1040 preparation and planning 9: standard deduction and

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1040 Preparation and Planning 9: Standard Deduction and Itemized Deductions (2021)

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1040 Preparation and Planning 9: Standard Deduction and Itemized Deductions (2021) Welcome

Welcome to 1040 Preparation and Planning 9: Standard Deduction and Itemized Deductions (2021). This course is developed by Wolters Kluwer in cooperation with Sidney Kess and Barbara Weltman. This course covers standard deduction amounts and itemized deductions.

Learning Objectives

Upon completing this course, you should be able to:

▪ List standard deduction amounts ▪ List which items can be deducted as medical expenses ▪ Identify which type of interest is deductible ▪ Determine which taxes are deductible ▪ Figure charitable contribution deductions and comply with substantiation

requirements ▪ Identify the rules for determining disaster losses ▪ Determine which miscellaneous itemized deductions are deductible in

2018 through 2025

Reference Material

IRS Forms and Publications

You will need Acrobat Reader to view or print the Portable Document Format (PDF) resources. If you need to install it, download the free plugin from Adobe's website.

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Forms

▪ Form 1040, U.S. Individual Income Tax Return ▪ Form 1040-SR, U.S. Tax Return for Seniors ▪ Form 1040 or 1040-SR Schedule A, Itemized Deductions ▪ Form 1098, Mortgage Interest Statement ▪ Form 4684, Casualties and Thefts ▪ Form 4952, Investment Interest Expense Deduction ▪ Form 8283, Noncash Charitable Contributions

Publication

▪ Publication 502, Medical and Dental Expenses (Including the Health Coverage Tax Credit)

▪ Publication 526, Charitable Contributions ▪ Publication 529, Miscellaneous Deductions ▪ Publication 547, Casualties, Disasters, and Thefts ▪ Publication 550, Investment Income and Expenses (Including Capital Gains

and Losses) ▪ Publication 907, Tax Highlights for Persons with Disabilities ▪ Publication 936, Home Mortgage Interest Deduction ▪ Publication 1771, Charitable Contributions: Substantiation and Disclosure

Requirements

Final versions of all 2020 tax forms, schedules, and other publications have not been released. We have used the most current versions available at the time this course was posted. Additional tax legislation, court decisions and IRS pronouncements could affect 2020 returns.

Standard Deduction

Individuals may elect to itemize their deductions or to take the standard deduction, whichever is greater (Code Sec. 63(c)(7)). The standard deduction amounts for 2020 are:

▪ Joint returns and surviving spouses: $24,800 ▪ Heads of household: $18,650 ▪ Singles: $12,400 ▪ Married persons filing separately: $12,400

https://www.irs.gov/pub/irs-dft/f1040--dft.pdf

f1040s.pdf

https://www.irs.gov/pub/irs-pdf/f1040sa.pdf

f1040s.pdf

https://www.irs.gov/pub/irs-pdf/f1098.pdf


https://www.irs.gov/pub/irs-pdf/f4952.pdf


https://www.irs.gov/pub/irs-pdf/p502.pdf




p550.pdf




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Pitfall Married taxpayers filing separate returns are ineligible to use the standard deduction if either spouse itemizes.

Taxpayers of Age 65 or Older There is an additional standard deduction amount for taxpayers who are of age 65 or older by the end of the year and/or blind.

For 2020, the additional amount is $1,650 for singles and heads-of-households, and $1,300 for married persons filing a joint or separate return, and for surviving spouses (Rev. Proc. 2019-44). Standard Deduction - Examples

Example 1 Jill Gregory is entitled to file a joint return with her husband, Howard Gregory. However, Howard elects to file a separate return for 2020 and itemizes his deductions.

Because he itemizes, Jill is not entitled to claim the standard deduction on her return, but she must also itemize her deductions, if she has any.

Example 2 In 2020, Jerry Gilbert, a single individual, age 55, who is blind (and does not own a home), can claim a standard deduction of $14,050 ($12,400 + $1,650). A married couple where one spouse is age 66 and the other is age 64 can claim a standard deduction of $26,100 ($24,800 + $1,300).

Standard Deduction for Dependents

A person who is viewed as a dependent on another taxpayer’s return is subject to special rules for the standard deduction, which depend on the dependent’s age and whether or not the dependent is blind.

For a dependent who is under age 65 and not blind, the standard deduction for 2020 is the greater of:

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1. $1,100, or 2. Earned income, plus $350 (but not more than the standard deduction for the

dependent’s filing status).

A dependent who is age 65 or older or blind has two parts to his or her standard deduction.

1. The standard deduction is the greater of $1,100, or earned income plus $350 (but not more than the standard deduction for the dependent’s filing status).

2. The dependent can add the additional standard deduction amounts for age and/or blindness.

Example In 2020, Melissa Stills, a single individual, age 17, is her parents’ dependent. She has earned income from a summer job of $2,200 and unearned income from investments of $600. Her standard deduction is $2,550 ($2,200 earned income plus $350); this is not more than the standard deduction for her filing status of $12,400.

Assume that Stills is 66, widowed in 2019 (not remarried), and a dependent of her adult son; she has the same income. In this case, as a single person over the age of 65, she can add $1,650 to her standard deduction, for a total standard deduction of $4,200.

Qualified Business Income Deduction

Another type of deduction from adjusted gross income is the qualified business

income (QBI) deduction (Code Sec. 199A). The deduction for owners of pass-through entities can be claimed whether the taxpayer uses the standard deduction or itemizes other personal deductions.

The qualified business income deduction is explained in 1040 Preparation and Planning 6: Business, Farm, and Rental Income and Expenses.

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Overview of Itemized Deductions

The tax law allows individuals to deduct certain costs if they forego the standard deduction and list the various itemized amounts. Itemized deductions are reported on Schedule A of Form 1040 or 1040-SR. They include:

▪ Medical expenses

▪ State and local taxes

▪ Interest payments

▪ Charitable contributions

▪ Casualty and theft losses in federally declared disasters

▪ Gambling losses

For 2018 through 2025, the deduction for miscellaneous itemized deductions subject to the 2%-of-adjusted-gross-income floor is suspended. This means that no deduction can be claimed for such costs as:

▪ Investment expenses

▪ Job-related expenses

▪ Hobby activity expenses

▪ Tax return preparation fees

Medical Expenses

Individuals are no longer required to have minimum essential coverage for themselves and their dependents (the penalty for failing to have such coverage was repealed for 2019 and beyond).

However, the government Marketplaces for health coverage are still in effect. Those who need financial assistance in paying the premiums because their household income is below a threshold amount may find it in the form of a federal premium tax credit for coverage obtained through a government Marketplace. The premium health credit is explained in 1040 Preparation and Planning 11: Tax Credits.

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Taxpayers who pay for their own coverage, as well as out-of-pocket medical expenses, may be able to deduct these costs.

Medical expenses not covered by insurance or other reimbursement (such as distributions from health flexible spending accounts or health savings accounts) can be deductible by a taxpayer who itemizes deductions (Code Sec. 213).

Generally, costs are deductible in the year in which they are paid.

Planning Pointer 1 Self-employed persons deduct health insurance for themselves, spouses, dependents, and children under age 27 as an adjustment to gross income (Code Sec. 162(l)(1)).

Planning Pointer 2 A taxpayer who charges a deductible medical expense to a credit card can deduct the payment in the year of the charge, rather than in the year in which the bill is paid. Thus, a taxpayer who buys prescription sunglasses on December 27, 2020, (assume this is not covered by insurance), and charges the cost can deduct the payment in 2020 even though she pays the credit card bill in 2021.

Which Medical Expenses are Deductible?

The expenses must have been paid in the tax year, regardless of when the expenses were incurred. The Internal Revenue Code defines medical expenses as amounts paid for "the diagnosis, cure, mitigation, treatment, prevention of disease, or for the purpose of affecting any structure or function of the body.“

The cost of cosmetic surgery generally is not deductible.

This bar does not apply to cosmetic surgery necessary to ameliorate a deformity arising from, or directly related to a:

▪ Congenital abnormality ▪ Personal injury resulting from an accident or trauma ▪ Disfiguring disease

Deductible medical expenses also include expenditures incurred for transportation primarily for, and essential to, medical care.

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Unreimbursed long-term care services are treated as deductible medical expenses.

Long-term care services include necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, and rehabilitative services, and maintenance or personal care services required by a “chronically ill individual” (defined further) and provided under a plan of care prescribed by a licensed health care practitioner.

A chronically ill individual is someone certified by a licensed health care practitioner within the prior 12 months as one of the following (Code Sec. 7702B(c)(2)):

▪ Being unable to perform without substantial help from another individual at least two activities of daily living (eating, toileting, transferring, bathing, dressing, and continence) for a period of at least 90 days due to a loss of functional capacity.

▪ Having a similar level of disability according to regulations prescribed by the Secretary in consultation with the Secretary of Health and Human Services to the level of disability described above, or

▪ Requiring substantial supervision to protect the person due to severe cognitive impairment.

The costs of hospitalization and premiums for medical insurance are deductible. The cost of life insurance is not deductible.

The cost of attending special schools or institutions for the mentally or physically handicapped is deductible if the resources of the institution for alleviating the handicap are the principal reasons for attending the school.

Thus, amounts paid (including payments for board and lodging) for a blind child to attend a school where Braille is taught, or for a deaf child to attend a school for the teaching of lip-reading, are deductible.

Special Equipment. Purchase or installation of special equipment or devices of a medical nature or for medical purposes (e.g., ramps or railings to accommodate a handicap) is deductible, even though the equipment or devices acquired are of a capital nature.

https://www.law.cornell.edu/definitions/uscode.php?width=840&height=800&iframe=true&def_id=26-USC-1264422296-1293213338&term_occur=3473&term_src=title:26:subtitle:F:chapter:79:section:7702B

https://www.law.cornell.edu/definitions/uscode.php?width=840&height=800&iframe=true&def_id=26-USC-1264422296-1293213338&term_occur=3474&term_src=title:26:subtitle:F:chapter:79:section:7702B

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However, if the equipment or installation increases the value of the taxpayer’s home, the deduction is reduced by the amount of the increase.

Thus, for instance, the cost of central air conditioners or elevators, installed for medical reasons, is deductible, but only to the extent that the items do not add to the permanent value of the house.

A medically dictated improvement can generate annual medical deductions. To illustrate: operating costs during the year are $125 for electricity to operate the elevator and $50 for maintenance. This $175 cost is a medical expense.

The rule is that if the improvement is a medical expense, so are annual outlays for operation and maintenance. Furthermore, the entire amount of these yearly expenses qualifies, even though none or only part of the original cost of the improvement gave rise to a medical deduction.

Example On his physician’s advice, Bob Lynn, a heart patient, installs a home elevator at a cost of $2,500. A qualified appraisal indicates that the elevator increases the value of the home by about $1,000. Bob can take a medical expense deduction of $1,500. Qualifying Medical Expenses The following items qualify as deductible medical expenses, including:

▪ Fees to doctors, osteopathic doctors, dentists, chiropractors, oculists, podiatrists, psychologists, physical therapists, acupuncturists, and Christian Science practitioners

▪ Hospital, nursing, and laboratory fees ▪ X-rays and therapy treatments ▪ Cost and maintenance of eyeglasses and contact lenses; hearing aids;

artificial teeth and limbs; braces, canes, walkers, and crutches; wheelchairs; and oxygen equipment

▪ Seeing-eye dogs and other service animals to assist a visually impaired or hearing disabled person, or a person with other physical disabilities (including food, grooming, and veterinary care)

▪ Braille books ▪ Orthopedic shoes in excess of the cost of normal shoes ▪ The cost of stop-smoking programs (but not over-the-counter treatments

such as nicotine gum) ▪ The cost of weight-loss programs to treat obesity or other health condition

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▪ The cost of gender-reassignment surgery ▪ Organ donor expenses for surgery, hospital stay, lab fees, and transportation ▪ Lactation equipment ▪ Legal fees to obtain guardianship over a mental patient who has refused to

accept therapy voluntarily ▪ Expenses incurred for radial keratotomy (i.e., eye surgery to correct

nearsightedness) ▪ Telehealth services

Non-qualifying Medical Expenses The following items do not qualify as itemized medical expenses, including: ▪ Over-the-counter medications and supplements (even though these are

qualified medical expenses for purposes of reimbursements from FSAs, HRAs, HSAs).

