Section 1200 Income and Assets

INDIVIDUALS 1200 Income and Assets 1211 Income 1211.01 Wages, salaries, and tips received by an employee for performing services for an employer must be included in the employee’s gross income. Amounts withheld for taxes, including but not limited to income tax, Social Security, and Medicare taxes are considered “received” and must be included in gross income in the year they are withheld. Generally, an employer’s contribution to a qualified pension plan for the taxpayer is not included in his or her gross income at the time it is contributed. However, amounts withheld under certain salary reduction agreements with the taxpayer’s employer may have to be included in gross income in the year they are withheld. 1211.02 An employer should provide a Form W‐2 showing the taxpayer’s total income and withholding. The taxpayer must include all wages and withholdings from all Forms W‐2 he or she receives, and if filing jointly, all of the taxpayer’s spouse’s Forms W‐2. The taxpayer should attach a copy of each W‐2 to the front of his or her tax return as indicated in the instructions. 1211.03 A taxpayer must include every increment to wealth in their gross income for federal tax purposes unless there is a specific statutory exclusion from gross income for a specific item. For example, a gift that a taxpayer receives is an increment to a taxpayer’s wealth, but the Internal Revenue Code specifically provides that gifts are not taxable. 1211.04 All increments to wealth, unless they are statutorily excluded from tax, must be included in the taxpayer’s income regardless of whether he or she receives a W‐2, K‐1, or 1099 indicating that such income will be reported to the IRS. Although income is normally received in dollars, gross income includes the fair market value of property received or the amount of debt a taxpayer is relieved of. 71 INDIVIDUALS 1211.05 Most individuals use the cash basis method of accounting. Under the cash basis method of accounting, a taxpayer includes items on income in the years in which they are received. The term “received” includes actual receipt and constructive receipt. Constructive receipt occurs when a taxpayer is legally entitled to receive income. This concept applies to various types of income such as interest, compensation, and dividends. 1211.06 A taxpayer has constructive receipt on the first date he or she has a right to claim income. Thus, a taxpayer does not have to physically possess the income; it is considered received if it is credited to the taxpayer’s account or made available to the taxpayer. There is no constructive receipt if there are substantial limitations or restrictions on the taxpayer’s control of its receipt. Example: The taxpayer received a paycheck on December 31, 20X1, but did not cash the check until sometime in January 20X2. The taxpayer must include the paycheck as income on their 20X1 tax return as the money was available to them in 20X1. 1211.07 Earned income includes all the taxable income and wages a taxpayer gets from working. There are two ways to get earned income: the taxpayer works for someone who pays them; or they work in a business they own or run. Taxable earned income includes: a. Wages, salaries, tips, and other taxable employee pay; b. Union strike benefits; c. Long‐term disability benefits received prior to minimum retirement age; d. Net earnings from self‐employment if: e. 72 (i) The taxpayer owns or operates a business, or (ii) The taxpayer is a minister or member of a religious order. Gross income received as a statutory employee. INDIVIDUALS 1211.08 Examples of income that is not earned income include the following: a. Pay received for work while an inmate in a penal institution; b. Interest and dividends; c. Retirement income; d. Social Security; e. Unemployment benefits; f. Alimony; and g. Child support. 1211.09 If a taxpayer works as an employee in the United States, he or she must pay Social Security and Medicare taxes in most cases. The taxpayer’s payments of these taxes contribute to his or her coverage under the U.S. Social Security system. An employer deducts these taxes from each wage payment. In general, U.S. Social Security and Medicare taxes apply to payments of wages for services performed as an employee in the United States, regardless of the citizenship or residence of either the employee or the employer. 1211.10 The United States has entered into totalization agreements with certain foreign countries to coordinate the taxation of United States citizens employed for part or all of their working careers in certain foreign countries and the taxation of foreign citizens from certain countries working in the United States. These agreements are commonly referred to as “totalization agreements.” Under these agreements, dual coverage and dual contributions (taxes) for the same work are eliminated. The agreements generally make sure that Social Security taxes (including self‐employment tax) are paid only to one country. These agreements must be taken into account when determining whether any alien is subject to the U.S. Social Security/Medicare tax, or whether any U.S. citizen or resident alien is subject to the Social Security taxes of a foreign country. 73 INDIVIDUALS 1211.11 The United States has an “extraterritorial” income tax, in that an American citizen or a resident of the United States must report all income regardless of where it is earned. Thus, a United States citizen living and working in Canada must report and pay tax on all his or her income to the United States. 1211.12 Generally, a taxpayer is in constructive receipt of income when interest is posted to his or her savings or checking account regardless of whether the taxpayer withdraws or spends the interest. A taxpayer who owns a certificate of deposit (CD) or some other deferred interest account will be paid interest one or more times per year, or in one lump sum at maturity. The taxpayer must report the interest as income when he or she actually receives it or when he or she can withdraw money from the CD without paying a substantial penalty. If a taxpayer withdraws funds from a deferred interest account before it matures and he or she pays an early withdrawal penalty, the taxpayer must report the total amount of interest paid during the year without subtracting the penalty. 1211.13 Interest Income Generally, all interest received is taxable. Interest on state and municipal obligations is, however, excluded from gross income. Interest on U.S. Savings Bonds may be reported in the year accrued or postponed until the year of surrender by a cash‐basis taxpayer. Original issue discount (OID) Original issue discount (OID), a form of interest, is the excess of an obligation’s stated redemption price at maturity over its issue price (acquisition price for a stripped bond or coupon). A discount of less than 1/4 of 1 percent of the stated redemption price at maturity, multiplied by the number of full years from the date of issue to maturity, is considered to be zero. Original issue discount can apply to securities, such as bonds, debentures, notes, or certificates and is the difference between the maturity, or face value, of the security and the original cost to purchase the security. The original issue discount is important because the IRS uses special rules for determining them. Taxpayers receive the amount of their original issue discount on Form 1099‐OID. 74 INDIVIDUALS The issuer will prepare a Form 1099‐OID for each person who is a holder of record of the obligation if the OID includible in the holder’s gross income is $10 or more and the debt instrument term is at least one year. A taxpayer may be able to exclude from income all or part of the interest they receive on the redemption of qualified U.S. savings bonds during the year if the taxpayer pays qualified higher educational expenses during the same year. This exclusion is known as the Education Savings Bond Program. 1211.14 Dividends of cash or property: a. Dividends are distributions of cash or property from a corporation to its shareholders. Generally, dividends are taxable when received. Federal law requires a corporation to inform the shareholder as to taxable and nontaxable amounts. b. Dividends paid on deposits with the following: mutual savings banks, cooperative banks, credit unions, U.S. building and loan associations, and other similar institutions are not considered dividends. These are interest and should be reported as such. c. There are two types of dividends. 1) Ordinary dividends are paid out of the earnings and profits of a corporation. They are the most common type of dividends and taxed at the taxpayer’s ordinary tax rate, along with most other income. 