Transcript Deductions: General Concepts and Trade or Business Deductions

CCH Federal Taxation
Basic Principles
Chapter 6
Deductions: General
Concepts and Trade or
Business Deductions
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Chapter 6 Exhibits
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Four Types of Usage for Expenses and Property
Tax Treatment for the Four Types of Usage
Business Expenses—Seven Criteria
Defending Tax Treatment for a Business Activity
Hobby Expenses—Template for Problem Solving
Home Office Deductions—Template for Problem
Solving
Computing Home Office Deductions for SelfEmployed Persons
Computing Home Office Deductions for
Employees
Interest Expense—An Overview
Investment Interest Expense—Example
Taxes—An Overview
Chapter 6, Exhibit Contents
12. Property Taxes—Allocation Between
Buyer and Seller
13. Depreciation—Code Sec. 179 Election
14. Amortization
15. Research and Experimental
16. Depletion
17. Political Contributions and Lobbying
18. Business Start-Up Expenses
19. Meals and Entertainment
20. Moving Expenses
21. Student Loan Interest
CCH Federal Taxation Basic Principles
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Four Types of Usage for
Expenses and Property
 “Personal-use” property refers to the function of
property. It means that the property is held for the
taxpayer’s own enjoyment.
 “Personal” property refers to the physical nature of the
property. It means that the property is mobile, i.e., not
affixed to “real” property.
The following examples illustrate the four types of
usage for expenses, personal property, and real property.
Chapter 6, Exhibit 1a
CCH Federal Taxation Basic Principles
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Four Types of Usage for
Expenses and Property
Type of Usage
Expense
Personal Property
(property that is mobile)
Tangible
(value lies in
its physical
substance)
Business Use
Chapter 6, Exhibit 1b
Airfare to
Lawnmower
meet with
used by
client to
landscape firm
discuss cost
control
Intangible
(value lies in its
nonphysical
substance)
Stock held as
inventory by
dealer
CCH Federal Taxation Basic Principles
Real Property
(property that is
immobile)
Office building
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Four Types of Usage for
Expenses and Property
Type of Usage
Expense
Personal Property
(property that is mobile)
Tangible
(value lies in
its physical
substance)
Hobby Use
Chapter 6, Exhibit 1c
Airfare to
attend
Barbie™
doll
collectors
convention
Intangible
(value lies in its
nonphysical
substance)
Lawnmower
N/A
held by one
who tinkers
with old motors
in spare time
CCH Federal Taxation Basic Principles
Real Property
(property that is
immobile)
Home office
used exclusively
for stamp
collecting
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Four Types of Usage for
Expenses and Property
Type of Usage
Expense
Personal Property
(property that is mobile)
Tangible
(value lies in its
physical
substance)
Investment Use
Chapter 6, Exhibit 1d
Airfare to
attend
investment
seminar
Intangible
(value lies in its
nonphysical
substance)
First lawnmower Stock held by
ever sold by
investor
John Deere Co.
held by private
individual
CCH Federal Taxation Basic Principles
Real Property
(property that is
immobile)
Raw land
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Four Types of Usage for
Expenses and Property
Type of Usage
Expense
Personal Property
(property that is mobile)
Tangible
(value lies in
its physical
substance)
Personal Use
Chapter 6, Exhibit 1e
Airfare to
visit
grandmother
Intangible
(value lies in its
nonphysical
substance)
Lawnmower N/A
used for
personal lawn
care
CCH Federal Taxation Basic Principles
Real Property
(property that is
immobile)
Principal
residence
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Tax Treatment for the
Four Types of Usage
The tax treatment for losses and expenses varies
according to their type of usage.
Usage
Tax Treatment for Losses and Expenses
Business
Unlimited deductions, except for passive activity
losses (usually offers the most favorable tax
treatment)
Hobby
Limited to net hobby income
Investment
Capital loss limited to $3,000; investment
expenses limited to net investment income
Personal
Generally not deductible unless specifically
allowable as with itemized deductions (usually
results in the least favorable tax treatment)
Chapter 6, Exhibit 2
CCH Federal Taxation Basic Principles
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Business Expenses—Seven Criteria
Business expenses are generally deductible without limitation when the following seven
criteria are met:
1.