▪ Menstrual products (even though these are qualified medical expenses for purposes of reimbursements from FSAs, HRAs, HSAs).

▪ Prescription drugs obtained from Canada or other foreign countries (This item is not included in Publication 502)

▪ Funeral and cemetery expenses ▪ Cost of meals and lodging received by an aged person in an old-age home

(except that portion of the cost representing medical and nursing care) ▪ Maternity clothing ▪ Swimming lessons ▪ Dancing lessons ▪ Flexible Spending Account contributions ▪ Diaper service and infant formula ▪ Cost of caring for children while their parent is sick or recovering from an

illness ▪ Amounts paid for the preservation of the taxpayer’s general health, such as

for health clubs, steam baths, and vacations ▪ Cost of a housekeeper, unless a portion of her time is devoted to nursing

services, in which case a proportionate part of the expense is deductible ▪ Illegal operations or illegal treatment ▪ Social activities (e.g., dancing lessons or swimming lessons) for the general

improvement of health ▪ Cosmetic surgery that is not medically necessary ▪ Marijuana (even if medically prescribed and legal in the taxpayer’s state)

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▪ In vitro fertilization paid by a healthy male who wants a child through a female surrogate (Morrissey, DC FL, 2017-1 USTC ¶50,140; aff’d CA-11, 9/25/17)

Medical Transportation Expenses If a taxpayer incurs transportation expenses primarily for and essential to obtaining medical care, these qualify as a medical deduction. ▪ This includes not only the patient’s transportation expenses but also, where

necessary, the expenses incurred by accompanying persons, such as nurses or parents of a child too young to travel alone.

▪ However, the taxpayer should be able to prove that the trip was made on the physician’s advice for the treatment or mitigation of a specific disease or condition, and not merely for a change in environment or general improvement of health.

▪ Thus, a person suffering from a heart ailment was not allowed to deduct the cost of traveling to Florida for the winter.

▪ If taxpayers use their own autos for medical purposes, they can either deduct the actual cost of gas and oil (but not depreciation or insurance) or take a flat mileage allowance of 17¢ per mile for 2020 (down from 20¢ per mile in 2019).

▪ Expenses incurred for tolls and parking fees are separately deductible.

Meals and Lodging Payment for meals and lodging furnished by a hospital or similar institution, as a necessary incident to medical care, is a medical expense if the patient’s condition is such that the availability of medical care is the principal reason for the patient’s presence there.

Amounts paid for lodging (but not meals) while away from home primarily for and essential to medical care provided by a doctor in a licensed hospital, including a medical care facility, will qualify for a medical expense deduction.

The amount is limited to $50 per night per individual.

Thus, for example, if the away-from-home lodging expenses for a child being treated at a medical care facility qualify as medical expenses, so too would the lodging expenses of a parent who accompanies that child.

The $50 per night would apply separately to each of them.

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When an individual is in a nursing or old-age home to receive treatment for a mental or physical condition, the entire cost of maintenance, including meals and lodging, is deductible. On the other hand, if an individual is in a home primarily for custodial purposes, only that portion of the maintenance cost attributable to medical or nursing care is deductible.

Although the cost of transportation incurred for medical reasons is deductible, the cost of meals while away from home for medical treatment or for the alleviation of a specific condition is not, even if the trip was made on a physician’s advice.

If a taxpayer with a severe heart ailment spends every winter in Florida at his doctor’s insistence, the taxpayer’s transportation to and from Florida is deductible. The taxpayer’s living expenses en route or while there are not deductible.

Medicines and Drugs Amounts paid for prescription medicines and for insulin are included in medical expenses.

Over-the-counter drugs, vitamins, iron, and other food supplements are not deductible, even if ordered by a doctor.

Limitations on the Medical Expense Deduction

AGI floor In general, medical expenses are deductible in 2020 only to the extent that they exceed 7.5% of the taxpayer’s adjusted gross income. This percentage applies regardless of the taxpayer’s age. Note that a 10%-of-AGI threshold was supposed to apply for 2019 and 2020, but was changed by Congress to 7.5% of AGI. The threshold is scheduled to increase to 10% of AGI in 2021 unless again changed by Congress.

Example Jim Gray’s adjusted gross income in 2020 is $28,000. His costs for prescription medicine and drugs were $1,300, and his costs for other medical expenses were $2,600.

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If he itemizes his personal deductions, he can deduct medical expenses of $1,800 on Schedule A of Form 1040 ($3,900 medical expenses less 7.5% of adjusted gross income, or $2,100).

The "Medical and Dental Expenses" section of Schedule A prompts taxpayers to take into account the 7.5%-of-AGI limitation.

Whose Medical Expenses are Deductible? A taxpayer can deduct medical expenses for him/herself, spouse, and dependents.

Planning Pointer A child of divorced parents who is subject to the special dependency exemption rules (even though no dependency exemption can be claimed) is treated as the dependent of both spouses for purposes of the rules relating to medical expenses and medical reimbursements.

Thus, the spouse who would not be entitled to the exemption (if the dependency exemption were not suspended for 2018 through 2025) for a child may nevertheless claim a deduction for medical expenses paid by him or her for that child.

A taxpayer may also deduct medical expenses paid for a parent.

The taxpayer must pay more than half of the parent’s support and would otherwise be barred from claiming a dependency exemption if the dependency exemption were not suspended for 2018 through 2025 only because the parent’s gross income exceeds a threshold amount ($4,300 in 2020).

Example 1 Helen Adams, who is suffering from Parkinson’s Disease, lives with her adult daughter June.

June pays more than half of Helen’s support, including medical expenses of $11,246 that are not covered by insurance.

Helen’s gross income is $6,800 so Helen would not have been june’s dependent. June can treat the $11,246 in medical expenses as her own in figuring her itemized medical deduction.

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Married couples may find it beneficial to file separate returns in order to claim a larger medical deduction.

Example 2 Sidney Green, age 47, during the year, paid the following unreimbursed medical and dental expenses: $2,110 for himself; $800 for his wife, Evelyn, age 46; $350 for his child; and $2,450 for his mother (who qualifies as Sidney’s dependent).

Sidney and his wife file a joint return on which they report adjusted gross income of $50,000.

On Schedule A, Sidney can deduct $1,960 ($5,710 of medical expenses minus $3,750 [7.5% of AGI]).

Example 3 Assume that Sidney and Evelyn Green, in the previous example, file separate returns instead of a joint return.

Sidney’s adjusted gross income is $22,000, and he treats his child and mother as his dependents. Evelyn’s adjusted gross income is $28,000. The medical deduction of each will be computed as follows:

Sidney's Return:

Sidney's, his child's and his mother's medical expenses ($1,110 + $350 + $2,450)

$3,910

Less: 7.5% of AGI 1,650

Total medical deduction on Sidney's return $2,260

Evelyn's Return:

Evelyn's medical and dental expenses 800

Less: 7.5% of AGI 2,100

Total medical deduction on Evelyn's return $0

Total medical deductions on separate returns $2,260

Total deduction on joint return $1,960

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Pitfall The fact that separate returns will yield a greater medical deduction does not necessarily mean that they will result in less tax.

A joint return, because of lower tax rates, may still produce a lower tax. Therefore, the only way one can be certain of filing the most advantageous return in such a situation is by computing the actual tax liability both separately and jointly.

It should be understood that the 7.5%-of-AGI reduction is taken only once on each return, regardless of the number of individuals for whom a medical deduction is claimed.

Medical Insurance Premiums. The cost of hospitalization and medical insurance (including Medicare Part B, Part C, and Part D) is deductible as a medical expense.

If the taxpayer is not covered under Social Security (or was not a government employee who paid Medicare tax) and is age 65 or older, the taxpayer can voluntarily enroll in Medicare A. In this situation the taxpayer can include the premiums paid for Medicare A as a medical expense.

Planning Pointer Self-employed individuals can deduct their health insurance premiums as an adjustment to gross income. This is explained in 1040 Preparation and Planning 8: Adjustments to Gross Income.

The cost of accident and health insurance policies may be partly deductible.

Such policies typically provide for reimbursement not only of hospitalization, doctors’ bills, and other medical expenses but also for loss of earnings and for loss of life, sight, or limbs.

Because only the medical expense portion of the premiums is deductible, a deduction can be claimed only if the insurance company clearly allocates what portion of the premium is for medical or other nonmedical benefits.

If such an allocation is made, the medical portion is deductible; if no allocation is made by the company, no part of the premium is deductible.

Examples of other deductible medical insurance premiums include:

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▪ Contact lens replacement insurance ▪ Medigap (supplemental Medicare insurance) ▪ Student health fee

Long-term Care Insurance Long-term care insurance is a type of coverage that provides payments for costs usually related to chronic conditions that are not covered by regular coverage or Medicare.

The cost of long-term care insurance is treated as medical coverage for purposes of deducting health insurance premiums.

However, the deductible portion in 2020 is subject to the following limitation based on the taxpayer’s age:

Age Before the Close of the Tax Year

Limitation

40 or under $430

More than 40-50 $810

More than 50-60 $1,630

More than 60-70 $4,350

Over 70 $5,430

Planning Pointer States may provide other tax breaks for long-term care insurance for state income tax purposes, such as a full deduction regardless of age or a tax credit.

Reimbursement of Medical Expenses The total medical expense deduction for the year must be reduced by any reimbursement received from insurance or other sources during the year, including basic Medicare benefits and supplementary Medicare benefits, whether paid directly to the taxpayer or to the provider of the services.

However, amounts received for loss of earnings or damages for injuries are not considered as reimbursements.

Example

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Seth Myer’s total medical expenses for the year came to $1,600. He is 32 years old. His insurance company paid him $1,125 for doctor bills and $700 for loss of earnings while he was ill. His total deductible medical expenses for the year (before the 7.5% floor for 2020) are $475 ($1,600 – $1,125).

The reimbursement for loss of earnings is disregarded for calculating the medical expense deduction.

If, as often happens, medical expenses are paid in one year but reimbursement is not received until a later year, the expenses are deductible in the year paid.

However, the reimbursement must be included in gross income in the year received if the medical deduction was taken.

Such income is reported as “other income” on Schedule 1 of Form 1040 or 1040-SR.

If no medical expense deduction was taken in a previous year, the reimbursement is tax-free and need not be reported on the return.

If a reimbursement from insurance exceeds the total medical expenses, the excess reimbursement may or may not be taxable, depending on who paid for the policy.

▪ If the taxpayer paid the premiums for the insurance policy, the excess reimbursement is tax-free and need not be included in gross income.

▪ If the taxpayer’s employer paid the premiums, the excess reimbursement is taxable.

If both the taxpayer and the employer paid the premiums, the excess reimbursement is taxable in the same proportion as the premium payment.

Thus, when the employer and the employee each pay half of the premium, one-half of the excess reimbursement is taxable.

Rebates of insurance premiums because of the medical loss ratio are taxable according to the “tax benefit rule.”

This means that if a taxpayer claimed the standard deduction in the year in which the premiums were paid, the rebate in the following year is not taxable.

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If the taxpayer deducted the premiums, the rebate is taxable to the extent the write-off produced a tax benefit.

Medical Expenses of a Decedent

Expenses paid from a decedent’s estate for his medical care are treated as paid by the decedent in the year incurred if they are paid within one year after the decedent’s death and are not deducted in computing his taxable estate for federal estate tax purposes.