2) Qualified dividends are subject to a lower tax rate than ordinary dividends. The qualified dividend tax rates are 0% for amounts that would be taxed at 10% or 15%, 15% for amounts that would be taxed at 15%–37%, and 20% for amounts that would be taxed at a higher rate than 37%. Use the worksheet included with Schedule D instructions to figure the qualified dividends tax rate. To be a qualified dividend, the dividend must have been paid by a U.S. corporation or qualified foreign corporation, the taxpayer must meet the holding period 75 INDIVIDUALS (generally greater than 60 days during the 121‐day period beginning 60 days before the first date following the declaration of a dividend on which the buyer cannot receive the next dividend payment, or the ex‐dividend date), and the dividend cannot be one of the following: 3) d. 76 i. Capital gain distributions ii. “Dividends” that are actually interest (discussed in (b) above) iii. Dividends on employer securities paid by a corporation and held by an employee stock ownership plan (ESOP) iv. Dividends on stock for which the taxpayer is required to purchase substantially similar or related property v. Payments in lieu of dividends (if the taxpayer knows or has reason to know that the payments are not qualified dividends) vi. Dividends reported as qualified dividends from a foreign corporation to the extent the taxpayer knows or has reason to know that these are not qualified dividends Capital gain distributions are paid by regulated investment companies (RICs) and real estate investment trusts (REITs). These are always reported as long‐term capital gains and must be reported even if undistributed. Individuals with modified adjusted gross income over certain threshold amounts must pay the Net Investment Income Tax (NIIT) if they have net investment income. This is a 3.8% tax on the lesser of net investment income or the modified adjusted gross income (MAGI). The threshold amount for 2023 is $250,000 for joint returns, $125,000 for married filing separate returns, and $200,000 for other filing statuses. The Net Investment Income Tax is a contribution to Medicare and is calculated/reported on INDIVIDUALS Form 8960, Net Investment Income Tax – Individuals, Estates, and Trusts. e. f. g. h. If the taxpayer has a choice of stock or cash: 1) Any cash received is income. 2) Any stock received is income to the extent of the fair market value of the stock on the date received. i. The basis of the new stock is also the fair market value of the stock. ii. The holding period for the new stock begins on the date the dividend is received. Stock dividends that do not result in a disproportionate distribution are not considered income. Likewise, stock splits do not produce income for the shareholders. 1) The basis of original shares must be allocated between the new and the original shares. 2) The holding period of the acquired stock is the same as that of the old stock. Any distribution of stock or stock rights made to preferred shareholders is taxable as a dividend. 1) The fair market value of the property received constitutes income and establishes the basis of that property. 2) The holding period for this property begins at the date of receipt. Property received as a dividend is income. 1) The fair market value of the property on the date of distribution constitutes income. 2) The basis of the property is also equal to the fair market value. 3) The holding period of the property acquired begins on the date the property is received. 77 INDIVIDUALS i. 1211.15 78 Amounts received in a partial or complete liquidation are treated as follows: 1) A return of capital until the taxpayer’s investment is recovered. 2) A capital gain on amounts received after the taxpayer’s investment is recovered. Rents and royalties: a. Royalties are included in gross income when received. b. Rental income is any payment received for the use or occupation of property. A taxpayer must include in gross income all amounts that are received as rent. 1) Rent is taxable when received if the taxpayer uses the cash basis; or when accrued, if the taxpayer uses the accrual basis. Any amount received from a tenant to cancel a lease is treated as rent and included in income. 2) If a tenant pays any of the taxpayer’s expenses, the payments are rental income and included in income. 3) Prepaid rental income (i.e., advance rent) is recognized in the year received whether the taxpayer is on the accrual or cash basis. c. Security deposits are not included in rental income if the amount is to be returned to the tenant at the end of the lease. If the taxpayer keeps part or all of the security deposit during any year because the tenant does not live up to the terms of the lease, the amount retained becomes income for that year. d. If an amount called a security deposit is to be used as a final payment of rent, it is advance rent, and as such, it is included as rental income in the year that it is received. INDIVIDUALS e. 1211.16 1211.17 Rental of personal residence: 1) When a personal residence is rented out for less than 15 days, no rental income is recognized and expenses are not required to be prorated between personal use and rental use. 2) When a personal residence is rented out for more than 14 days, the rental income is recognized and the expenses must be allocated between personal use and rental use. A portion of mortgage interest and real estate taxes must be allocated to reduce the rental income. Taxpayers cannot deduct a loss from renting a personal residence. Gambling winnings and losses: a. All gambling winnings are included in gross income. b. Losses are deductible as an itemized deduction, but only to the extent of winnings. Under the Tax Cuts and Jobs Act of 2017 (TCJA), the law is clarified: for example, an individual’s expenses traveling to and from a casino are only deductible to the extent of gambling winnings. That is, there is no separate deduction for expenses incurred in winning the gambling income. Tax treatment for forgiveness of debt In general, if a taxpayer is liable for a debt that is canceled, forgiven, or discharged, he or she will receive a Form 1099‐C, Cancellation of Debt, and must include the amount of the canceled debt in gross income unless he or she qualifies for an exception under §108. For example, §108 provides that if the debtor is insolvent or in bankruptcy, he or she need not include the cancelled debt in income. If the taxpayer receives a Form 1099‐C, but the creditor continues to attempt to collect the debt, then the creditor has not cancelled the debt and the taxpayer does not have taxable cancellation of debt income at that time. One exception to this rule is debt forgiveness associated with PPP (Paycheck Protection Program) loans. The Tax Relief Act of 2020 clarified that PPP loan forgiveness will not generate income from cancellation of debt. Additionally, the taxpayer will not have to 79 INDIVIDUALS decrease any tax attributes as a result of nonrecognition of income. 80 1211.18 A debt includes any indebtedness whether the taxpayer is personally liable or liable only to the extent that he or she owns the property securing the debt. Cancellation of all or part of a debt that is secured by property may occur because of a foreclosure, a repossession, a voluntary return of the property to the lender, abandonment of the property, or a loan modification. The taxpayer must report any taxable amount of a cancelled debt for which he or she is personally liable, as ordinary income from the cancellation of debt. The taxpayer must report as taxable amount of a discharged or forgiven debt whether or not he or she receives a Form 1099‐C (exception to this rule is PPP loan forgiveness, see above). 1211.19 If a taxpayer’s debt is secured by property and that property is taken by the lender in full or partial satisfaction of the debt, the taxpayer will be treated as having sold that property and may have a reportable gain or loss. The gain or loss on such a deemed sale of property is a separate issue from whether any canceled debt also associated with that same property is includable in gross income. 1211.20 Canceled debts that meet the requirements for any of the following exceptions or exclusions are not taxable: a. Amounts specifically excluded from income by law such as gifts or bequests; b. Cancellation of certain qualified student loans; c. Canceled debt that if paid by a cash basis taxpayer is otherwise deductible; and d. A qualified purchase price reduction given by a seller. INDIVIDUALS 1211.21 Canceled debts that qualify for exclusion from gross income are as follows: a. Cancellation of qualified principal residence indebtedness; b. Debt canceled in a Title 11 bankruptcy case; c. Debt canceled during insolvency; d. Cancellation of qualified farm indebtedness; e. Cancellation of qualified real property business indebtedness; and f. Cancellation of debt associated with PPP (Paycheck Protection Program) loans. 1211.22 The exclusion for “qualified principal residence indebtedness” provides canceled debt tax relief for many American homeowners involved in the mortgage foreclosure crisis that affected much of the country. The exclusion allows taxpayers to exclude up to $750,000 ($375,000 if married filing separately) of “qualified principal residence indebtedness.” The debt must be used to buy, build, or substantially improve the main or second home. The excluded amount reduces the taxpayer’s basis in the residence. 