Purpose is business related. If part business, part personal, use a reasonable allocation (e.g., mileage for automobiles).
2.
Ordinary (common, acceptable response to a business situation) and necessary (helpful, but not essential). (Welch v.
Helvering)
3.
Reasonable in amount. This is of main concern to closely held corporations, particularly regarding officers’ salaries. One
way to substantiate reasonableness is by presenting documentation of similar expenses by comparable businesses.
4.
Capital expenditures are not deductible (but may be depreciable). Sales tax on capital expenditures must be capitalized.
5.
Activity must be related to a business, not to investments, hobbies, or personal-use property. There must be (1) an intent to
make a profit the IRS is generally satisfied if 3 of 5 years are profitable) and (2) an entrepreneurial effort.
6.
Exempt income must not be connected with the business expense (e.g., business interest expense on a loan used to buy local
utility bonds is not deductible).
7.
Public policy must not be violated by the expense. Fines, kickbacks, bribes, etc. are not deductible. (Tank Truck Rentals)
Chapter 6, Exhibit 3
CCH Federal Taxation Basic Principles
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Defending Tax Treatment for a
Business Activity
Whether losses or expenses receive favorable business
treatment is an issue of fact. The taxpayer wins if the
facts meet the statutory requirements; the IRS wins if
they do not. Reg. §1.183-2(b) provides the statutory
framework. It states that all facts and circumstances of
an activity are to be taken into account and that no one
factor makes the determination. It lists the following
nine factors that should normally be taken into account
in making the determination. Taxpayers and the IRS
should make their factual arguments within the context
of these nine factors.
Chapter 6, Exhibit 4a
CCH Federal Taxation Basic Principles
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Defending Tax Treatment for a
Business Activity
Nine Factors Cited in
Reg. §1.183-2(b)
Facts Supporting Business Status
Facts Supporting Nonbusiness Status
1.
Financial status of taxpayer
No substantial income from other sources
Substantial income from other sources
2.
Asset appreciation potential
Asset appreciation potential may satisfy the
profit requirement
Neither profit potential nor asset
appreciation potential are evident
3.
Recreational elements
Absence of personal or recreational
motives
Evidence of personal or recreational motives
4.
Manner of conducting activity
Complete and accurate records, separate
bank account, separate phone line
Records compiled when annual return is
filed, deposits and checks written out of
personal account, no dedicated phone line
5.
Time and effort
Substantial personal time and effort
Minimal time and effort devoted to the
activity
6.
History of success with
similar/dissimilar businesses
Successful track record with other activities
No track record
7.
Expertise of taxpayer
Extensive personal study or hiring of
outside consults to understand the activity
No concept of the economics underlying the
activity
8.
Profit frequency
Consistent profits beyond start-up stage
Inconsistent profits beyond start-up stage
9.
Profit size
Any past losses overshadowed by current
profits
Future profit potential not sufficient to
recoup accumulated losses
Chapter 6, Exhibit 4b
CCH Federal Taxation Basic Principles
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Hobby Expenses—Template for Problem Solving
If an activity is a hobby, expenses are deductible in the following three tiers:
Hobby income (Revenue - Cost of goods sold)
FIRST-TIER EXPENSES (reported on Schedule A)
–
Taxes (property tax and state and local income tax allocable to hobby)
–
Interest (interest on principal residence mortgages and home equity loans allocable
to hobby)
–
Casualty loss deductions (related to principal residence and allocable to hobby)
=
First-Tier Limit
Chapter 6, Exhibit 5a
CCH Federal Taxation Basic Principles
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Hobby Expenses—Template for Problem Solving
=
First-Tier Limit
SECOND-TIER EXPENSES (qpplied only if the first-tier limit is a positive value)
–
Out-of-pocket expenses (reported on Schedule A as miscellaneous itemized
deductions, subject to 2% AGI floor)
=
Second-Tier Limit
–
THIRD-TIER EXPENSES (only if the second-tier limit is a positive value)
–
Depreciation expense (reported on Schedule A as a miscellaneous itemized
deduction, subject to 2% AGI floor)
=
Hobby income (A hobby loss is not allowed for tax purposes.)