Example John Smith, who filed his return on a calendar-year basis, died on June 1, 2020, after having incurred $8,000 in medical expenses. $5,000 of that amount was incurred during 2019, and the balance of $3,000 was incurred in 2020. John’s executor paid off the entire $8,000 liability in August 2020. The executor may file an amended return for 2019 claiming the $5,000 in medical expenses as a deduction, thus securing a refund resulting from the increase in the decedent’s 2019 deductions.

The $3,000 of expenses incurred in 2020 may be deducted on the decedent’s final income tax return.

Planning Pointer If an estate is not subject to federal estate tax (the estate tax exemption for a decedent dying in 2020 is $11.59 million), there is no need to waive the right to deduct medical expenses for estate tax purposes in order to deduct them on the decedent’s final income tax return.

For estates of decedents subject to estate tax, the executor must weigh the tax savings on the income tax return against that on the estate tax return.

Remember that there is no AGI limit on medical expenses deducted on an estate tax return, but the top estate tax rate is 40% versus the top individual income tax rate of 37%.

Waiver of Estate Tax Deduction A copy of a waiver of the estate tax deduction follows:

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Note (To Be Filed with Form 1040 IN DUPLICATE) Name ___________________________________ I.D. # _____ Address _________________________________ City-State ______________________________ Year ________ WAIVER OF ESTATE TAX DEDUCTION Pursuant to Section 213(c) of the Internal Revenue Code of 1986, the fiduciary states that, to the best of his/her knowledge and belief, medical expenses amounting to $__________ claimed as a deduction on the attached return have not been allowed as a deduction under Section 2053 of the Code in computing the taxable estate for the purpose of the estate tax imposed by Section 2001 of said Code. The fiduciary hereby waives any and all right to have the foregoing item allowed at any time as a deduction under Section 2053.

Study Question

When itemizing deductions, medical expenses are deductible to the extent that they exceed what percentage of AGI for someone age 54 in 2020?

• 2.0%

• 7.5%

• 10%

• 20%

Taxes

Certain personal taxes are deductible only as itemized deductions (Code Secs. 164(b)(6) and 275).

Unless expressly made nondeductible, foreign, state, and local taxes incurred in the operation of a business or charged against property used in business are

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deducted from gross income together with other business deductions on Schedule C (or Schedule F, for farmers).

If the above taxes are incurred as to operating and maintaining property producing rents and royalties, they may be deducted on Schedule E, Form 1040 or 1040-SR.

The same taxes are also deductible if they were paid (or accrued) as to other income-producing activities or property, but only as a deduction from adjusted gross income, if the itemized method is used.

They are deducted on Schedule A of Form 1040 or 1040-SR. Federal income taxes, however, are never deductible and will qualify neither as a business expense nor as a personal deduction.

Planning Pointer Foreign taxes can be deducted as an itemized deduction or claimed as a tax credit. Limit on SALT Taxes For 2018 through 2025, there is an overall cap on the deduction for state and local taxes (SALT). These include state and local income or sales taxes plus real estate taxes (these taxes are discussed later). The limit is $10,000 ($5,000 for married persons filing separate returns).

Note: Some states have enacted or are considering work-arounds to enable their residents to benefit tax-wise from state and local taxes. The IRS has issued regulations essentially shutting down certain work-arounds, as explained later in this program under Charitable Contributions. However, other states have different workarounds for owners of pass-through entities, which have yet to be ruled on by the IRS. Deductible Personal Taxes The following personal taxes are deductible from adjusted gross income: ▪ State and local income taxes or state and local sales taxes (the taxpayer

must choose which type of taxes to deduct), subject to the overall cap on SALT.

▪ Foreign income taxes

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Planning Pointer Instead of claiming an itemized deduction for foreign taxes, a foreign tax credit may be allowed. This credit is discussed in 1040 Preparation and Planning 11: Tax Credits.

▪ State, local, and foreign real estate and personal property taxes (subject

to the overall cap on SALT) ▪ State stamp and documentary taxes (in connection with income-

producing property only)

Also deductible are employee contributions to state disability or unemployment funds in California, New Jersey, New York, Rhode Island, and West Virginia and mandatory state family leave programs in California and New Jersey (subject to the overall cap on SALT).

Sales Taxes. Individuals can claim an itemized deduction for state and local general sales taxes if they do not claim an itemized deduction for state and local income tax (subject to the overall cap on SALT).

The amount of the state and local general sales tax deduction is based on the state of residence, income range, and number of people in the household.

The deduction is taken from an IRS table.

To this amount is added any sales tax paid on big-ticket items, such as a car, boat, or mobile home.

Those who live in more than one state during the year are required to allocate the deduction amount in the table according to the number of days in each state.

State and Local Income Taxes A common error made in preparing returns relates to the deduction for state income taxes. The amount of state and local taxes withheld is frequently overlooked, or the incorrect state estimated income tax paid is used in determining the state income tax deduction.

Example

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For 2020, a taxpayer deducts state income taxes withheld, plus any state

estimated taxes paid in 2020, plus the additional state income tax on 2019

income paid in 2020, plus any deficiencies for prior years paid in 2020 (subject to

the overall cap).

Tax Refunds Taxpayers who received a refund may or may not receive Form 1099-G showing the amount. If the taxpayer did not itemize in the year in which the taxes were paid, then the full refund is automatically tax-free.

If the taxpayer did itemize, the refund may be partially or fully taxable under the tax benefit rule (Code Sec. 111). Under the tax benefit rule, only the portion of the refund that provided a benefit is includible in gross income. Because of the SALT cap, determining the tax benefit from a refund is more complicated. The following examples are adapted from Rev. Rul. 2019-11 (assume in all the examples that the taxpayer is single):

Example: State income tax refund fully includable In 2019, a taxpayer paid local real property taxes of $4,000 and state income taxes of $5,000. In 2020, he receives a $1,500 refund of state income taxes paid in 2019. Had he paid the correct amount, his deduction would have been reduced from $9,000 to $7,500 and as a result, his itemized deductions would have been reduced from $14,000 to $12,500, a difference of $1,500. So he received a tax benefit from the overpayment of $1,500 in state income tax in 2019 and is required to include the entire $1,500 state income tax refund in his gross income in 2020.

Example: State income tax refund not includable In 2019, a taxpayer paid local property taxes of $5,000 and state income taxes of $7,000. In 2020, she receives a $750 refund of state income taxes paid in 2019. Had she paid only the proper amount of state income tax in 2019, her state and local tax deduction would have remained the same ($10,000) and her itemized deductions would have remained the same ($15,000). She received no tax benefit from the overpayment of $750 in state income tax in 2019, so she is not required to include the $750 state income tax refund in her gross income in 2020.

Example: State income tax refund partially includable In 2019, a taxpayer paid local property taxes of $5,000 and state income taxes of $6,000. In 2020, he receives a $1,500 refund of state income taxes paid in 2019. Had he paid only the proper amount of state income tax in 2019, his state and

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local tax deduction would have been reduced from $10,000 to $9,500 and as a result, his itemized deductions would have been reduced from $15,000 to $14,500, a difference of $500. He received a tax benefit from $500 of the overpayment of state income tax in 2019, so he is required to include $500 of the state income tax refund in his gross income in 2020.

If some or all of the refund is taxable, it is reported on the 2020 return on Schedule 1 of Form 1040 or 1040-SR. No amended return for the prior year is required.

Planning Pointer If a refund of state income tax is reported as income on the 2020 return, it is treated as a reduction to income for alternative minimum tax purposes.

Personal Property Taxes State and local (but not foreign) personal property taxes are deductible if they are ad valorem (i.e., based on the value of the personal property).

Example Iowa imposes a motor vehicle registration tax of 1% of the value of the vehicle, plus 40¢ per hundredweight.

A taxpayer’s automobile is valued at $2,000 and weighs 3,500 pounds, and he therefore pays an annual registration tax to Iowa of $34 (1% of $2,000 = $20, + 35 x $.40 = $14).

The $20 portion, which is based on the value, is deductible. The balance, which is based on the auto’s weight, is not deductible unless incurred in connection with the taxpayer’s trade, business, or other income-producing activities.

Not all personal property taxes are deductible.

Nondeductible personal property taxes are: ▪ Federal personal property taxes ▪ State and local personal property taxes incurred for income-producing

activities

Moreover, state and local levies are deductible only if they are classified as a tax, not as regulatory or service fees. Thus, charges for government services, such as water and sewers, are not a true tax, but merely payment for services rendered.

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As such, they are not deductible. (These charges, of course, will be deductible if they qualify as business expenses.)

Real Estate Taxes Taxes on a home or vacation property generally are deductible as an itemized deduction (subject to the overall cap on SALT). There is no restriction on the number of homes for which real estate taxes can be deductible. Deductible real estate taxes generally do not include taxes charged for local benefits and improvements that increase the value of the property. They also do not include taxes for local benefits, itemized charges for services (such as trash and garbage pickup fees) assessed against specific property or certain people, transfer fees (or stamp taxes), rent increases due to higher real estate taxes, or homeowners’ association charges, even if the charge is paid to the taxing authority.

For example, a fire prevention fee imposed by California law (CCA 201310029) on every structure is not a deductible tax (Letter Ruling 201310029).

If real estate is sold, the deduction for real estate taxes must be apportioned between the buyer and the seller regardless of who actually pays the taxes, according to the number of days in the real property tax year that each held the property. The taxes are apportioned to the seller up to the date of sale and to the buyer beginning with the date of sale.

A settlement statement usually reflects the apportionment. If the buyer pays delinquent back taxes imposed upon the seller, such payments may not be deducted by the buyer but must be added to the cost of the property.

Planning Pointer The closing statement for the sale generally lists the apportionment of taxes.

Nondeductible Taxes Deductible taxes in excess of the overall cap on SALT are not deductible in the current year, and they cannot be carried over to become deductible in a future year. In addition, state and local cigarette, tobacco, gasoline, and alcoholic beverage taxes are not deductible. None of the following items are deductible: ▪ Federal income taxes (including income taxes withheld from pay).

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▪ Employment taxes, including Social Security and Medicare (FICA) and Railroad Retirement taxes paid by the employee

▪ Additional Medicare taxes on earned income and Net Investment Income (NII)

▪ Federal and state estate, inheritance, and gift taxes. However, the recipient of income in respect of a decedent (IRD) that includes it in gross income can deduct federal estate tax attributable to the IRD.

▪ Motor vehicle registration fees except the amount based on the value of the vehicle

▪ Dog tag fees, hunting and fishing licenses, driver’s license fees, federal excise and stamp taxes, and customs duty, unless any of these are incurred as expenses in carrying on a trade or business

▪ Per capita taxes ▪ Foreign taxes on income earned by U.S. citizens and U.S. resident aliens who

qualify for the foreign earned income exclusion ▪ Passport fees ▪ Penalties assessed as taxes

The portion of Social Security and Medicare taxes (FICA) paid by the employer is deductible as a business expense. Federal unemployment insurance (FUTA) is paid by the employer and is, therefore, deductible by the employer. Self-employed individuals can deduct the so-called “employer portion” of Social Security and Medicare taxes, but not the additional Medicare tax which has no “employer portion” as an adjustment to gross income (not as a business expense). If they elect to defer the employer portion of Social Security taxes for 2020, they can only deduct the employer portion of Medicare taxes on 2020 returns. Then 50% of the deferred employer portion of Social Security taxes will be paid in 2021 and added to the deduction on that return, while the other 50% will be paid in and deducted on the 2022 return. Contributions to state unemployment insurance funds are deductible by employers and (in states requiring employee contributions) by the employees. Who May Deduct Taxes? All taxes are deductible only by the person on whom they are imposed.

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Thus, taxes paid by a parent on a child’s property are deductible neither by the parent (they were not the parent’s obligation) nor by the child (because the child did not pay them). Of course, a parent can give the child the money for the taxes so that the child can take the deduction.