1211.23 Generally, if a taxpayer excludes canceled debt from income under one of the exclusions listed above, he or she must also reduce his or her tax attributes (certain credits, losses, and basis of assets) by the amount excluded. The taxpayer must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to report the exclusion and the corresponding reduction of certain tax attributes. 1211.24 Tax treatment of a U.S. citizen/resident with foreign earned income: If a taxpayer meets certain requirements, he or she may qualify for the foreign earned income, foreign housing exclusions, and the foreign housing deduction. A U.S. citizen or a resident alien of the United States who lives abroad is taxed on his or her worldwide income. However, the taxpayer may qualify to exclude from income up to $120,000 in 2023. In addition, a taxpayer can exclude or deduct certain foreign housing amounts. 81 INDIVIDUALS 1211.25 To claim the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, a taxpayer must meet all three of the following requirements. a. The taxpayer’s tax home must be in a foreign country; b. The taxpayer must have foreign earned income; and c. The taxpayer must be one of the following: (i) A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, (ii) A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, or (iii) A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months. 1211.26 Tax home in a foreign country To qualify for the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, the taxpayer’s tax home must be in a foreign country throughout his or her period of bona fide residence or physical presence abroad. 1211.27 Tax home If a taxpayer does not have a regular or main place of business because of the nature of his or her work, the taxpayer’s tax home may be the place where he or she regularly lives. If the taxpayer has neither a regular or main place of business nor a place where he or she regularly lives, the taxpayer is considered an itinerant and his or her tax home is wherever he or she works. 82 INDIVIDUALS 1211.28 Temporary or indefinite assignment The location of a taxpayer’s tax home often depends on whether his or her assignment is temporary or indefinite. If he or she is temporarily absent from his or her tax home in the United States on business, he or she may be able to deduct his or her away‐ from‐home expenses (for travel, meals, and lodging), but he or she would not qualify for the foreign earned income exclusion. If his or her new work assignment is for an indefinite period, his or her new place of employment becomes his or her tax home and he or she would not be able to deduct any of the related expenses that he or she has in the general area of this new work assignment. If his or her new tax home is in a foreign country and he or she meets the other requirements, his or her earnings may qualify for the foreign earned income exclusion. If he or she expects his or her employment away from home in a single location to last, and it does last, for one year or less, it is temporary unless facts and circumstances indicate otherwise. If he or she expects it to last for more than one year, it is indefinite. If the taxpayer expects it to last for one year or less, but at some later date he or she expects it to last longer than one year, it is temporary (in the absence of facts and circumstances indicating otherwise) until his or her expectation changes. Once his or her expectation changes, it is indefinite. 1211.29 Foreign country To meet the bona fide residence test or the physical presence test, a taxpayer must live in or be present in a foreign country. A foreign country includes any territory under the sovereignty of a government other than that of the United States. 83 INDIVIDUALS 1211.30 Bona fide residence test A taxpayer meets the bona fide residence test if they are a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year. The taxpayer can use the bona fide residence test to qualify for the exclusions and the deduction only if they are either: a. A U.S. citizen; or b. A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect. 1211.31 A taxpayer does not automatically acquire bona fide resident status merely by living in a foreign country or countries for one year. If a taxpayer goes to a foreign country to work on a particular job for a specified period of time, they ordinarily will not be regarded as a bona fide resident of that country even though they work there for one tax year or longer. The length of their stay and the nature of their job are only two of the factors to be considered in determining whether they meet the bona fide residence test. 1211.32 To meet the bona fide residence test, a taxpayer must have established a bona fide residence in a foreign country. A taxpayer’s bona fide residence is not necessarily the same as their domicile. A taxpayer’s domicile is their permanent home, the place to which they always return or intend to return. Example: A taxpayer could have their domicile in Cleveland, Ohio, and a bona fide residence in Edinburgh, Scotland, if they intend to return eventually to Cleveland. The fact that a taxpayer goes to Scotland does not automatically make Scotland their bona fide residence. If they go there as a tourist, or on a short business trip, and return to the United States, they have not established bona fide residence in Scotland. But if they go to Scotland to work for an indefinite or extended period and they set up permanent quarters there for themselves and their family, they probably have established a bona fide residence in a foreign country, even though they intend to return eventually to the United States. 84 INDIVIDUALS 1211.33 The taxpayer is clearly not a resident of Scotland in the first instance. However, in the second instance, they are a resident because their stay in Scotland appears to be permanent. If their residency is not as clearly defined as either of these illustrations, it may be more difficult to decide whether they have established a bona fide residence. 1211.34 Physical presence test A taxpayer meets the physical presence test if he or she is physically present in a foreign country or countries 330 full days during a period of 12 consecutive months. The 330 days do not have to be consecutive. Any U.S. citizen or resident alien can use the physical presence test to qualify for the exclusions and the deduction. The physical presence test is based only on how long a taxpayer stays in a foreign country or countries. This test does not depend on the kind of residence he or she establishes, his or her intentions about returning, or the nature and purpose of his or her stay abroad. Generally, to meet the physical presence test, a taxpayer must be physically present in a foreign country or countries for at least 330 full days during a 12‐month period. The taxpayer can count days he or she spent abroad for any reason. 1211.35 Foreign earned income To claim the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, a taxpayer must have foreign earned income. Foreign earned income generally is income a taxpayer receives for services he or she performs during a period in which he or she meets both of the following requirements: a. His or her tax home is in a foreign country; and b. He or she meets either the bona fide residence test or the physical presence test. 85 INDIVIDUALS 1211.36 Earned income This is pay for personal services performed, such as wages, salaries, or professional fees. The list that follows classifies many types of income into three categories. The column headed Variable Income lists income that may fall into either the earned income category, the unearned income category, or partly into both. Earned Income Salaries and wages Commissions Bonuses Professional fees Tips 1212 Other Income 1212.01 Scholarships and fellowships 1212.02 86 Unearned Income Dividends interest Capital gains Gambling winnings Alimony Social Security benefits Pensions Annuities Variable Income Business profits Royalties Rents Scholarships and fellowships a. A degree candidate may exclude scholarships and fellowships to the extent the amount received is used for tuition, course fees, books, and supplies. Amounts used for room and board are taxable. b. Amounts received are taxable if specific services, such as teaching, are required to receive the scholarship or fellowship. c. Any amount paid to a nondegree candidate is taxable. Bartering income a. Bartering occurs when a taxpayer exchanges goods or services without exchanging money. An example of bartering is a plumber doing repair work for a dentist in exchange for dental services. A taxpayer must include in gross income in the year of receipt the fair market value of goods and services received in exchange for goods or services the taxpayer provided. b. Generally, a taxpayer reports this income on Form 1040, Schedule C, Profit or Loss from Business. If a taxpayer INDIVIDUALS failed to report this income, he or she should correct his or her return by filing a Form 1040X. 