Chapter 6, Exhibit 5b
CCH Federal Taxation Basic Principles
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Home Office Deductions—
Template for Problem Solving
The rules for deducting home office expenses are similar to the hobby expense rules
except as follows:

Business expenses not related to the home office (e.g., advertising, wages) are
deductible without limitation before the three-tiered limitations take effect; hobby
expenses not related to the home office are subject to the second-tier limitation.

Self-employed persons report business expenses (deductible within the three-tiered
limitations) on Schedule C, not on Schedule A as is the case with hobby expenses.
Employed persons report unreimbursed business expenses (deductible within the threetiered limitations) on Schedule A (similar to the hobby rules).
Chapter 6, Exhibit 6a
CCH Federal Taxation Basic Principles
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Home Office Deductions—
Template for Problem Solving
Business income =(Revenue – Cost of goods sold)
–
Business expenses not related to home office (e.g., advertising, wages)
=
Net business income before home office expenses
–
FIRST-TIER EXPENSES (reported on Schedule C, not Schedule A as is
the case with hobbies)
–
Taxes (property tax and state and local income tax allocable to home
office)
–
Interest (interest on principal residence mortgages and home equity
loans allocable to home office)
–
Casualty loss deductions (related to principal residence and allocable to
home office)
=
First-Tier Limit
Chapter 6, Exhibit 6b
CCH Federal Taxation Basic Principles
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Home Office Deductions—
Template for Problem Solving
First-Tier Limit
–
SECOND-TIER EXPENSES (applied only if the first-tier limit is a
positive value)
–
Out-of-pocket expenses (e.g., utilities, maid service, pest control)
=
–
Second-Tier Limit
THIRD-TIER EXPENSES (applied only if the second-tier limit is a
positive value)
–
Depreciation expense (allocable to home office)
=
Net business income
Chapter 6, Exhibit 6c
CCH Federal Taxation Basic Principles
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Computing Home Office Deductions for
Self-Employed Persons
Example 1. Home office maintained on an exclusive and regular basis that
occupies 10% of the home’s total space.
Sales and Expenses
Total Amount
Sales
Allocable Amount
$300,000
$ 300,000
200,000
200,000
Business expenses not allocable to home
office use (e.g., supplies, wages paid)
94,000
94,000
Real estate taxes
10,000
1,000
Mortgage interest
20,000
2,000
Utilities (water, electricity, gas, sewer)
8,000
800
Repairs, maintenance, and maid service
12,000
1,200
Depreciation
15,000
1,500
Cost of goods sold
Chapter 6, Exhibit 7a
CCH Federal Taxation Basic Principles
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Computing Home Office Deductions For
Self-employed Persons
Example 1 Calculation
Allocable Amount
Sales
$ 300,000
Cost of goods sold
(200,000)
Gross income
$ 100,000
Business expenses not allocable to home office use
LIMIT ON ALLOCABLE TAXES AND INTEREST
(94,000)
6,000
Real estate taxes
(1,000)*
Mortgage interest
(2,000)*
LIMIT ON ALLOCABLE OUT-OF-POCKET EXPENSES
Utilities (water, electricity, gas, sewer)
Repairs, maintenance, and maid service
LIMIT ON DEPRECIATION
Depreciation allowed (of $1,500 total)
NET INCOME (LOSS) FROM RETAIL BUSINESS
3,000
(800)*
(1,200)*
1,000
(1,000)*
0
*Total home office deduction (total of items marked “*”)
6,000
Unused depreciation expense carried over ($6,500 - $6,000)
(500)
Chapter 6, Exhibit 7b
CCH Federal Taxation Basic Principles
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Computing Home Office Deductions For
Self-Employed Persons
Note: The $500 unused depreciation expense may be
deductible in the next year even if the home office is
converted to residential use at the beginning of the
next year, so long as the deduction does not create a
business loss.
Chapter 6, Exhibit 7c
CCH Federal Taxation Basic Principles
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Computing Home Office Deductions for Employees
Example 2. Home office maintained for employer’s convenience occupies 10% of the home’s
total space; employee’s AGI is $50,000
Example 2 Calculation
Total Amount
LIMIT ON ALLOCABLE HOME OFFICE
EXPENSES (i.e., employment income)
N/A
Allocable
Amount
Deductible
Amount
$50,000
Fully deductible home office expenses:
Real estate taxes
$ 10,000
$1,000
Mortgage interest
20,000
2,000
Total amount fully deductible
30,000
3,000
8,000
800
Repairs, maid service, etc.