Planning Pointer A third party who pays property taxes and wants to claim the deduction but has no legal obligation for the payment can claim the deduction if he or she can show there is beneficial ownership. This means proving that the taxpayer has assumed the benefits and burdens of ownership, even though he or she lacks legal title to the property. Factors used in determining this include whether the taxpayer: 1. Has the right to possess the property and to enjoy its use, rents, or profits 2. Has a duty to maintain the property 3. Is responsible for insuring the property 4. Bears the property’s risk of loss 5. Is obligated to pay the property’s taxes, assessments, or charges 6. Has the right to improve the property without the owner’s consent 7. Has the right to obtain legal title at any time by paying the balance of the

purchase price Tax Payment by a Tenant If taxes are paid by a tenant, as part of the rental arrangement, for his or her landlord on business property, they will be deductible by the tenant, not as a tax expense, but as additional rent (provided that the rent is a deductible business expense). Then the tax would be deductible by the landlord. Tenant-stockholders in a cooperative apartment house or home development can deduct a pro rata portion of their carrying charges as real property taxes. Foreign Income Taxes A taxpayer who has reportable income from foreign sources on which income taxes to a foreign country have been paid may claim a credit (Code Sec. 901).

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Instead of claiming the foreign tax credit on Form 1116, a taxpayer may elect to deduct the amount of such taxes on Schedule A along with his or her other itemized deductions. The deduction for foreign income taxes is not subject to the SALT cap.

Planning Pointer Individuals who are subject to the alternative minimum tax should consider claiming the foreign tax credit rather than deducting such expenses. This is because the deduction will reduce regular income taxes, thereby increasing alternative minimum tax, whereas the foreign tax credit can be used to reduce the alternative minimum tax.

Study Question

Which of the following taxes is subject to the SALT cap:

• Foreign taxes

• Real estate taxes on a principal residence

• Additional Medicare tax on net investment income

• FICA taxes

Interest Payments

A taxpayer may deduct interest paid (if on the cash basis) or accrued (if on the accrual basis) on a debt, provided that he or she is legally obligated to pay the debt and there is no tax rule specifically limiting or barring the deduction (Code Sec. 163). Interest paid on another person’s debt is not deductible by the person who paid it because that person had no legal obligation to do so; the payment is treated as a gift to the debtor and is not deductible in this case by either party.

Example Elliot Anderson’s brother Steve owned a home. Because Steve was in financial difficulties, Elliott made the mortgage payment. No deduction is allowed to either Elliott or Steve.

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Steve did not make the payment and Elliott, who made the payment, had no legal liability to do so.

Planning Pointer In the previous example, Elliott should make a gift to his brother. If Steve then pays the interest, he can claim a deduction. The same is true where spouses file separate returns and one spouse pays interest on the other’s indebtedness. No deduction is allowed for personal interest paid during the year (other than home mortgage interest subject to limits explained below and student loan interest within limits described in Preparation and Planning 8). Personal interest includes interest paid on car loans, credit cards, life insurance policy loans, and other personal loans. Pitfall Interest on loans from 401(k) plans generally is nondeductible. Interest on tax deficiencies generally is treated as nondeductible personal interest. This includes interest on tax deficiencies related to Schedules C, E, or F. Mortgage interest on a principal residence or second home is not subject to the personal interest limitation where the interest on the loan is treated as “qualified residence interest” (discussed below). Investment interest is deductible, subject to limitation. The amount of investment interest that is currently deductible cannot exceed the amount of investment income for the year. Investment interest in excess of investment income for any given year is carried over into the next tax year.

Planning Pointer Interest on student loans, which is personal interest, is deductible as an adjustment to gross income.

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Limitations apply, as explained in 1040 Preparation and Planning 8: Adjustments to Gross Income. Interest incurred to acquire an interest in a passive activity is subject to the passive loss limitation rules. The character of interest—as business interest, personal interest, investment interest, or passive activity interest—is determined by how loan proceeds are used and not by the type of collateral used for the loan. Generally, the character of the interest is established by “tracing” the use of the loan proceeds. Where to Deduct Interest Interest, like taxes, may be deductible from gross income or from adjusted gross income. If the interest paid is in connection with a taxpayer's business, rental property, or traveling expenses (such as interest payments on automobiles used for business travel), it is an above-the-line deduction and, therefore, deductible from gross income in computing adjusted gross income. If the interest is paid in connection with nonbusiness activities, such as investment properties or on home loans, it is a deduction from adjusted gross income if personal deductions are itemized. Whether the interest is a business or a nonbusiness expense depends on the use of the money borrowed, not on the kind of property used to secure the loan. The character of the interest is established by “tracing” the use of the loan proceeds. Interest on loans used to buy merchandise is deducted from gross income (on Schedule C), even though the loan was secured by a mortgage on the taxpayer's private residence. Schedule A is used for claiming interest deductible from adjusted gross income. Mortgage Interest

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Monthly mortgage payments normally consist of both interest and repayment of the loan principal. However, only the interest portion is deductible; payments of principal are not deductible. For 2018 through 2025, special tax rules apply. Acquisition Indebtedness For loans obtained to buy, build, or substantially improve a residence (“acquisition indebtedness”) obtained before December 16, 2017, interest is deductible on loans up to $1 million ($500,000 for married persons filing separately). For loans obtained after December 15, 2017, interest is deductible on loans up to $750,000 ($375,000 for married persons filing separately). The $1 million dollar (or $750,000) limit applies for a couple filing jointly and for each non-married co-owner (Voss, 2015-2 USTC ¶50,427, CA-9, acq. AOD 2016-02). A married person filing separately is limited to $500,000 (or $375,000) even if the other spouse does not own a home or claim a mortgage interest deduction (Bronstein, 138 TC 382 (2012)). Home Equity Loans No deduction is allowed for interest on a home equity loan, regardless of when the loan originated. However, if the funds are used to substantially improve a residence secured by the loan, then the loan is treated as acquisition indebtedness, and the interest is deductible up the limits discussed above (IR-2018-32, 2/21/2018). The deduction for mortgage interest is limited to a principal residence and one other residence (e.g., a vacation home) designated annually by the taxpayer. Planning Pointer 1 Homeowners participating in the Hardest Hit Fund (HHF) program can use a safe harbor to allocate payments and deduct the lesser of (1) all payments on the home mortgage actually made to the mortgage servicer to the State Housing Finance Agency (HFA), or (2) the sum of amounts shown on Form 1098 for mortgage interest received, real property taxes, and mortgage insurance premiums (Notice 2017-40). Alternatively, they can allocate amounts first to mortgage interest up to the amount shown on Form 1098, and then use any

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reasonable method to make further allocations to real estate taxes, home insurance premiums, etc. (Notice 2018-63). Banks and savings and loan associations usually furnish a statement (Form 1098, Mortgage Interest Statement) for the year-end, showing the total amount of interest paid (Code Secs. 163 and 461(g)).

Planning Pointer 2 Form 1098, Mortgage Interest Statement, contains not only the usual information about the amount of mortgage interest paid, but also the mortgage origination date, the amount of the outstanding principal on the mortgage as of the beginning of the calendar year, and the address of the property securing the mortgage. This information effectively enables the IRS to deny mortgage interest deductions on loans exceeding the dollar limits for acquisition indebtedness explained later. Homeowners deducting interest on seller-financed mortgages must report the seller’s taxpayer identification number. Points Points are paid to a lender to reduce the interest rate. One point is equal to 1% of the mortgage amount (i.e., $1,000 for every $100,000 borrowed). Points paid to banks and other financial institutions in order to obtain a mortgage to buy, build, or substantially improve a principal residence are deductible as interest in the year paid (unless the deduction causes a material distortion of income). The charge must have been incurred for the use of the money, not to reimburse the lender for credit investigation, appraisal, and other costs incurred in granting the loan. Further, the points must not exceed the amount of points generally charged in the area, and the charging of points must be an established business practice in the area. As a matter of administrative practice, points paid in connection with the purchase of a principal residence are deductible by a taxpayer in the year paid if the following conditions are met:

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▪ The Unified Settlement Statement (HUD-1) identifies amounts as points incurred in connection with the indebtedness (e.g., loan origination fees, loan discount fees, discount points, or points).

▪ Amounts are computed as a percentage of the stated principal loan amount.

▪ Amounts paid conform to an established business practice of charging points for personal residence loans in the area, and the amount charged does not exceed the amount generally charged in the area.

▪ The taxpayer uses the cash method of accounting. ▪ Amounts are paid in connection with the acquisition of the taxpayer's

principal residence that secures the loan. ▪ The amounts are paid directly by the taxpayer to the lender. This

requirement is met where an amount is provided by the borrower (such as a down payment, escrow deposits, earnest money applied at closing, and funds actually paid at closing). Also, an amount charged to the seller as points on the acquisition of a principal residence is treated as paid directly by the borrower.

▪ The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.

Planning Pointer Taxpayers can opt to amortize points over the life of their home mortgage rather than deduct them in full in the year of the payment. (There are some conditions for amortization not discussed here.) This option should be used where they do not have sufficient itemized deductions to benefit from the points write-off in the year of payment but may be able to itemize in the coming years. Loan origination fees paid by a buyer for obtaining a VA or FHA loan may be treated as deductible points, but such fees paid by a seller may not. Points paid to obtain a loan for the purchase of a principal residence are reported on Form 1098. Points Paid to Refinance a Mortgage Generally, points paid to refinance a mortgage, regardless of how the taxpayer arranges to pay them, are not deductible in full in the year paid unless they are paid in connection with the purchase or improvement of a home. This is true even if the new mortgage is secured by the taxpayer’s principal residence.

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In this case, points are deductible ratably over the term of the mortgage. However, one appeals court has allowed a current deduction in a refinancing of a short-term mortgage where the refinancing was viewed as an integral step in the overall financing of the home purchase. Planning Pointer Any points that have not yet been deducted when the property is disposed of or the mortgage is refinanced with a new lender can be deducted at that time. Tenant-stockholders in a cooperative apartment house can deduct their portion of interest payments on the indebtedness of the cooperative. They can also deduct their share of the real estate taxes on the building. Example Fred Garcia owns and occupies an apartment in a cooperative project. His yearly carrying charges amount to $2,100, of which $850 represents his share of the interest on the building mortgage, and $625 is his share of real estate taxes on the building. These two items are deductible on Fred’s return as interest and taxes, respectively. Note: Certain taxpayers may be entitled to a mortgage interest credit. A cooperative housing corporation that charges tenant-stockholders with part of the cooperative’s interest and taxes in a manner that reasonably reflects the cost to the cooperative of the interest and taxes allocable to each tenant-stockholder’s dwelling unit can elect to have the tenant-stockholder deduct the separately allocated amounts. Prepayment penalties imposed for the privilege of prepaying a mortgage have been treated as deductible interest. In contrast, bank charges imposed on delinquent payments that are not tied to the period of delinquency are treated as nondeductible service charges. Refinancing If a homeowner refinances a mortgage that is acquisition debt, the treatment of the interest on the new loan may or may not be fully deductible. If the new loan simply replaces the old loan, the new loan is treated as acquisition debt and the interest is fully deductible as such.