1212.03 c. A barter exchange or barter club is any organization with members or clients or persons who contract with each other (or with the barter exchange) to jointly trade or barter property or services. The term does not include arrangements that provide solely for the informal exchange of similar services on a noncommercial basis. d. The Internet has provided a medium for new growth in the bartering exchange industry. This growth prompts the following reminder: barter exchanges are required to file Form 1099‐B for all transactions unless they meet certain exceptions. Persons who do not contract a barter exchange, but who trade services, are not required to file Form 1099‐B. However, they may be required to file Form 1099‐MISC. If a taxpayer is in a business or trade, he or she may be able to deduct certain costs incurred to perform the work that was bartered. If a taxpayer exchanged property or services through a barter exchange, he or she should receive a Form 1099‐B, Proceeds from Broker and Barter Exchange Transactions. The IRS also will receive the same information. Hobby income a. The TCJA of 2017 eliminates the itemized deduction for hobby expenses. Some expenses, however, are deductible regardless of hobby income. These would include all expenses to which the taxpayer is normally entitled as a personal deduction, such as interest, taxes, and casualty losses. b. A hobby may be treated as a business if it meets the following profitability tests: 1) A profit is generated in three out of five consecutive years. 2) A profit is generated in two out of seven consecutive years for breeding, training, showing, or racing horses. 87 INDIVIDUALS c. 1212.04 If facts and circumstances can prove an intent to make a profit, the activity may still be considered a business after failing the above test. However, the burden of proof is on the taxpayer. Alimony and separate maintenance payments Note: The TCJA of 2017 changes the treatment of alimony and separate maintenance payments negotiated after December 31, 2018. (see f. below) a. Excluding the portion that is designated for child support, qualified payments are included in the gross income of the recipient and deductible from gross income by the payor if the payments are made after: 1) Decree or divorce or separate maintenance, 2) Written separation agreement, or 3) Decree for support (this applies to periods pending finality of divorce or legal separation). b. Qualified payments are required to meet the following guidelines: c. 88 1) Payments must be in cash. 2) Payments must terminate at the death of the recipient. 3) Payments cannot be made to a payee who lives in the same household as the payor. 4) Payments cannot be specified as something other than alimony. Special rules apply if alimony payments in the second‐ or third‐year decrease by more than $15,000 from the payments made in the previous year. 1) If the change in payments exceeds statutory limits, recapture of excessive alimony payments will result. 2) All of the recapture will take place in the third year. INDIVIDUALS d. 1212.05 i. The payor must include the excess amounts in gross income. ii. The payee is allowed to deduct the excess payments from gross income to arrive at adjusted gross income. Any amount that can be identified as child support cannot be treated as alimony. 1) Child support payments are neither deductible by the payor nor income to the recipient 2) If both child support and alimony are provided for in the agreement, any amounts paid are first considered to be child support until that obligation is met. e. The transfer of property between divorcing spouses in exchange for release from marital obligations is nontaxable. The basis of the transferred property to the transferee will be the same as it was to the transferor. f. For any divorce or separation agreement executed after December 31, 2018, or executed before that date but modified after it (if the modification expressly provides that the new amendment applies), alimony and separate maintenance payments are not deductible by the payor spouse nor includible in income of the payee spouse. Military combat pay a. U.S. Armed Forces members, including enlisted persons or warrant officers, may exclude military pay received for military services for the entire month of any month while serving in a combat zone. Commissioned officers are capped at the highest enlisted pay, plus any hostile fire or imminent danger pay received. b. Military pay received by enlisted personnel who are hospitalized as a result of injuries sustained while serving in a combat zone is excluded from gross income for the period of hospitalization. c. Reenlistment bonuses received are excluded from gross income if the member reenlists early while in a combat 89 INDIVIDUALS zone even if the bonus is not received until several months later while stationed outside the combat zone. d. 1212.06 90 Deadlines, including filing and paying income tax due, are automatically extended for service persons in a combat zone. Canceled debt: a. Generally, a canceled debt is income to the debtor when the cancellation is not intended to be a gift. b. The presence or absence of consideration is a vital factor in determining whether or not a gift was intended. c. When a seller cancels a buyer’s purchase indebtedness, the buyer can generally avoid income recognition by electing to reduce the basis of the property by the amount of the debt discharged. d. Discharge of indebtedness due to debtor insolvency or federal bankruptcy law is generally not included in gross income but is used instead to reduce the basis of assets or other items carrying favorable tax attributes, such as loss or credit carryovers. e. A shareholder’s cancellation of a corporation’s indebtedness is treated as a contribution of capital. f. Some states make loans to students under an agreement that the loan will be canceled if the student works in a certain profession, in a location within the state after graduation. 1) The canceled debt is excluded from gross income. 2) This exclusion also applies to loans from tax‐ exempt charitable organizations. However, the debt cancellation cannot relate to services performed for the lender organization. 3) The TCJA of 2017 excludes any income resulting from the discharge of student debt due to death or disability for discharges of student loans after 2017 and before 2026. INDIVIDUALS 1213 Constructive Receipt of Income 1213.01 An accounting method is a set of rules used to determine when and how income and expenses are reported. A taxpayer’s accounting method includes not only the overall method of accounting he or she uses, but also the accounting treatment he or she uses for any material item. 1213.02 A taxpayer chooses an accounting method for his or her business when he or she files his or her first income tax return that includes a Schedule C for the business. After that, if a taxpayer wants to change his or her accounting method, he or she must generally get IRS approval. Generally, a taxpayer can use any of the following accounting methods: a. Cash method; b. An accrual method; c. Special methods of accounting for certain items of income and expenses; or d. Combination method using elements of two or more of the above. A taxpayer must use the same accounting method to figure his or her taxable income and to keep his or her books and must use an accounting method that clearly shows his or her income. 1213.03 A taxpayer can account for business and personal items under different accounting methods. For example, a taxpayer can figure business income under an accrual method, even if he or she uses the cash method to figure personal items. If a taxpayer has two or more separate and distinct businesses, he or she can use a different accounting method for each if the method clearly reflects the income of each business. They are separate and distinct only if he or she maintains complete and separate books and records for each business. 91 INDIVIDUALS 1213.04 Cash method Most individuals and many sole proprietors with no inventory use the cash method because they find it easier to keep cash method records. However, if an inventory is necessary to account for income, the taxpayer must generally use an accrual method of accounting for sales and purchases. Under the cash method, the taxpayer should include in gross income all items of income he or she actually or constructively received during his or her tax year. If a taxpayer receives property or services, he or she must include their fair market value in income. Example: On December 30, 20X1, Mrs. Sycamore sent taxpayer a check for interior decorating services the taxpayer provided to her. The taxpayer received the check on January 2, 20X2. The taxpayer must include the amount of the check in income for 20X2. A taxpayer has constructive receipt of income when an amount is credited to his or her account or made available to him or her without restriction. The taxpayer does not need to have possession of it. If the taxpayer authorizes someone to be his or her agent and receives income for the taxpayer, he or she is treated as having received it when his or her agent received it. Example: Interest is credited to a taxpayer’s bank account in December 20X1. The taxpayer does not withdraw it or enter it into his or her passbook until 20X2. The taxpayer must include it in his or her gross income for 20X1. 