12,000
1,200
Depreciation
15,000
1,500
Total amount subject to 2% AGI limitation
35,000
3,500
$3,000
Expenses subject to 2% AGI limitation:
Utilities (water, electricity, etc.)
Total home office deductions
2,500 *
5,500
* $2,500 = [$3,500 – ($50,000 AGI x 2% floor)]
Chapter 6, Exhibit 8
CCH Federal Taxation Basic Principles
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Interest Expense—An Overview
Code Section
Description
Tax Treatment
Code Sec. 1662
Business interest expense
Deductible “for” AGI
Code Sec. 163(d)
Production of income (PI) interest
expense ( i.e., investment interest
expense or portfolio interest expense)
Deductible “from” AGI,
limited to net investment
income (NII)
Code Sec. 163(h)(2)
Consumer interest
Not deductible
Code Sec. 163(h)(3)
Qualified residence interest
Deductible “from” AGI
Code Sec. 221
Student loan interest
Deductible “for” AGI,
limited to $2,500 in 2003
Code Sec. 265(a)(2)
Interest on funds used to buy taxexempt securities
Not deductible
Code Sec. 469
Interest expense connected with
passive activities
Deductible “for” AGI,
limited to passive income
Chapter 6, Exhibit 9
CCH Federal Taxation Basic Principles
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Investment Interest Expense—Example
CALCULATING THE DEDUCTION FOR PRODUCTION OF INCOME INTEREST
EXPENSE
AGI (includes $10,000 dividend income
from stock)
$80,000
Production of income interest expense
Investment expense other then interest
State ad valorem tax on stock
8,000
No 2% AGI Floor
Limitation
Subject to 2% AGI
Floor
$3,000
Safe deposit box rental
$120
Investment counseling fee
1,200
Noninvestment misc. expenses
Unreimbursed business travel expenses
850
Uniforms
600
Chapter 6, Exhibit 10a
CCH Federal Taxation Basic Principles
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Investment Interest Expense—Example
1. How much of the miscellaneous investment expenses are deductible?
The lesser of:
 INVESTMENT miscellaneous itemized deductions, WITHOUT REGARD to the
2% AGI floor:
120 + 1,200 = 1,320
 ALL miscellaneous itemized deductions AFTER SUBTRACTING the 2% AGI floor:
(120 + 1,200 + 850 + 600) – (2% x 80,000) = 1,170 [Answer]
Chapter 6, Exhibit 10b
CCH Federal Taxation Basic Principles
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Investment Interest Expense—Example
2. How much is the net investment income? (This sets the limit on
deductible investment interest expense for the tax year.)
Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$10,000
Investment expense other than interest:
Fully deductible ad valorem taxes . . . . . . . . . . . . . . . . . . .
(3,000)
Deductible miscellaneous investment expenses . . . . . . . .
(1,170)
Net investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5,830
Interest expense that is deductible (of $8,000 production
of income expense) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5,830
Interest expense that is carried over to next year . . . . . . . .
2,170
Chapter 6, Exhibit 10c
CCH Federal Taxation Basic Principles
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Taxes—An Overview
Most Common Types of
Taxes
Business Use
Personal Use
Federal income tax
Not deductible
Not deductible
State income tax
Deductible “for”AGI
Deductible “from” AGI
FICA employee
Not deductible
N/A
FICA employer
Deductible “for”AGI
N/A
Sales tax on capital asset
Capitalize and depreciate
Capitalize only
Sales tax on deductible
expenditure
Deductible “for”AGI
Not deductible
Property taxes
Deductible “for”AGI
Deductible “from” AGI
Chapter 6, Exhibit 11
CCH Federal Taxation Basic Principles
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Property Taxes—
Allocation Between Buyer and Seller
 Property taxes are generally deductible without limitation if
they are “ad valorem” (i.e., based on value).
 Property taxes should be allocated between seller and buyer
based on the number of days held, not the number of
months held. Furthermore, property taxes allocable to the
day of closing are attributable to the buyer, not the seller.