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If the new loan amount is greater than the outstanding balance of the old loan, it is treated as acquisition debt only if the proceeds are used to substantially improve the home. Otherwise, the excess is treated as home equity debt, which is not deductible in 2018 through 2025. Mortgage Insurance If a homebuyer pays less than 20% of the purchase price, lenders typically require mortgage insurance (MI). Such insurance is issued by private lenders, as well as government agencies (Veterans Administration, Federal Housing Administration (FHA), and Rural Housing Administration). For mortgage insurance obtained in 2007 through 2020, the premium is deductible as interest, limited to the AGI threshold. Planning pointer The deduction for mortgage insurance, which had expired at the end of 2017, was extended for 2018, 2019, and 2020. A taxpayer who was eligible to claim the deduction on a 2018 or 2019 return but did not, may want to file for a refund on an amended return. If premiums to the Veterans Administration or the Rural Housing Administration are prepaid, they are deductible in full in the year of prepayment. If premiums are prepaid to the FHA or a private mortgage insurer, determine the portion of the premium that pays for insurance for the year of prepayment by dividing the total premium by the stated term (number of months) of the mortgage, or 84 months, whichever is shorter. Multiply that amount by the number of months during the year of prepayment that the home was covered by the mortgage insurance. If the home is sold before all the premiums have been deducted, there is no additional write-off allowed (in effect the balance of the premiums become nondeductible). Income Limit for Deduction

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There is an income limit for this deduction, assuming the deduction is extended. The full premium can be deducted only if the home owner’s AGI does not exceed $100,000. The deduction is reduced by 10% for each $1,000 of AGI in excess of $100,000; no deduction can be claimed once AGI exceeds $109,000. The AGI limit for married persons filing separate returns is $50,000, with a 10% reduction for each $500 of excess AGI; it is fully phased out once AGI exceeds $54,500. Other Interest Discounts on Notes and Bank Loans When a taxpayer borrows money from a bank, the interest is usually deducted or “discounted” in advance. The discount is deductible as interest when actually paid (or accrued), not when the note was signed.

Example Rachel Adams borrows money from her bank to purchase stock on June 20, agreeing to pay it back in 12 equal installments, beginning July 20. She signs a note for $1,000, but because the note is discounted in advance at 18%, she actually receives only $820. If she uses the cash method, the discount of $180 is considered as being repaid in 12 equal installments of $15 each. Thus, if Rachel pays before the end of the year all six payments due in the current year, she can deduct as investment interest $90 (6 x $15). If Rachel is on the accrual basis, she can deduct $90 (6/12 x $180) for accrued interest, regardless of whether she made all payments. Interest Paid to Produce Tax-exempt Income If a taxpayer borrows money to buy or carry tax-exempt securities, the interest is not deductible (Code Sec. 265). Example

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James West borrowed $10,000 at 9% to purchase $5,000 worth of corporate stock and $5,000 worth of municipal bonds. Only one-half of the interest paid is deductible because the income from municipal bonds is tax-exempt. The disallowance of an interest deduction applies to costs incurred to carry personal property used in a short sale. Amortization of Bond Premium If a taxpayer paid a premium in acquiring taxable bonds, the taxpayer may, at his option, amortize the premiums by deducting a pro rata portion each year over the life of the bond (Code Sec. 171). Except in the case of bond dealers (who treat premium amortization as a business expense), the amortization is deductible from adjusted gross income. If the interest on bonds is exempt from all tax, taxpayers may not deduct the amortization, even though they must reduce the basis of the bonds each year by a portion of the premium. Unstated Interest In a sale of property with the proceeds payable in installments, a portion of the payments may be treated as “unstated” or “imputed” interest (Code Sec. 483). An “imputed interest rate” will be treated as being charged if less than the market rate of interest is charged. Whether there is adequate stated interest in a debt instrument issued for non-publicly traded property is determined by reference to an appropriate “test rate.” When adequate interest is not stated, the imputed interest rules recharacterize part of the debt instrument’s principal amount using a somewhat higher “imputation rate”. The amounts of principal and interest as recharacterized will generally determine the seller’s amount realized, the buyer’s basis in the property, and the amount of interest deductions and interest income for the buyer and the seller, respectively. For 2020, when the amount of seller financing does not exceed $6,039,100, the minimum interest rate generally cannot be more than 9% compounded

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semiannually or the applicable federal rate (AFR) (see IRS Publication 537 for more information). For sales over $6,039,100, the minimum interest rate is 100% of the AFR (Rev. Proc. 2019-44). A special 6% rate applies in the case of intra-family installment sales of real property valued at less than $500,000. Investment Interest The deduction for investment interest (defined below) cannot exceed net investment income (Code Sec. 163(d)). The amount of investment interest that cannot be deducted because of this limit can be carried forward to the next tax year and may be deducted to the extent that the net investment income exceeds the investment interest in that later year. Planning Pointer Check for any investment interest carryforwards from prior years that may be added to investment interest for this year.

Investment interest generally is interest paid or accrued on money borrowed to buy or carry property held for investment. However, no deduction is allowed for interest to buy or carry tax-exempt bonds. No deduction is allowed for interest expenses on straddles. Net Investment Income Net investment income, for purposes of the limit on the deduction for investment interest, is figured by subtracting investment expenses (other than interest expense) from investment income. Investment Income Investment income generally includes gross income derived from property held for investment (like interest, dividends, annuities, and royalties). Investment income does not include Alaska Permanent Fund dividends. The IRS also considers interest on tax refunds to be investment income. Net capital gain from the disposition of investment property and qualified dividends subject to the capital gain tax rate are not treated as investment income. An election can be made to include all or part of net capital gain (including capital gain distributions from mutual funds) and/or qualified dividends as investment

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income to the extent that net capital gain and/or qualified dividends are treated as ordinary income (the special capital gains rates do not apply if the election is made). Before making either choice, consider the overall effect on tax liability. Planning Pointer An election may be advisable where there is no other investment income to offset investment interest.

Investment Expenses Investment expenses include all income-producing expenses (other than interest expense) relating to the investment property.

Example Jill Johnstone, a single taxpayer, has investment income derived from interest income, which together total $12,000. Jill’s investment expenses (other than interest), which were directly connected with the production of this income, amounted to $980. Jill also incurred $12,500 of investment interest expense. Jill figures her net investment income and the limits on the amount of her investment interest expense deduction in the following way:

Total investment income $12,000

Less: Investment expenses (other than interest) 980

Net investment income $11,020

Less: Investment interest expense 12,500

Excess interest expense $(1,480)

This excess interest expense may be carried forward to the following year. The investment interest expense deduction is figured on Form 4952, Investment Interest Expense Deduction. Prepaid Interest A cash-method taxpayer must deduct prepaid interest over the period of the loan (Code Sec. 461(g)).

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This rule covers interest paid for a home mortgage, business, or investment purpose. An exception is provided for “points” on a mortgage on a personal residence where certain requirements are met, as discussed above. Below-market Loans A below-market loan is a loan on which no interest is charged or on which interest is charged at a rate below the Applicable Federal Rate (AFR). A below-market loan is generally recharacterized as an arm’s-length transaction in which the lender is deemed: (1) To have made a loan to the borrower in exchange for a note that requires the payment of interest at the applicable federal rate, and (2) To have made an additional payment to the borrower The lender’s additional payment to the borrower is treated as a gift, dividend, contribution to capital, payment of compensation, or other payment, depending on the substance of the transaction (Code Sec. 7872). Below-market Demand Loans For below-market gift loans and demand loans (loans payable in full at any time on the lender’s demand), the lender is treated as transferring the foregone interest in the form of a gift, charitable contribution, dividend, compensation or other form of payment to the borrower. Similarly, the borrower is treated as transferring the foregone interest to the lender as interest and may, therefore, be entitled to deduct the amount as interest expense. These transfers are deemed to occur annually, generally on December 31. Pitfall The failure to report interest from below-market loans has been identified by the IRS as one of the most common errors made on individual income tax returns. Below-market Term Loans For below-market term loans (loans that are not demand loans), the lender is treated as transferring a lump-sum cash payment to the borrower on the date the loan is made.

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The amount transferred is the excess of the amount of the loan over the present value of all payments due under the loan. In addition, an amount equal to this excess is treated as original issue discount. Planning Pointer If a demand loan is outstanding for the entire year, interest can be figured using a blended rate (Code Sec. 7872(e)(2)). For 2020, the blended rate is 0.89% (Rev. Rul. 2020-14). There are two exceptions to the below-market loan rules: Where the loan is considered a “gift loan,” there is no imputed interest if the amount outstanding is not over $10,000 (de minimis). The $10,000 is not adjusted annually for inflation. This gift loan limit does not mirror the annual gift tax exclusion amount ($15,000 in 2020). For gift loans between individuals, if the outstanding loans between the lender and borrower total $100,000 or less, the forgone interest to be included in income by the lender and deducted by the borrower is limited to the amount of the borrower's net investment income for the year. If the borrower's net investment income is $1,000 or less, it is treated as zero. Each month the IRS publishes the AFR for loans of varying lengths (short-term, mid-term, or long-term).

Study Question Which of the following interest payments are deductible in full in the year of payment?

• Interest on a tax deficiency arising from Schedule C.

• Points paid to acquire a principal residence.

• Interest on a loan used to buy tax-exempt securities.

• Points paid to acquire investment property.

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Charitable Contributions To encourage taxpayers to make voluntary donations to charitable, religious, and similar organizations, the Code permits a deduction for contributions made to qualified charitable, educational, or similar organizations. Qualification Criteria To be deductible, the contributions must have actually been made during the year, regardless of when pledged (Code Sec. 170). Example Walter Bell owns Bell Electronics. On behalf of Bell Electronics, Walter signs a $1,000 building fund pledge, payable over five years, to his alma mater. Because this is only a pledge and not a payment, no deduction can be taken. Planning Pointer 1 Contributions deductible in the current year also include any carryovers from the prior five years (check the prior year’s return for any carryovers). Planning Pointer 2 Taxpayers age 70½ or older can contribute their IRA distributions to charity (by a direct transfer from the IRA to the charity) up to $100,000 annually and obtain tax-free treatment (“qualified charitable distribution” or QCD). While this benefits a charity, no tax deduction is claimed for this donation, although QCDs count toward the taxpayers’ RMDs. Pitfall 1 If taxpayers age 70½ or older make deductible IRA contributions, they reduce the $100,000 lifetime limit for QCDs. Pitfall 2 Employees who participate in their company’s leave sharing programs in 2020, donating their unused vacation, sick, and personal days, cannot deduct this contribution. Due to COVID-19, they are not taxed on their donated days (which would otherwise be treated as taxable compensation), but only the employer making a cash donation before 2022 can take a charitable contribution deduction.

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Schedule A is used to claim charitable contribution deductions. By those who itemize deductions. Those who claim the standard deduction report the charitable contribution deduction up to $300 in 2020 directly on Form 1040 or 1040-SR (see 1040 Preparation and Planning 8: Adjustments to Gross Income).

Which Organizations Qualify to Receive Deductible Contributions Contributions can qualify as tax deductions only if they were made to one of the following recipients:

▪ A corporation, trust, community chest, fund, or foundation organized and operated exclusively for a charitable, religious, educational, scientific, or literary purpose, or for the prevention of cruelty to children or animals. Certain organizations that foster national or international amateur sports competition also qualify.

• Moreover, the organization must have been organized or created under the laws of the United States, any state, the District of Columbia, its territories, or its possessions.

▪ The United States, a state, a territory, a city, or a political subdivision of the above, if made for a public purpose.

▪ War veterans’ organizations, including posts, auxiliaries, trusts, or foundations, organized in the United States or any of its possessions (including Puerto Rico).

▪ Certain nonprofit cemetery companies or corporations if the funds are dedicated to the perpetual care of the cemetery as a whole, not to the care of a particular lot or mausoleum crypt.

▪ Domestic fraternity societies, orders, and associations operating under the lodge system if the contribution is to be used exclusively for charitable, religious, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals.

In addition to being organized and operated exclusively for the purposes named, the organizations listed previously must also meet the following requirements:

▪ No part of the net earnings of the organization can go to the benefit of any private shareholder or individual.

▪ No substantial part of the activities of the organization may consist of carrying on propaganda or otherwise attempting to influence legislation.

The following is a representative list of some qualifying funds and organizations.