1213.05 Delaying receipt of income: A taxpayer cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying tax on the income. The taxpayer must report the income in the year the property is received or made available to him or her without restriction. Example: Frances Jones, a service contractor, was entitled to receive a $10,000 payment on a contract in December 20X1. She was told in December that her payment was available. At her request, she was not paid until January 20X2. She must include this payment in her 20X1 income because it was constructively received in 20X1. 92 INDIVIDUALS 1213.06 Checks: Receipt of a valid check by the end of the tax year is constructive receipt of income in that year, even if the taxpayer cannot cash or deposit the check until the following year. Example: Dr. Redd received a check for $500 on December 31, 20X1. She could not deposit the check in her business account until January 3, 20X2. She must include this fee in her income for 20X1. 1214 Passive Income 1214.01 In order to understand the rules dealing with rental income and expenses, it is necessary to understand how the passive activity loss rules work. The passive activity loss rules (§469 of the Internal Revenue Code) limits the taxpayer’s ability to deduct losses from businesses in which he or she does not materially participate and from rental activities. The passive activity loss rules are applied at the individual level and extend to virtually every business or rental activity whether reported on Schedule C, Schedule F, or Schedule E of the Form 1040, as well as to flow‐through income and losses from partnerships, S corporations, and trusts. The passive loss limitations also apply to personal service corporations and to closely held C corporations, but with limited applications. 1214.02 In general, losses generated by passive activities can only be used to offset income generated by passive activities. A passive activity is an activity for the tax year if the activity is a trade or business activity in which the taxpayer does not materially participate for such taxable year or is a rental activity, without regard to whether or to what extent the taxpayer participates in the activity. 1214.03 Section 469 generally divides a taxpayer’s income and losses into three types, which relate to the three types of activities provided for under §469: 1. Passive; 2. Active; and 3. Portfolio. 93 INDIVIDUALS 1214.04 Section 469 provides that passive losses may only be used to offset passive income and expenses related to passive activities can be deducted only to the extent of income from all of the taxpayer’s passive activities. Passive losses that cannot be used to offset other income are suspended and carried forward to offset passive income in a subsequent year. Suspended passive losses may also offset portfolio or active income when the taxpayer disposes of his or her entire interest in the activity that generated the suspended passive losses. 1214.05 When the taxpayer makes a full and compete disposition of a passive activity with suspended losses, the losses are used to offset income in the following order: 1214.06 1214.07 94 1. Gain on the disposition of the passive activity. 2. Net income from any of the taxpayer’s passive activities. 3. All other income ‐‐ active and portfolio income. Activities that are generally passive: Income and losses from the following activities are generally passive: 1. Rental real estate (except rentals in which a real estate professional materially participates) and equipment leasing. 2. Sole proprietorship or a farm in which the taxpayer does not materially participate. 3. Limited partnership interest, with some exceptions. 4. Partnership, S corporation, and limited liability company business in which the taxpayer does not materially participate. Activities that are generally non‐passive: Income and losses from the following are generally non‐passive: 1. Salaries, wages, and Form 1099‐MISC commissions. 2. Guaranteed payments from partnerships. 3. Portfolio income (interest, dividends, royalties, gains on stocks and bonds). 4. Sale of undeveloped land or other investment property. INDIVIDUALS 1214.08 1214.09 5. Royalties. 6. Sole proprietorship or farm in which the taxpayer materially participates. 7. Partnership, S corporation, or LLC business in which the taxpayer materially participates. Portfolio income: Passive activity gross income does not include portfolio income, which includes all gross income other than income derived in the ordinary course of a trade or business that is attributable to the following: • Interest • Dividends • The disposition of property that produces interest • Gross income derived in the ordinary course of a trade or business • The disposition of property held for investment • Royalties Definition of passive activity loss: Generally, a taxpayer’s passive activity loss for the tax year is the excess of his or her passive activity deductions over his or her passive activity gross income. Closely held corporations can offset net active income with passive activity losses but cannot use passive losses to offset their portfolio income. Portfolio income is interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business. For a closely held corporation, the passive activity loss is the excess of passive activity deductions over the sum of passive activity gross income and net active income. A trade or business activity is not a passive activity if the taxpayer materially participated in the activity. 95 INDIVIDUALS 1214.10 96 Material participation tests: A taxpayer materially participated in a trade or business activity for a tax year if he or she satisfies any one of the following tests: 1. He or she participated in the activity for more than 500 hours. 2. His or her participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity. 3. He or she participated in the activity for more than 100 hours during the tax year, and he or she participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year. 4. The activity is a significant participation activity, and the taxpayer participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which the taxpayer participated for more than 100 hours during the year and in which he or she did not materially participate under any of the material participation tests, other than this test. 5. The taxpayer materially participated in the activity for any five (whether or not consecutive) of the ten immediately preceding tax years. 6. The activity is a personal service activity in which the taxpayer materially participated for any three (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income‐producing factor. 7. Based on all the facts and circumstances, the taxpayer participated in the activity on a regular, continuous, and substantial basis during the year. INDIVIDUALS 1214.11 Documenting material participation: An individual may establish his or her participation in an activity by any reasonable means. Reasonable means may include, for example, the identification of services performed over a period of time and the number of hours spent performing such services based on appointment books, calendars, or narrative summaries. An individual is not required to maintain contemporaneous daily time reports, logs, or similar documents, provided he or she can otherwise substantiate the level of his or her participation in an activity. 1215 Pass‐Through Entities 1215.01 Certain domestic corporations may elect not to be taxed. Instead, the corporation makes an “S election” and income is passed through to the stockholders, who are taxed on their share of the corporation’s earnings. Stockholders are taxed on their share of the earnings even though the earnings are not distributed. 1215.02 Shareholders must include on their personal tax returns their share of the S corporation’s income or loss and special items from the corporate tax year that has ended with or within the shareholder’s tax year. Thus, income is reported and recognized on a basis similar to but not the same as that of partnerships. a. When ownership has changed during the year, each owner must recognize their share of income on a per‐share per‐ day of ownership allocation. b. Loss pass‐throughs in excess of the taxpayer’s basis in the corporation may be carried forward indefinitely and deducted when the taxpayer’s basis is increased sufficiently, either by the corporation’s income or a contribution of capital, to absorb the loss. 97 INDIVIDUALS 1215.03 Distributions of cash and property are basically given the same treatment. Shareholders must recognize as a distribution the amount of cash and the fair market value of any property distributed. a. The taxability of a distribution is determined by its source. b. Distributions from an S corporation come from the following sources in the order listed: 1) Distributions are first considered to come from an “accumulated adjustments account” (AAA). i. ii. c. 1. Tax‐exempt income 2. Corporate expenses not deductible in computing taxable income and not chargeable to a capital account Distributions from the AAA are nontaxable. 