Chapter 6, Exhibit 12
CCH Federal Taxation Basic Principles
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Depreciation–
Code Sec. 179 Election
Expense election. In 2003, an election may be made to
expense up to $25,000 of tangible business and personal
property rather than capitalize and depreciate it. This election
must be made when the return is filed; it cannot be made on
an amended return. If an election is made and a portion of the
$25,000 creates a business loss, that portion creating the loss
must be carried over to the next year’s return.
Phaseout. The expense allowance is phased out on a dollarfor-dollar basis for purchases exceeding $200,000.
Chapter 6, Exhibit 13
CCH Federal Taxation Basic Principles
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Amortization
Amortizable property. Intangible property that is
used for business and is of limited life (e.g.,
goodwill, going-concern value, licenses, covenants
not to compete, franchises, trademarks, patents, and
copyrights).
Method. Straight-line method over a minimum of 15
years.
Chapter 6, Exhibit 14
CCH Federal Taxation Basic Principles
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Research and Experimental (R & E)
Qualifying expenditures. Experimental and laboratory costs for
pilot models, plant processes, products, formulas, inventions, or
similar properties. These costs include R&E salaries.
Nonqualifying expenditures. Ordinary testing or inspection of
materials or products for quality control, management studies,
consumer surveys, advertising, or promotions.
Tax treatment. R&E expenditures may be expensed
immediately, or if elected, amortized over a minimum of 5 years.
Chapter 6, Exhibit 15
CCH Federal Taxation Basic Principles
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Depletion
Cost depletion method
Cost of natural resources excluding land
Recoverable units
Chapter 6, Exhibit 16a
x
(Number of units
recovered AND sold)
CCH Federal Taxation Basic Principles
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Depletion
% depletion method
Statutory % x Gross income from natural resources
(where gross income equals revenues
without regard to cost of sales)
Chapter 6, Exhibit 16b
CCH Federal Taxation Basic Principles
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Depletion
Limitation of % Depletion
• Oil and gas properties: 100% of taxable income from
natural resources BEFORE depletion. (Code Sec.
613A(c)(6)(H)).
• Other properties (e.g., phosphate, copper, gold): 50% of
taxable income from natural resources BEFORE depletion.
Chapter 6, Exhibit 16c
CCH Federal Taxation Basic Principles
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Political Contributions and Lobbying
Type of Expenditure
Deductible
Not Deductible
Direct or indirect political contributions
by businesses for advertising, tickets to
dinners, balls, etc.

Lobbying expenses to influence federal
and state legislation
Lobbying expenses to monitor federal
and state legislation

Lobbying expenses to influence local
legislation
Chapter 6, Exhibit 17


CCH Federal Taxation Basic Principles
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Business Start-Up Expenses
Business Investigation Expenses
Definition
Expenditures that help determine whether to
create or buy a business
Timing
Occur before a decision to make or buy is
reached
Examples
Travel, marketing surveys, legal, accounting,
and engineering
Chapter 6, Exhibit 18a
CCH Federal Taxation Basic Principles
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Business Start-Up Expenses
Business Start-Up Expenses
Definition
Preoperational costs
Timing
Occur after a "go for it" decision is
reached, but before the doors open for
business
Employee training and stationery
Examples
Chapter 6, Exhibit 18b
CCH Federal Taxation Basic Principles
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Business Start-Up Expenses
Deductibility
Type
Similar business?
Business
Yes  deductible
Investigation No    
Expenses
No    
Business
Start-up
Expenses
Chapter 6, Exhibit 18c
“Go for it” decision?
Yes  Capitalize and
amortize  60 months
No  Not deductible
or capitalized, but lost
Yes  deductible
No  Capitalize and
amortize > 60 months
CCH Federal Taxation Basic Principles
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Business Start-Up Expenses
Tax Pointer. Avoid being trapped into
capitalizing business start-up costs attributed to a
dissimilar business. Instead, try to postpone as
much of them as possible until after the doors are
open for business. The postponement may result
in immediate expensing.
Chapter 6, Exhibit 18d
CCH Federal Taxation Basic Principles
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Meals and Entertainment
Tax Treatment
Self-Employed Individuals
Nonreimbursed Employees
50% deductible
50% deductible, and
limited to the 2% AGI floor
“For” AGI
“From” AGI as a
miscellaneous itemized
deduction
Chapter 6, Exhibit 19
CCH Federal Taxation Basic Principles
38 of 48
Moving Expenses
Amount Limitation. None.