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▪ 4-H Clubs ▪ American Cancer Society ▪ American Heart Association ▪ American Legion ▪ American Red Cross ▪ American Veterans of World War II ▪ American Veterans’ Committee ▪ Americare ▪ Boy Scouts of America and Girl Scouts of America ▪ CARE ▪ Catholic War Veterans ▪ Churches and synagogues ▪ Damon Runyon-Walter Winchell Cancer Fund ▪ Disabled American Veterans ▪ Greater New York Fund ▪ Humane societies and associations ▪ Hurricane disaster relief funds ▪ Junior leagues ▪ Legal aid societies ▪ Marine Corps League ▪ Nonprofit schools and hospitals ▪ Police Athletic League ▪ Salvation Army ▪ Seeing-Eye, Inc. ▪ September 11, 2001, disaster relief funds ▪ Tuberculosis associations and societies ▪ Veterans of Foreign Wars of the United States ▪ Wounded Warriors ▪ Young Men's and Young Women's Christian or Hebrew Associations

Bear in mind that the preceding list enumerates only a very small fraction of the many organizations that qualify. The IRS publishes a Cumulative List of Organizations, which contains the names of all organizations that have specifically qualified and is available only online (https://www.irs.gov/app/pub-78). The list contains only the names of organizations on which a special ruling has been requested.

https://www.irs.gov/app/pub-78

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Hence, the fact that an organization is not listed does not necessarily mean that it does not qualify. In case there is doubt as to whether contributions to a particular organization are deductible, a taxpayer may call the IRS toll free at 877-829-5500. Also deductible are contributions to federal, state, and local governments for public purposes. However, regulations (T.D. 9864, 6/11/19) make it clear that a taxpayer who makes payments or transfers property to an entity eligible to receive tax deductible contributions (state-enacted workarounds of the SALT limitation) must reduce the charitable deduction by the amount of any state or local tax credit the taxpayer receives or expects to receive. For example, if a state grants a 70% state tax credit and the taxpayer pays $1,000 to an eligible entity, the taxpayer receives a $700 state tax credit. The taxpayer must reduce the $1,000 charitable contribution by the $700 state tax credit, leaving an allowable charitable contribution deduction of $300 on the taxpayer’s federal income tax return. The regulations also apply to payments made by trusts or decedents’ estates in determining the amount of their contribution deduction. Under a de minimis rule, there is an exception if dollar-for-dollar state tax deductions and tax credits are no more than 15% of the payment amount or of the fair market value of the property transferred (Notice 2019-12). A taxpayer who makes a $1,000 contribution to an eligible entity is not required to reduce the $1,000 deduction on the taxpayer’s federal income tax return if the state or local tax credit received or expected to be received is no more than $150. Additional final regulations add to these rules by allowing an itemizer who makes a payment to an entity in exchange for a state or local tax credit for which a charitable contribution deduction is or will be disallowed to treat the payment as state or local tax (subject to the SALT cap) (T.D. 9907, 8/7/20). Nondeductible Contributions Contributions to the following kinds of organizations are not deductible as charitable contributions, including:

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▪ Civic leagues and associations (but civic organization dues may be deductible as a business expense)

▪ Chamber of commerce and other business leagues or organizations ▪ Country clubs and other social clubs ▪ Homeowners’ associations ▪ Labor unions ▪ Most International and foreign organizations (even though devoted to

charitable, religious, educational, etc., purposes), other than certain Canadian, Israeli, or Mexican charitable organizations

Pitfall Gifts to an individual, no matter how needy the individual, are not deductible. What Forms of Contributions are Deductible? Contributions are deductible whether they are made in the form of outright gifts, membership dues, pew rentals, or in any other manner. If the gifts, contributions, or other payments entitle the taxpayer to certain benefits, only the excess of the amount paid over the fair market value of the benefit is deductible. For instance, in the case of tickets to a charitable benefit, only the excess of the amount paid over the amount that would ordinarily be paid for admission to similar entertainment is deductible. Likewise, tuition fees paid to parochial schools are payments for services rendered and, thus, not deductible as contributions. Note: No charitable contribution deduction can be claimed for a donation entitling the donor to purchase athletic seating rights. A taxpayer who contributes the use of his or her property to a charity, without contributing the actual property itself, is not entitled to a contribution deduction. Example Russell Sims, the owner of an office building, permits a charitable organization to occupy, rent free, a suite of offices with a rental value of $2,000 per year. He can claim no contributions deduction. Pitfall

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It is not advisable to donate the use of a vacation home to a charity. Not only is the donation of the use not deductible, but the homeowner may also lose deductions for the home. Use of the vacation home by someone who obtains the right from the charity is treated as personal use by the vacation homeowner under the vacation home rules.

Services Rendered

The value of services rendered or contributed to charitable organizations is not

deductible.

Example

Cynthia, an attorney, performs legal services for her church. Usually she charges

$300 per hour and has spent 6 hours working for her church. She cannot deduct

the $1,800 that she would have received if the services had been performed for a

paying client.

Unreimbursed Expenses Unreimbursed expenditures made as a result of rendering services to such an organization are deductible. For instance, the cost of uniforms required to be worn by volunteer Red Cross workers is deductible. Planning Pointer If out-of-pocket costs are $250 or more, they must be substantiated by a written acknowledgment from the charity. Unreimbursed transportation expenses incurred in rendering donated services are deductible. Also, deductible are expenditures for meals and lodging incurred while away from home in the course of rendering such services. “While away from home” is interpreted by the Treasury to mean away from home overnight. Expenses (travel, meals, lodging, etc.) incurred in attending a convention of a qualified organization are deductible by delegates or officers of the organization, but not by members who have no official capacity.

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If taxpayers use their own automobiles on behalf of a qualified organization instead of deducting the actual car expenses, they may elect to take a flat 14¢-per-mile deduction. The expenses incurred for tolls and parking are separately deductible. No charitable contribution is allowed for transportation or other travel expenses incurred in performing services away from home on behalf of a qualified charitable organization unless there is no significant element of personal pleasure, recreation, or vacation in the travel. Contributions of Intellectual Property The donation of a patent or other intellectual property (other than certain copyrights or inventory) is initially limited to the taxpayer’s basis in the property or its fair market value, whichever is less. When the deduction is initially limited to tax basis, the taxpayer is allowed to deduct additional amounts over 10 years, beginning with the year you made the contribution based on a specified percentage of the “qualified donee income” received or accrued by the charitable recipient from the contributed property. However, donors can also claim an additional deduction for a percentage of the income that the charity receives from the donated property (either in the year of the contribution or in a subsequent year (Code Sec. 170(m)). The amount of the additional charitable deduction is figured using a sliding-scale percentage of income that the charity receives with respect to the donated property, from 100% in the first year after the contribution to 20% in the 10th year after the contribution. No deduction is allowed for income received after the expiration of the legal life of the patent or intellectual property or after the 10th anniversary of the date the contribution was made.

Pitfall No additional deduction is allowed for donations of intellectual property to a private foundation, unless it is a private operating foundation. Substantiation Requirements

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The charity must inform a donor at the time a contribution is made that it intends to treat the property as subject to the additional charitable contribution deduction rule (i.e., that the charity intends to use the property to obtain income). Planning Pointer To claim the additional deductions, donors must give a written statement to the charity at the time of the donation advising the charity of the intention to claim these additional deductions.

The charity will provide donors with information returns each year (Form 8899, Notice of Income from Donated Intellectual Property) that include the income derived by the charity from the intellectual property so that donors can apply the applicable percentage and claim the additional deductions.

Substantiation of Cash Contributions Donations in any amount must be substantiated with a written acknowledgment from the charity or a bank statement. For those who make contributions through payroll deductions, the substantiation requirement is met by keeping a pay stub, Form W-2, or an employer-furnished document showing the amount withheld as a donation, as well as a pledge card or similar document from the charity. Contributions Over $250 Contributions over $250 must be accompanied by a written acknowledgment from the charity or certain payroll deduction records. The instructions to Form 1040 or 1040-SR require that an explanatory statement, giving a description of the kind of property contributed (e.g., paintings or securities), date of gift, and method of valuation (except for securities), be attached to the return. Donations of used clothing and household items can be deducted only if items are in good “used” condition. Condition is not specified when a single item valued over $500 is supported by an appraisal. Property Donations Exceeding $500 and $5,000

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Where a donation of property exceeds $500, the IRS has warned that no deduction will be allowed unless Form 8283, Noncash Charitable Contributions, is filed. This form identifies the charity as well as the property that was donated. If the property donation exceeds $5,000 (other than publicly traded securities or privately held securities valued at $10,000 or less), then the charity must sign the acknowledgment on Part IV of Form 8283 and a summary of a written appraisal must be attached. If the donation is art valued at more than $20,000, certain photographs must also be included with the form.

Planning Pointer Taxpayers donating art valued at more than $50,000 can request a Statement of Value (SOV) from the IRS before filing a tax return. There are user fees for obtaining an SOV (Rev. Proc. 2020-1). The request received after February 1, 2020, must include a copy of an appraisal and a user fee of $6,500 to cover an SOV for up to three items, plus $300 for each additional item for which an SOV is requested. Payment must be made through Pay.gov. Receiving an SOV can assure a taxpayer that the claimed value will hold for deduction purposes.

If a gift entitles the donor to some benefit, the charity must provide a statement as to the value of the benefit and the amount of the deduction. Example Marcy Smith contributes $100, which entitles her to attend a dinner given by the charity. The charity must tell her that the value of the dinner in this instance is $40 and the charitable contribution is $60. Planning Pointer If the value of the benefit is merely a token (e.g., a calendar, mug, key chain), the benefit can be ignored and the full contribution is deductible. Note that the dollar limit on token benefits is fixed each year by the IRS. For 2020 amounts, see Rev. Proc. 2019-44. Vehicles Donations In the case of a vehicle donation, the organization must provide the taxpayer with a contemporaneous statement that it is retaining the car for its use (so that

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the donor can use his own valuation) or is selling or has sold it (so that the donor is limited in the deduction to the gross sale proceeds). The statement must be received within 30 days of (1) the donation (if the charity keeps the car) or (2) the date of the car’s disposition (if the charity sells the car), whichever is later. The gross sale proceeds limitation does not apply if the charity:

▪ Sells the car at a price significantly below fair market value to a needy individual in furtherance of its charitable purpose.

▪ Uses the car in a significant way in its charitable purpose or makes

material improvements before selling it (e.g., a major car repair, which does not include paint jobs, rustproofing, waxing, removal of dents and scratches, cleaning or repairing upholstery, and installation of antitheft devices).

Pitfall If a taxpayer donates a car valued at more than $500 to charity that is sold without a substantial intervening use by the organization, the deduction is limited to the gross sale proceeds or $500 whichever is higher, even if this is lower than the car’s fair market value.

Example If Joyce Davidson donates a car to Meals on Wheels and the organization uses it to deliver meals, Joyce can deduct the value of the car based on its fair market value. But if Meals on Wheels auctions off the car for $1,100 to get the proceeds for use in its charitable activities, Joyce can deduct only $1,100, even if the car’s value is properly estimated at $1,400. Charities must report the donation to the IRS on Form 1098-C, Contribution of Motor Vehicles, Boats, and Airplanes. A copy of Form 1098-C will suffice as an acknowledgment to the donor and must be attached to the donor’s return. For cars valued at more than $250 but not more than $500, a written acknowledgment is still required, including a statement by the charity if any goods or services were provided to the donor. However, even if the charity sells the car, the donor can deduct the car’s full fair market value.

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Form 8283, Noncash Charitable Contributions, is used by taxpayers to report noncash contributions over $500.

Pitfall The IRS has warned taxpayers about valuation of donations of used cars to charity. AGI Limitation on Charitable Deductions The amount of a charitable contribution that is currently deductible is limited by a taxpayer’s adjusted gross income. For cash contributions in 2020, the deduction is 100% of the taxpayer’s adjusted gross income (AGI). This limit applies only to regular charities (“50% charities”). It does not apply to certain private foundations or donor-advised funds. The 100%-of-AGI limit applies for donations to any 50% charities; it is not limited to COVID-19 related relief organizations even though the limit was increased because of the pandemic. However, the 100% limit is reduced by all other 2020 contributions. Contributions exceeding the limitation are generally allowed to be carried forward and deducted for up to five years, subject to the later year’s ceiling. Pitfall Any carryforward of unused deductions from prior years to 2020 are subject to the 60%-of-AGI limit, even if the 100% limit applies to cash contributions made in 2020. For contributions of capital gain property (property held more than 12 months) and gifts to non-operative private foundations, a 30% limitation applies. However, the taxpayer can elect to apply a 50% limit, explained later For donations of conservation easements, a 50% limitation also applies (100% in the case of land used for farming or ranching). For donations of capital gain property to a private non-operating foundation, a 20% limitation applies.