2) Distributions are then considered as dividends to the extent of any accumulated earnings and profits (E&P) from a time when the corporation’s S election was not in effect (provided the entity was a C corporation prior to electing S status. If the entity elects S status immediately after formation, the entity would not have any Accumulated E&P). 3) When E&P is exhausted, distributions are a return of capital to the extent of the shareholder’s stock basis, and then capital gain. If an S corporation distributes appreciated property to a shareholder, the transfer is treated as if the property had been sold to the shareholder at fair market value. 1) 98 The AAA represents income earned after 1982 adjusted by any additions and subtractions that shareholders were required to make to the basis of their stock for this period. However, no adjustment is made for the following: A gain is recognized at the corporate level. INDIVIDUALS 2) 1215.04 The gain is subsequently passed through to the shareholders, each of whom reports the percentage of the gain equal to her or his percentage ownership of the corporation’s shares. Before 2018, partnerships were not taxable entities. They were reporting entities. Partnerships functioned as a conduit for income tax purposes and passed all items of income, deduction, gain, loss, and credits through to the partners. a. Ordinary income and losses along with special gain and loss items channel through the partnership to the partners, who report these items on their tax returns. In addition to individuals, partners can be corporations, trusts, other partnerships, and estates. b. The partnership must report each partner’s distributive share of the ordinary gain or loss as well as any specially treated items that the partner might use on an individual return. c. Self‐employment taxes apply to all ordinary income passing to the owners. d. Beginning with tax year 2018, new rules for auditing partnerships and assessing tax deficiencies will apply. The new rules are commonly referred to as the “partnership audit regime” and they provide, among other items: 1) a requirement that a partnership appoint a “partnership representative” who will act for the partnership in all matters involving the IRS. 2) that a tax deficiency arising from an audit of a partnership is a liability of the partnership, not the partners. 3) elections to deal with issues created by the new rules, such as assessing and collecting a partner’s share of a tax deficiency. 4) a procedure for a small partnership to elect out and remain covered by the TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) rules. 99 INDIVIDUALS 1216 Itemized Deduction Recoveries 1216.01 State and/or local tax refund If the taxpayer received a state or local income tax refund in 2023, the taxpayer generally must include it in income if the tax was previously deducted. The state or local agency should send a Form 1099‐G by January 31, 2024 to the taxpayer. The IRS will also receive a copy of the Form 1099‐G. The maximum refund that you may have to include in income is limited to the excess of the tax the taxpayer deducted for the year. 1216.02 Mortgage interest refund If the taxpayer received a refund or credit of mortgage interest paid in an earlier year, the amount should be included in Form 1098 received from the mortgage servicer. The amount refunded is not subtracted from the interest paid; it is instead reported as income. 1216.03 Interest on recovery Interest on any amounts the taxpayer recovers must be reported as interest income in the year received. 1216.04 Deductions not itemized If the taxpayer did not itemize their deductions for the year in which the recovery was received, the amounts are not included in income. 100 INDIVIDUALS 1217 1099 Reporting 1217.01 1099 reporting requirements: a. 1099‐MISC This is the most common form used. The following are the items reported on this form: b. 1) At least $10 in royalties or broker payments in lieu of dividends or tax‐exempt interest; 2) At least $600 in: i. Rents; ii. Prizes and awards; iii. Other income payments; iv. generally, the cash paid from a notional principal contract to an individual, partnership, or estate. v. Any fishing boat proceeds vi. Medical and health care payments; vii. Crop insurance proceeds; viii. Payments to an attorney (box 10); ix. Section 409(A) – box 12; and x. Non‐qualified deferred compensation (box 14). 1099‐NEC This form is used for each person in the course of your business beginning with tax year 2023 to whom you have paid the following of at least $600 during the year: 1) Services performed by someone who is not the taxpayer’s employee (including parts and materials); 2) Cash payments for fish (or other aquatic life) the taxpayer purchases from anyone engaged in the trade of business of catching fish; or 101 INDIVIDUALS 3) c. Payments to an attorney (box 1) 1099‐C This form is used to report cancellation of debt in excess of $600. d. 1099‐DIV This form is used to report payment of dividends. e. SSA‐1099 This form is used by the Federal government to report the taxpayer’s Social Security benefits. f. 1099‐G This form is used by state and local governments to report payments to taxpayers. The most common types of payments reported on this form are unemployment compensation and tax refunds. 1217.02 1099 Reporting Issues a. Form 1099 Not Received The taxpayer is required to maintain accurate records. The taxpayer is required to report any income received in excess of the limits listed previously even if a Form 1099 is not received. The taxpayer should contact the paying organization and inform them of non‐receipt. b. Errors The taxpayer should contact the payer presenting the 1099 of any errors as soon as practicable so they may provide the taxpayer with a corrected 1099. Also, a corrected 1099 is sent to the IRS. 102 INDIVIDUALS 1220 Retirement Income 1221 IRA Overview 1221.01 Deductible and nondeductible contributions to an IRA A traditional individual retirement account (IRA) is an IRA that allows individuals to direct pretax income, up to specific annual limits, toward investments that can grow tax‐deferred (no capital gains or dividend income is taxed until withdrawn). Individual taxpayers are allowed to contribute 100 percent of compensation up to a specified maximum dollar amount to their traditional IRA. Contributions to the traditional IRA may be tax deductible depending on the taxpayer's income, tax‐filing status, and other factors. IRAs cannot be owned jointly; however, any amount remaining in an IRA upon the owner’s death can be paid to his or her beneficiary or beneficiaries. 1221.02 Contributions to a traditional IRA can be made for a given year at any time during the year or by the due date for filing the taxpayer’s income tax return for that year, not including extensions. For example, contributions to an IRA for 2023 must be made by April 15, 2024. For 2020 and later, there is no age limit on making regular contributions to traditional or Roth IRAs. 1221.03 Contributions to a traditional IRA may be deductible, partially deductible, or nondeductible. A nondeductible traditional IRA is a traditional IRA that consists of nondeductible contributions. If a taxpayer is covered by an employer’s retirement plan and their Modified Adjusted Gross Income (MAGI) exceeds the applicable income limit, they cannot deduct contributions to a traditional IRA. 1221.04 If an amount is contributed to a taxpayer’s traditional IRA between January 1 and April 15, the taxpayer should tell the IRA sponsor which year (the current year or the previous year) the contribution is for. If the taxpayer does not tell the sponsor which year the contribution is for, the sponsor can assume, and report to the IRS, that the contribution is for the current year (the year the sponsor received it). 103 INDIVIDUALS 1221.05 A taxpayer can file his or her tax return claiming a traditional IRA contribution before the contribution is actually made. A taxpayer is not required to contribute to his or her traditional IRA annually; any contributions an IRA owner does make are discretionary with the IRA account owner. 1221.06 Comparison of traditional IRA and Roth IRA With a traditional IRA, contributions may be tax‐deductible and can grow tax‐deferred. With a Roth IRA, contributions are non‐ deductible, but have the potential to grow tax‐free. A taxpayer may contribute 100 percent of earned income to a traditional IRA, a Roth IRA, or both types of IRAs up to the annual contribution limit. The annual contribution limits for 2023 for both traditional and Roth IRAs is $6,500 or $7,500 if the taxpayer is 50 years of age or older. 