Qualified moving expenses.
1. Transporting household goods and personal
effects
2. Traveling from old residence to new residence
3. Lodging during the move
Chapter 6, Exhibit 20a
CCH Federal Taxation Basic Principles
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Moving Expenses
Nonqualified moving expenses.
1.
2.
3.
4.
Premove house hunting
Temporary living quarters at new location
Meals during a qualified move
Real estate commissions on sale of old
residence
Chapter 6, Exhibit 20b
CCH Federal Taxation Basic Principles
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Moving Expenses
Time Requirement for the Moving Expense Deduction
Self-Employed


Employee
Work full time at new job > 39 weeks
during first 12 months, AND
Work full time at new job > 78 weeks
during first 24 months
Chapter 6, Exhibit 20c

Work full time at new job > 39 weeks
during first 12 months
CCH Federal Taxation Basic Principles
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Moving Expenses
Distance Requirement for the Moving Expense Deduction
Self-Employed
If the move is due to a relocation:
Distance, which must be  50 miles, between
(b) and
 Distance from the old residence to the new
job, and the
 Distance from the old residence to the old
job.
Chapter 6, Exhibit 20d
Employee
Same as for self-employed
CCH Federal Taxation Basic Principles
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Moving Expenses
Reporting Requirement for the Moving Expense Deduction:
Self-Employed
“For” AGI
Chapter 6, Exhibit 20e
Employee
“For” AGI (i.e., same tax treatment)
CCH Federal Taxation Basic Principles
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Student Loan Interest
Tax Treatment. Deductible “for” AGI. Thus, a student can
claim the student loan interest deduction even if the standard
deduction is used.
Deductible Limitation:
Chapter 6, Exhibit 21a
$2,500
CCH Federal Taxation Basic Principles
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Student Loan Interest
Time Limitation. The deduction for interest paid on a
student loan is allowed for all months in which interest
payments are required.
Chapter 6, Exhibit 21b
CCH Federal Taxation Basic Principles
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Student Loan Interest
Qualified Student Loans. To be eligible for the deduction, the
education loan must be used solely to pay for any of the
following expenses: tuition, student activity fees, room and
board, books and supplies, and other related expenses.
Note: The qualified purpose of a student loan is similar in
scope to the qualified purpose of “education withdrawals”
from ordinary IRAs and education IRAs. On the other hand,
the student loan is much broader in scope than the Hope
Scholarship or Lifetime Learning Credits.
Chapter 6, Exhibit 21c
CCH Federal Taxation Basic Principles
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Student Loan Interest
Phaseout of Student Loan Interest Deduction
Filing Status
Threshold for Modified AGI
Floor
Ceiling
Single, head of household, $50,000 $65,000
surviving spouse
Married filing jointly
$100,000 $130,000
Married filing separately
N/A
N/A
Chapter 6, Exhibit 21d
CCH Federal Taxation Basic Principles
Phaseout
Range
$15,000
$30,000
N/A
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Student Loan Interest
Example: Phaseout of Student Loan Interest Deduction
FACTS: A married couple files jointly. The wife has been paying interest on a student loan
for 3 years. In the current year, $6,000 of interest was paid. If the couple’s modified AGI
is $110,000, how much of the interest may be deducted?
(a)
Actual student loan interest paid during the year
(b)
Deductible limitation for the current year
(c) = lesser of (a) or (b) Amount subject to phaseout
$ 6,000
2,500
2,500
(d)
Modified AGI
110,000
(e)
Modified AGI threshold, floor
100,000
(f) = (d) – (e)
Excess modified AGI
10,000
(g)
Phaseout range
30,000
(h) = (f)  (g)
Phaseout percentage ($10,000  $30,000)
33.3%
(i) = (c) x (h)
Phaseout amount ($2,500 x 33.3%)
(j) = (c) – (i)
Allowable interest deduction ($2,500 – $833 =
$1,667)
Chapter 6, Exhibit 21e
CCH Federal Taxation Basic Principles
833
1,667
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