Example Michael Finley’s adjusted gross income is $10,000. During the year, he contributed $700 to his church, $800 to Princeton University (both public

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charities), plus $3,300 to the Finley Family Foundation, a private 30%-ceiling charity. To determine Michael’s deduction, first deduct the $1,500 ($700 + $800) cash contributed to the public charities. Also deduct $3,000 (the 30% maximum) of the private charity contribution. The total charitable contribution deduction is $4,500. The $300 remainder of the private foundation donation can be carried over for five years.

Privately Supported Organizations An organization is considered as “privately supported” if it does not receive a substantial part of its support from the general public and/or governmental sources. Thus, the organizations enumerated at the beginning of the section would generally qualify for the 60% cash contribution limit because they receive a substantial part of their financial support from the general public This group would also include museums, libraries, civic centers, symphony orchestras, and similar organizations that normally derive a substantial part of their financial support from a representative number of persons in the communities where the activities are centered. Donations to Other Organizations Donations to foundations, trusts, and other organizations, which normally derive their financial support almost entirely from the members of a single family or from a few individuals, would be limited to the 30% maximum. However, recognizing the fact that some private foundations do indeed perform valuable and beneficial functions, the 60% deduction ceiling on cash contributions has been extended to any private foundation that distributes all contributions during the taxable year in which they were received or within a 2½-month period after the end of the year. Also qualifying for the 50% ceiling is a private operating foundation (i.e., a private foundation operating a hospital, clinic, museum, etc., on a nonprofit basis) and certain other private foundations and organizations catering to the public.

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Five-Year Contribution Carryover Contributions that cannot be deducted in the current year because they exceed the AGI limitations are not lost. They may be carried forward up to a period of 5 years. For each year that the unused cash contribution is carried forward, the aggregate contribution limit is reduced (but not below zero) by the total contributions allowed under the 60% limit rule. It is possible that donations in 2020 in excess of 100% of AGI may have a 100% limit rule for carryovers, but the IRS has yet to clarify this. Contributions for the current year are deducted before any contribution carryovers. If a taxpayer has contribution carryovers for more than one year, the oldest carryover is exhausted first, followed by the next oldest, and so on. Planning Pointer There is a 15-year carryover for unused deductions for conservation easements. Special Rules for Donation of Property Charitable contributions need not be made in cash. They can be made as property donations in the form of stocks, bonds, merchandise, art objects, or other property items. Some special rules may apply. Planning Pointer The charity must obtain possession of the property within 10 years of the gift or the donor’s death, whichever is first. If it does not, the charitable deduction is recaptured and subject to a 10% penalty. Donations of appreciated property raise two questions:

1. What is the amount the contribution is based on—cost or value? 2. What is the percentage limitation on such gifts?

Stocks, Bonds, Other Intangibles, and Real Estate Gifts of such property held long-term are deductible at their fair market value on the date of the gift. In a sense, the appreciation is not taxed; rather, it is taken into account in figuring the amount of the contribution. The amount of such gifts cannot exceed 30% of adjusted gross income.

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However, there is a special election available to boost the ceiling to 50% if you reduce the fair market value of the property contributed by the appreciation in value. Stock Donations to Private Foundations Contributions of appreciated publicly traded stock made to private foundations are deductible at fair market value. The donation cannot be more than 10% of the outstanding stock. The donation is subject to the 20%-of-AGI ceiling.

Ordinary Income Property “Ordinary income property” includes all property that, if sold, would not result in long-term capital gain. Thus, it includes short-term gain property and ordinary income property (e.g., inventory). Such property is deductible at cost. Taxpayers contributing ordinary income property can deduct only the lesser of (1) the property’s fair market value or (2) the property’s adjusted basis, and the amount of the gift cannot exceed 50% of adjusted gross income. Tangible Personal Property The amount of the deduction for appreciated tangible personal property depends on the use of the donation by the charity.

▪ If the property is used by the charity in its exempt purpose, then the fair market value of the property is used to determine the contribution.

▪ If the property is not used by the charity in its exempt purpose, then the

amount of the gift is reduced by the appreciation, thereby limiting the contribution to cost.

If the fair market value is used, then the gift cannot exceed 30% of adjusted gross income. If the fair market value must be reduced by the appreciation because of unrelated use, then the gift cannot exceed 50% of adjusted gross income.

Example Mark and Maggie Smith give an old manuscript to the Red Cross. They paid $100 for the book many years ago, and it is now worth $1,000.

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They may deduct $100, subject to a 50%-of-adjusted-gross-income limit. But suppose instead they give the book to the university library. They may deduct $1,000, subject to a 30%-of-AGI limit.

Planning Pointer Donations of collectibles to charity help donors to avoid the 28% tax rate on their gain. For example, a donation of a painting to a college that is used in its art history program would entitle the donor to deduct the painting’s current value and avoid tax on appreciation if the painting had been sold.

Election of 50% Ceiling for Intangibles and Real Estate Instead of applying the 30% ceiling for gifts of intangibles and real estate as discussed above, a 50% ceiling can be used if the amount of the gift is reduced by all of the appreciation. If the election is made, then all gifts otherwise subject to the 30% ceiling (including carryovers) must be reduced by appreciation. The election is made simply by attaching to Form 1040 or 1040-SR a statement that the election is being made.

Planning Pointer 1 The election of the 50% ceiling for intangibles generally is advisable only where appreciation is minimal.

Planning Pointer 2 Gifts of appreciated property other than inventory and ordinary income property, like cash contributions, are exempt from alternative minimum tax. Gifts of Partial Interests In general, no deduction can be claimed for property in which the donor retains an interest. However, there are certain exceptions. Charitable remainder trusts The donor may deduct the present value of the remainder interest in a trust in which an income interest is retained for life or a term of not more than 20 years.

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The trust, which can be set up either as a charitable remainder annuity trust or as a charitable remainder unitrust, must meet strict requirements. Pooled income funds The donor may deduct the present value of the remainder interest in a pooled income fund in which an income interest is retained for life. Charitable remainder in a personal residence or farm The donor may deduct the present value of the remainder interest in a home or farm in which the right to use the property is retained for life.

The present value of the remainder interests given to charity is determined under IRS tables contained in Treasury regulations. Conservation Easements “Conservation easement” is the generic term for easements granted for outdoor recreation, natural habitat, open space, scenic and historic preservation of land and buildings. Conservation easements permanently restrict how land or buildings are used. However, while the property owner gives up certain rights he or she retains ownership of the underlying property (a way to have one’s cake and eat it too). The “deed of conservation easement” describes the conservation purpose(s), the restrictions and the permissible uses of the property. The deed must be recorded in the public record and contain legally binding restrictions enforceable by the organization receiving the donation under state law. The extent and nature of the organization’s control depends on the terms of the conservation easement. The organization has an interest in the encumbered property that runs with the land, which means that its restrictions are binding not only on the landowner who grants the easement but also on all future owners of the property. Conservation easements, which are called qualified conservation contributions (QCCs) are deductible up to 50% of adjusted gross income (100% for farmers and ranchers). To be a QCC, the gift must be for (Code Sec. 170(h)(4)(A)):

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▪ Preservation of land areas for outdoor recreation by, or the education of, the general public.

▪ Protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem.

▪ Preservation of open space (including farmland and forest land) if it yields a significant public benefit. It must be either for the scenic enjoyment of the general public or under a clearly defined federal, state, or local governmental conservation policy.

▪ Preservation of a historically important land area or a certified historic structure.

Just because the easement includes a golf course does not automatically disqualify it as a QCC (Retreat Golf Founders LLC, CA-11, 5/13/20, rev’g TC Memo 2018-146). The gift must also be in perpetuity. Examples of situations that prevent perpetuity:

▪ Where the donee could receive a share of proceeds equal to the fair market value of the easement on the date of the contribution if it were extinguished, the Tax Court said this was not a donation in perpetuity (Oakbrook Land Holdings LLC, 154 TC No. 10 (2020); see also Woodland Property Holdings LLC, TC Memo 2020-55).

▪ If there is a mortgage on the property, it must be subordinated to the easement at the time of the donation or the transfer is not in perpetuity (Mitchell, CA-10, 2015-1 USTC ¶50,130).

▪ A contingency, such as returning property if the IRS disallows the charitable deduction, prevents the gift being in perpetuity (Graev, 140 TC 377 (2013)).

▪ Similarly, the ability to substitute easement property bars a charitable contribution deduction (Belk, 140 TC 1 (2013), aff’d CA-4, 2015-1 USTC ¶50,107).

The value of a conservation easement must be determined by a qualified appraisal. This must reflect the fair market value of the easement at the time of the contribution. Pitfall The IRS has designated syndicated conservation easements as a listed transaction that must be disclosed on a tax return (Notice 2017-29).

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Planning pointer The IRS has a settlement program for syndicated conservation easement cases that have been docketed in Tax Court (IR-2020-130, 6/25/20).

Study Question

Gifts to which of the following organizations are not deductible as a charitable contribution?

• A local church

• International charity for religious purposes

• Veterans of Foreign Wars of the United States

• The American Red Cross

Study Question

Which of the following payments to a church is not a deductible contribution?

• Parochial school fees

• Pew rentals

• Membership dues

• Cash in the collection plate

Study Question

At what level must a cash donation be substantiated by a written acknowledgment from a charitable organization or a bank statement?

• Any amount

• $250

• $500

• $5,000

Study Question

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The carryover for charitable contributions in excess of the AGI limits is:

• Unlimited

• 2 years

• 3 years

• 5 years

Study Question

Harold Ebersole is a philanthropically minded individual. Which donation of his is not deductible?

• Allowing a local museum to hang a valuable painting he owns on its walls

• Transferring a vacation home to a charitable remainder unitrust

• Transferring a remainder interest in his farm to a conservation society

• Giving stock in his privately held corporation

Casualty and Theft Losses Until now, taxpayers were permitted a deduction for casualty losses on business or personal property (Code Sec. 165). However, for 2018 through 2025, a deduction is permitted only for casualty and theft losses to personal-use property incurred in federally-declared disaster areas. A casualty loss is the complete or partial loss or destruction of property as the result of a sudden, unexpected, or unusual destructive force, such as:

▪ An automobile collision ▪ A fire ▪ A flood, storm, drought, shipwreck, explosion, hurricane, or other similar

event ▪ Through theft, robbery, vandalism, or riot

Progressive deteriorations of property through a steadily operating cause or damage from a normal process are not casualty losses, even if they occur in a federally-declared disaster area.

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The steady weakening of a building brought on by normal or ordinary wind or weather conditions is not a casualty loss.

Pitfall Moth and termite damage is not normally a casualty loss. However, where it can be proven that property was suddenly infested and damaged by termites, the loss may be held deductible.

Amount of Loss The amount deductible depends on whether the loss incurred is a business casualty loss or a personal casualty loss. Regardless of the nature of the loss, the taxpayer must reduce the deduction by any insurance, or other compensation, recovered or recoverable. Business Casualty Loss A “business” casualty loss is a loss sustained on property used in the taxpayer’s trade or business, or held for investment or the production of income, even though not in the taxpayer’s trade or business. Personal Casualty Loss Where nonbusiness or personal property has been damaged or destroyed in a federally-declared disaster, the loss is the difference between the fair market value of the property immediately before and the fair market value immediately after the casualty. However, the recognized loss cannot be greater than the adjusted basis of the property. The deduction must be reduced by any salvage or insurance proceeds obtained.