1221.07 Amount of the IRA contribution Generally, a taxpayer can deduct the lesser of: 1221.08 104 a. The contributions to the taxpayer’s traditional IRA for the year; or b. The general limit (or the spousal IRA limit, if applicable) ‐‐ $6,500 for those under 50 years of age in 2023; $7,500 for those 50 years of age or older in 2023. If contributions to a taxpayer’s IRA for a year were more than the allowed limit, the taxpayer can apply the excess contribution in one year to a later year if the contributions for that later year are less than the maximum allowed for that year. However, a penalty or additional tax may apply. As soon as a taxpayer opens his or her traditional IRA, contributions can be made to it through his or her chosen sponsor (trustee or other administrator). Contributions must be in the form of money (cash, check, or money order). Other types of property cannot be contributed to an IRA. INDIVIDUALS 1221.09 Spousal IRA In the case of a married couple with unequal compensation amounts who file a joint return, the deduction for contributions to the traditional IRA of the spouse with less compensation is limited to the lesser of: a. $6,500 ($7,500 if the spouse with the lower compensation is age 50 or older); or b. The total compensation includible in the gross income of both spouses for the year reduced by the following three amounts: (i) The IRA deduction for the year of the spouse with the greater compensation, (ii) Any designated nondeductible contribution for the year made on behalf of the spouse with the greater compensation, and (iii) Any contributions for the year to a Roth IRA on behalf of the spouse with the greater compensation. 1221.10 If a taxpayer was divorced or legally separated (and did not remarry) before the end of the year, he or she cannot deduct any contributions to his or her spouse’s IRA. After a divorce or legal separation, a taxpayer can deduct only the contributions to his or her own IRA. The taxpayer’s deductions are subject to the rules for single individuals. 1221.11 IRA contributions by an individual covered by an employer retirement plan The rules determining if an individual is covered by an employer plan differ depending on whether the plan is a defined contribution plan or a defined benefit plan. Generally, a taxpayer is covered by a defined contribution plan for a tax year if amounts are contributed or allocated to the taxpayer’s account for the plan year that ends with or within that tax year. 105 INDIVIDUALS 1221.12 A defined contribution plan is a plan that provides for a separate account for each person covered by the plan. In a defined contribution plan, the amount to be contributed to each participant's account is spelled out in the plan. The level of benefits actually provided to a participant depends on the total amount contributed to that participant's account and any earnings and losses on those contributions. Types of defined contribution plans include profit‐sharing plans, stock bonus plans, and money purchase pension plans. Example: Company A has a money purchase pension plan. Its plan year is from July 1 to June 30. The plan provides that contributions must be allocated as of June 30. Bob, an employee, leaves Company A on December 31, 20X3. The contribution for the plan year ending on June 30, 20X4, is made February 15, 20X4. Because an amount is contributed to Bob’s account for the plan year, Bob is covered by the plan for his 20X3 tax year. 1221.13 Amount taxable Generally, if a taxpayer has made only deductible IRA contributions, he or she must include the full amount of all IRA distributions in his or her gross income. The distribution will be taxed as ordinary income. If such distributions are “premature,” generally those made before the account owner attains age 59½, they are subject to a 10‐percent tax penalty as well unless an exception applies. An IRA account owner may withdraw funds from an IRA temporarily without becoming subject to the regular income tax, the premature withdrawal penalty, or the excess contribution excise tax, provided he or she returns the withdrawn funds to the IRA within 60 days. Thus, a taxpayer may make a transfer from a traditional IRA to another traditional IRA or can make a distribution to himself or herself on an interest‐free basis for a maximum of 60 days and then make a return rollover contribution to an IRA. Such rollovers/interest free loans may occur only once during a 12‐month period beginning with the date of the withdrawal. A taxpayer may also roll over an IRA to a qualified plan as long as the qualified plan contains a provision permitting such a rollover. 106 INDIVIDUALS 1221.14 If a taxpayer has made both deductible and non‐deductible IRA contributions, he or she must treat a portion of each distribution as a non‐taxable return of the non‐deductible contributions and partially as a return of deductible or rollover contributions and earnings. When the taxpayer computes the taxable and non‐ taxable portions of the distribution, all IRA distributions made during the taxable year are treated as one distribution, and all of a taxpayer's IRA accounts are treated as a single account. Thus, IRAs, annuity contracts, Simplified Employee Pension (SEP) IRAs, and rollover IRAs are aggregated for purposes of determining the character of an IRA distribution. This rule provides uniform treatment for distributions from all IRA accounts so that the actual source of an IRA distribution in terms of identifying the distribution as coming from a specific IRA account is irrelevant. 1221.15 Defined benefit plan If a taxpayer is eligible to participate in the employer’s defined benefit plan for the plan year that ends within the tax year, the taxpayer is covered by the plan. This rule applies even if the taxpayer: a. Declined to participate in the plan; b. Did not make a required contribution; or c. Did not perform the minimum service required to accrue a benefit for the year. 1221.16 A defined benefit plan is any plan that is not a defined contribution plan. In a defined benefit plan, the level of benefits to be provided to each participant is spelled out in the plan. The plan administrator figures the amount needed to provide those benefits and those amounts are contributed to the plan. 1221.17 The amount of any reduction in the limit on a taxpayer’s IRA deduction depends on whether the taxpayer or his or her spouse was covered by an employer retirement plan. If a taxpayer is covered by an employer retirement plan and the taxpayer did not receive any Social Security retirement benefits, his or her IRA deduction may be reduced or eliminated depending on his or her filing status and MAGI, as shown in the tables below (sections 1221.18 and 1221.19), effective for 2023. 107 INDIVIDUALS 1221.18 If the taxpayer is covered by a retirement plan at work, use this table to determine if the taxpayer’s modified AGI affects the amount of his or her deduction. If Your Filing Status Is... And Your Modified AGI Is... Then You Can Take... Single or head of household $73,000 or less a full deduction up to the amount of your contribution limit. more than $73,000 but less a partial deduction. than $83,000 Married filing jointly or qualifying surviving spouse Married filing separately $83,000 or more no deduction. $116,000 or less a full deduction up to the amount of your contribution limit. more than $116,000 but less than $136,000 a partial deduction. $136,000 or more no deduction. less than $10,000 a partial deduction. $10,000 or more no deduction. If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the “Single” filing status. 108 INDIVIDUALS 1221.19 If the taxpayer is not covered by a retirement plan at work, use this table to determine if his or her modified AGI affects the amount of his or her deduction for 2023. If Your Filing Status Is... And Your Modified AGI Is... Then You Can Take... Single, head of household, or surviving spouse any amount a full deduction up to the amount of your contribution limit. Married filing jointly or separately with a spouse who is not covered by a plan at work any amount a full deduction up to the amount of your contribution limit. Married filing jointly with a spouse who is covered by a plan at work $218,000 or less a full deduction up to the amount of your contribution limit. more than $218,000 but less than $228,000 a partial deduction. $228,000 or more no deduction. less than $10,000 a partial deduction. $10,000 or more no deduction. Married filing separately with a spouse who is covered by a plan at work If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the “Single” filing status. 109 INDIVIDUALS 1221.20 Nondeductible contributions to an IRA Although a taxpayer’s deduction for IRA contributions may be reduced or eliminated, contributions can be made to a taxpayer’s IRA of up to the general limit or, if it applies, the spousal IRA limit. The difference between a taxpayer’s total permitted contributions and his or her IRA deduction, if any, is his or her nondeductible contribution. 