rev. Proc. 20-4) Automatic permission for changing depreciation accounting method. The IRS grants automatic consent to certain accounting method changes, including changing from an impermissible to permissible method of computing depreciation (which enables taxpayers who have claimed less than the allowable amount of depreciation to catch up to the allowable amount). Form 35, Application for Change in Accounting Method, is filled out in duplicate. The original is attached to a timely filed tax return (including extensions) for the year of change. The copy is filed with the IRS in Ogden, UT, no later than the time when the tax return is filed. See Form 35 instructions (revised March 202) for mailing address. There is no user fee under this procedure. U Caution: Automatic permission is not given to change from expensing an item to capitalizing and depreciating it. A Section 48(a) adjustment is usually required when an accounting method is changed to ensure that income or expense items are not omitted or duplicated. It is calculated on Form 35. The 48(a) adjustment is then reported as income (or a deduction) on the tax return, starting in the year of change. A negative adjustment (depreciation in previous years was understated) is recognized in full that year. A positive adjustment (depreciation was overstated) is spread over four years. Exception: A positive adjustment less than $25,000 can be recognized in the year of change. Note: The Section 48(a) adjustment is computed for all prior tax years, not just those that are still open. (Rev. Proc. 20-4) Example: Brad purchased a rental duplex on January, 2009 for $250,000 (not including land). While preparing the 202 return, the preparer discovers that no depreciation had been claimed for the duplex on the previous three returns. Straight-line depreciation over 27.5 years for the years equals $26,894 ($9,09 per year with mid-month convention in 2009). A Form 35 to change the accounting method is attached to Brad s 202 Form 040. The negative Section 48(a) adjustment of $26,894 is reported on his Schedule E reporting income and deductions from the duplex. 202 depreciation of $9,09 is claimed on Form Intangible Assets Amortization Rules Certain intangible assets can be amortized over 5 years beginning in the month they are acquired, even if there is no way to determine their useful life. 5-year amortization applies to the following intangible assets that are purchased by a taxpayer (not self-created): (IRC 97) Goodwill. Going concern value. Workforce in place. Covenant not to compete entered into as part of purchasing a business. Copyrights and patents. Franchise, trademark, trade names. Information bases such as client files, customer lists and direct mail and telemarketing lists. Contracts with customers or suppliers (unless the contracts have a fixed duration and are nonrenewable). Computer software acquired in connection with the purchase of a business and not available to the general public. Purchased mortgage servicing rights (can be amortized over 08 months if they are not acquired in an acquisition of a trade or business). [IRC 67(f)(3)] End of Tab Tax Year 040 Quickfinder Handbook Replacement Page 0/203