Example Adam Sanderson’s residence, which cost him $112,000 several years ago, was partially destroyed by the Mississippi flooding in March 2020 (declared as a federal disaster). The value of the home immediately before the fire was $188,000 and the value immediately after was $175,000. He collected $10,000 from his insurance company. The amount of the casualty loss is computed as follows:

Value before fire $188,000

Value after fire 175,000

Decreased in value $13,000

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Adjusted basis (cost in this case) $112,000

Loss (lesser of decrease in value or adjusted basis) $13,000

Less insurance recovery 10,000

Loss $3,000

To accurately determine the difference in the fair market value of the property immediately before and after the loss, a competent appraiser should be employed. The cost of repairs to damaged property is also acceptable as proof of the amount of the loss, provided that the repairs do no more than restore the property to its condition immediately before the casualty and that the amount spent for such repairs is not excessive. The cost of clearing the property of debris is also deductible.

Limitations on Personal Casualty Losses Personal casualty losses in federally-declared disaster areas generally are deductible only to the extent that the loss exceeds 10% of adjusted gross income. In addition, each separate casualty loss must be reduced by $100. Example Referring to the previous example, assuming that Adam’s adjusted gross income is $15,000, his casualty loss deduction is $1,400 [$2,900 ($3,000 – $100) – $1,500 (10% of AGI)]. Note: On March 13, 2020, the President declared COVID-19 to be a disaster, making the entire U.S. a federally-declared disaster area. It is unclear whether personal casualty and theft losses become deductible as a result of this declaration (it does not appear to be so). When the taxpayer suffers two or more losses as the result of one disaster, or when the events causing the casualty losses are closely related in origin, the resulting losses are considered as a single casualty and thus subject to only one $100 reduction. For example, if a hurricane (declared to be a federal disaster) damages a taxpayer’s residence and also damages the taxpayer’s automobile, parked in the driveway, it is considered as a single casualty. Similarly, if a

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hurricane causes both wind and flood damage to a taxpayer’s summer residence, a single casualty is involved. In addition to the $100 floor for each separate casualty, losses are deductible only when they exceed 10% of adjusted gross income. For purposes of applying the limitations, spouses filing a joint return are treated as one individual. If spouses file a joint return, only one $100 floor applies to each casualty, regardless of whether the property on which the loss was sustained is owned jointly or separately. Also, the overall 10%-of-adjusted-gross-income limitation applies. By the same token, if spouses file separate returns, each is subject to the $100 floor for each casualty, and the 10% of AGI limit applies on each of their returns. Individual taxpayers, other than spouses, are subject to a separate $100 floor for each casualty or theft, even though the property of other persons is damaged or destroyed by the same disaster. Example A volcano damages the house and household goods of one individual, as well as the property of a visiting nephew, the homeowner is subject to one $100 reduction, and the nephew to a separate $100 reduction. Insurance or Other Compensation As stated before, the loss deduction must be reduced by any insurance or other compensation received. This includes amounts received from disaster relief agencies (such as FEMA or the Red Cross) or other sources to restore or rehabilitate lost or damaged property. Food, medical supplies, and other forms of subsistence received are not replacements of lost or destroyed property and do not reduce the deduction. Pitfall A taxpayer is not allowed to deduct a personal casualty loss unless the taxpayer files a timely insurance claim for damage to that property. This rule applies to the extent any insurance policy would provide reimbursement for a loss.

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When to Deduct the Loss A special rule permits quick tax relief for casualty losses suffered by individuals residing in federally-declared disaster areas (Code Sec. 165(i)(1)). Under this rule, any such losses sustained during the current tax year may be deducted on the tax return filed for the previous tax year. The taxpayer has the choice of electing to take advantage of this provision or deferring the deduction until the return for the tax year.

Example Norm Wallace’s home was severely damaged by a flood in May 2020, and the area was subsequently declared a federal disaster area. Therefore, Norm may elect to claim the loss on his income tax return for either 2019 or 2020.

The election to claim the loss on the prior year return must be made no later than six months after the due date of the return for the year of the disaster (whether or not the taxpayer obtains a filing extension) (T.D. 9789, 10/16/16). The period for revoking an election to deduct the loss on the prior year’s return is now 90 days after the due date for making the election. Procedures for making and revoking an election are in Rev. Proc. 2016-53. Disaster loss treatment is extended when a disaster has rendered a personal residence unsafe (though still habitable) and the taxpayer has been ordered by state or local officials, within 120 days of the designation of the locality as a disaster area, to demolish or move the residence. If the casualty occurs after the return for the preceding year has been filed, the taxpayer may file an amended return in order to claim the loss.

Pitfall In the event that individuals elect to take into account a personal disaster loss for the tax year immediately preceding the tax year in which the disaster occurred, they must use their adjusted gross income for such prior year in determining the extent to which the loss is deductible.

Planning Pointer

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Taxpayers who are in presidentially declared disaster areas gain automatic postponement for certain tax acts, such as filing returns. Reporting Personal Casualty Gains and Losses Form 4684, Casualties and Thefts, is used to figure the gain or loss from casualties and thefts. If the net result of these events is a gain because of insurance or other reimbursements, it is entered on Form 8949 and then on Schedule D. If the net result of these events is a loss, then the loss must be reduced by the 10%-of-adjusted-gross-income floor. The reduced loss is then entered on Schedule A.

Example A federally-declared disaster caused $6,000 in damage to Rose Karl’s automobile. It has an adjusted basis of $2,000 and is used 50% for business and 50% for personal reasons. Rose collected $1,200 from her insurance company, with a net loss to her of $800. Half the loss ($400) is considered a business loss and is fully deductible. The remaining $400 is personal; it is reduced by $100, so that $300 is deductible on Schedule A as a personal disaster loss. However, because of the 10% AGI limit, it is unlikely that any personal loss is deductible.

Study Question

A personal disaster loss is deductible only to the extent it exceeds what percentage of adjusted gross income?

• 2%

• 7.5%

• 10%

• 12%

Miscellaneous Deductions Certain employee expenses, expenses of producing income, and other qualifying expenses are deductible as miscellaneous itemized deductions on Schedule A of Form 1040 or 1040-SR (Code Sec. 67).

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Most miscellaneous itemized deductions are subject to a 2% floor. For 2018 through 2025, no deduction can be taken for miscellaneous itemized deductions subject to the 2% floor. Examples of nondeductible expenses during this period include:

▪ 50% of unreimbursed business-related meal expenses ▪ Certain unreimbursed employee business expenses (e.g., a home office

deduction claimed by an employee) ▪ Convenience fee paid to processors of taxes charged to a credit card ▪ Educational expenses ▪ Expenses of looking for new job ▪ Fees paid to an IRA custodian ▪ Hobby activity expenses ▪ Home office expenses ▪ Investment counsel fees ▪ Investment expenses ▪ Legal fees for the production or collection of income ▪ Professional society dues ▪ Safe deposit box rental ▪ Tax return preparation fees (including legal and accounting fees) ▪ Union dues and fees ▪ Work clothes and uniforms

Miscellaneous Expenses Not Subject to the 2% Floor Certain miscellaneous expenses are deductible without regard to the 2%-of-AGI threshold. These expenses continue to be deductible in 2018 through 2025, and include the following:

▪ Gambling losses to the extent of gambling winnings (discussed later) ▪ Certain adjustments when a taxpayer restores amounts held under a claim

of right ▪ Amortizable bond premium on taxable bonds ▪ Impairment-related work expenses of a handicapped individual that are

for deductible attendant care services at the individual’s place of work and other expenses in connection with the place of work that are necessary for the individual to be able to work

▪ Federal estate tax attributable to income in respect of a decedent (IRD) (whether or not the estate tax has already been paid)

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Also, statutory employees (e.g., certain insurance agents and outside salespersons) can claim their business expenses on Schedule C. Gambling losses A person who is not engaged in gambling as a business may deduct gambling losses, along with other itemized deductions, from adjusted gross income, but only to the extent that the gambling income was reported (Code Sec. 165(d)). Example Joe Redfield, unmarried, had a $47,000 annual salary in 2019. He is an ardent racing fan and had total winnings of $1,800 and total losses of $3,000 resulting from betting on the horses. (He is not a professional gambler.) Although Joe’s wagering losses totaled $3,000, he can deduct only $1,800, his losses to the extent of his winnings (assuming he itemizes deductions). The $1,200 losses in excess of gains are not deductible and cannot be carried over to another year (Reg. §1.165-10).

Where spouses file a joint return and neither spouse is a professional gambler, their combined gambling losses are allowable as itemized deductions to the extent that their combined winnings from such transactions were included in income. While most miscellaneous itemized deductions are subject to a 2%-of-adjusted-gross-income floor and cannot be claimed in 2018 through 2025, this floor does not apply to gambling losses, which are deductible in full to the extent of gambling winnings as a miscellaneous itemized deduction. Overall Limitation on Itemized Deductions (Sec. 68(f)) For 2018 through 2025, the overall limitation on itemized deductions is eliminated. The previous law subjected higher-income taxpayers who itemized their deductions to a limitation.

Study Question

All of the following miscellaneous itemized deductions are subject to the 2% floor except:

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• Gambling losses

• Tax return preparation fees

• Union dues

• Legal fees for the production or collection of income

Final Exam

1. In 2020, the standard deduction for a child, age 16, who is a taxpayer’s dependent and has earned income of $2,000 and unearned income of $1,000 is:

a) $1,100 b) $2,350 c) $3,000 d) $12,400

2. In 2020, a single taxpayer’s AGI is $45,000. His medical costs (minus insurance reimbursements) total $6,500. He may deduct only medical costs in excess of:

a) $2,000 b) $3,375 c) $4,500 d) $6,500

3. All of the following procedures qualify as a deductible medical expense except:

a) Laser eye surgery b) Breast reconstructive surgery c) Face lift d) In vitro fertilization for a female having difficulty with conception

4. All of the following taxes could be deductible as itemized deductions except:

a) Local property tax b) Ad valorem personal property tax c) FICA paid by an employee on his/her wages

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d) Foreign income taxes

5. Which of the following interest expenses incurred by Leila Jackson is

treated as nondeductible personal interest?

a) Interest on an ordinary bank loan used to pay for her son’s medical care b) Interest on a home equity loan of $75,000 used to add on a room to her

home c) Bonds purchased with accrued interest d) Interest incurred by a partnership in which Leila is a limited partner

6. Points paid on a mortgage for a principal residence can be deducted in full in the year of payment except if the mortgage is taken to:

a) Pay off an existing mortgage on the residence (e.g., refinance at a lower rate)

b) Improve the residence c) Buy a principal residence d) Construct a principal residence

7. In 2020, Harold Stanton donates his old car to a reputable charity. He believes the car is worth $1,000; the charity immediately sells it at auction for $600 and provides Harold with a written acknowledgment. What amount can Harold deduct as a charitable donation?

a) Zero b) $500 c) $600 d) $1,000

8. On November 18, 2020, Maryann Reilly donates two bags of items of used clothing to the Salvation Army. Some of the items are in good used condition, whereas others are in poor condition. Which statement is correct (assume proper substantiation)?

a) She may deduct the value of all of the items. b) She may deduct her cost for all of the items. c) She may not deduct the value of any of the items. d) She may deduct only the value of the items in good used condition or

better.

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9. In December 2020, George Baker contributes cash to public charities (he makes no other contributions for the year). What, if anything, is the maximum deduction for these donations limited to?

a) 30% of adjusted gross income b) 50% of adjusted gross income c) 60% of adjusted gross income d) 100% of adjusted gross income

10. Unused charitable contributions (in excess of the AGI limit) (assume the contributions are not qualified conservation contributions):

a) Can be carried forward indefinitely b) Can be carried forward for 2 years c) Can be carried forward for 5 years d) Are lost forever

11. In 2020, a taxpayer experiences a severe uninsured loss as a result of a

storm declared to be a federal disaster. The loss is deducted in:

a) 2019 only b) 2020 only c) 2019 or 2020 d) The disaster loss is never deductible

1040 preparation and planning 9: standard deduction and

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