110 a. Form 8606 ‐‐ To designate contributions to an IRA as nondeductible, a taxpayer must file Form 8606, Nondeductible IRAs. A taxpayer must file Form 8606 to report nondeductible contributions even if he or she does not have to file a tax return for the year. A taxpayer uses Form 8606 if he or she makes nondeductible contributions to a traditional IRA or takes distributions from a traditional or Roth IRA, or from SEP and SIMPLE retirement accounts. Completing Form 8606 provides the taxpayer with the total taxable amount of IRA distributions that must be reported as income for the tax year on Form 1040. b. The instructions that accompany Form 8606 provide a worksheet a taxpayer can use to determine the maximum amount she is entitled to contribute to a Roth IRA in one calendar year. Furthermore, a taxpayer's total basis in a traditional IRA is reported to the IRS on Form 8606, and this amount can be used in subsequent tax years to calculate nontaxable amounts of distributions. With traditional IRAs, the basis is all nondeductible contributions plus nontaxable amounts included in rollovers to the IRA, minus the sum of all nontaxable distributions. c. If a taxpayer does not report nondeductible contributions on Form 8606, all of the contributions to a traditional IRA will be treated like deductible contributions when withdrawn. Thus, all distributions from an IRA will be taxed unless the taxpayer can show, with satisfactory evidence, that nondeductible contributions were made. A taxpayer must pay a $50 penalty if he or she does not file a required Form 8606, unless he or she can prove that the failure was due to reasonable cause. INDIVIDUALS 1221.21 d. As long as contributions are within the contribution limits, none of the earnings or gains on contributions (deductible or nondeductible) will be taxed until they are distributed. e. A taxpayer will have a cost basis in his or her traditional IRA if he or she made any nondeductible contributions. The taxpayer’s cost basis is the sum of the nondeductible contributions to his or her IRA minus any withdrawals or distributions of nondeductible contributions. Commonly, distributions from a traditional IRA will include both taxable and nontaxable amounts. Inherited IRA If a taxpayer inherits a traditional IRA, he or she is called a beneficiary. A beneficiary can be any person or entity the owner chooses to receive the benefits of the IRA after he or she dies. Beneficiaries of a traditional IRA must include in their gross income any taxable distributions they receive. 1221.22 If a taxpayer inherits a traditional IRA from his or her spouse, he or she has the following three choices: a. Treat it as his or her own IRA by designating himself or herself as the account owner; b. Treat it as his or her own by rolling it over into his or her IRA, or to the extent it is taxable, into a: (i) Qualified employer plan; (ii) Qualified employee annuity plan [§403(a) plan]; (iii) Tax‐sheltered annuity plan [§403(b) plan]; or (iv) Deferred compensation plan of a state or local government (§457 plan). c. Treat himself or herself as the beneficiary rather than treating the IRA as his or her own. 111 INDIVIDUALS 1221.23 A spousal beneficiary will be considered to have chosen to treat the IRA as his or her own if: a. He or she makes contributions (including rollover contributions) to the inherited IRA; or b. The taxpayer does not take the required minimum distribution for a year as a beneficiary of the IRA. 1221.24 The taxpayer will only be considered to have chosen to treat the IRA as his or her own if the taxpayer is the sole beneficiary of the IRA, and he or she has an unlimited right to withdraw amounts from it. However, if a taxpayer receives a distribution from his or her deceased spouse’s IRA, he or she can roll that distribution over into his or her own IRA within the 60‐day time limit, as long as the distribution is not a required distribution, even if he or she was not the sole beneficiary of his or her deceased spouse’s IRA. 1221.25 Nonspousal beneficiaries If a taxpayer inherits a traditional IRA from anyone other than his or her deceased spouse, he or she cannot treat the inherited IRA as his or her own. In such a case, the taxpayer cannot make any contributions to the IRA. It also means he or she cannot roll over any amounts into or out of the inherited IRA. However, a taxpayer can make a trustee‐to‐trustee transfer as long as the IRA into which amounts are being moved is set up and maintained in the name of the deceased IRA owner for the benefit of the taxpayer as beneficiary. 1221.26 112 Like the original owner, a taxpayer generally will not owe tax on the assets in the IRA until he or she receives distributions from it. The taxpayer must begin receiving distributions from the IRA under the rules for distributions that apply to beneficiaries. If the taxpayer inherits a traditional IRA from a person who had a basis in the IRA because of nondeductible contributions, that basis remains with the IRA. INDIVIDUALS 1221.27 Unless the taxpayer is the decedent’s spouse and chooses to treat the IRA as his or her own, the taxpayer cannot combine this basis with any basis the taxpayer has in his or her own traditional IRA(s) or any basis in traditional IRA(s) he or she inherited from other decedents. If a taxpayer takes distributions from both an inherited IRA and his or her IRA, and each has basis, he or she must complete separate Forms 8606 to determine the taxable and nontaxable portions of those distributions. 1221.28 Trustee‐to‐trustee transfer A transfer of funds in a taxpayer’s traditional IRA from one trustee directly to another, either at the taxpayer’s request or at the trustee’s request, is not a rollover. Because there is no distribution to the taxpayer, the transfer is tax free. Because it is not a rollover, it is not affected by the one‐year waiting period required between rollovers. 1221.29 Rollovers Generally, a rollover is a tax‐free distribution to the taxpayer of cash or other assets from one retirement plan that a taxpayer contributes to another retirement plan. The contribution to the second retirement plan is called a “rollover contribution.” An amount rolled over tax free from one retirement plan to another is generally includible in income when it is distributed from the second plan. 1221.30 A taxpayer can roll over amounts from the following plans into a traditional IRA: a. A traditional IRA; b. An employer’s qualified retirement plan for its employees; c. A deferred compensation plan of a state or local government (§457 plan); or d. A tax‐sheltered annuity plan (§403 plan). 113 INDIVIDUALS 1221.31 The following chart indicates the rollovers that are permitted between various types of qualified plans and IRAs. Roll To Roll From 1. 2. 3. 4. 5. 114 403(b) Plan (pre‐ tax) Designated Roth Account [401(k), 403(b), or 457(b)]2 Roth IRA Traditional IRA SIMPLE IRA SEP IRA 457(b) Plan Qualified Plan1 (pre‐tax) Roth IRA Yes No No No No No No No Traditional IRA Yes3 Yes No Yes Yes4 Yes Yes No SIMPLE IRA Yes3, after 2 years Yes, after 2 years Yes Yes, after 2 years Yes4, after 2 years Yes, after 2 years Yes, after 2 years No Yes3 Yes No Yes Yes4 Yes Yes SEP IRA No 3, 5 457(b) Plan 3 Yes Yes No Yes Yes Yes Yes Yes after 12/31/10 Qualified Plan1 (pre‐tax) Yes3 Yes No Yes Yes4 Yes Yes Yes3, 5 after 9/27/10 403(b) Plan (pre‐tax) Yes3 Yes No Yes Yes4 Yes Yes Yes3, 5 after 9/27/10 Designated Roth Account [401(k), 403(b) or 457(b)]2 Yes No No No No No No Yes, if a direct trustee‐to‐ trustee transfer Qualified plans include, for example, profit‐sharing, 401(k), money purchase, and defined benefit plans. Governmental 457(b) plans, after December 31, 2010. Must include in income. Must have separate accounts. Must be an in‐plan rollover. INDIVIDUALS 1221.32 Rollovers completed after the 60‐day period In the absence of a waiver, amounts not rolled over within the 60‐ day period do not qualify for tax‐free rollover treatment. A taxpayer must treat them as a taxable distribution from either the taxpayer’s IRA or the taxpayer’s employer’s plan. These amounts are taxable in the year distributed, even if the 60‐day period expires in the next year. A taxpayer may also have to pay a 10 percent additional tax on early distributions, as discussed later. Unless there is a waiver or an extension of the 60‐day rollover period, any contribution a taxpayer makes to his or her IRA more than 60 days after the distribution is a regular contribution, not a rollover contribution. Example: A taxpayer received a distribution in late December 2023 from a traditional IRA that she did not roll over into another traditional IRA within the 60‐day limit. She did not qualify for a waiver. This distribution is taxable in 2023 even though the 60‐day limit did not expire until 2024. 1221.33 Converting from any traditional IRA into a Roth IRA A taxpayer can withdraw all or part of the assets from a traditional IRA and reinvest them (within 60 days) in a Roth IRA. The amount that he or she withdraws and timely contributes to the Roth IRA is called a conversion contribution. If properly (and timely) rolled over, the 10 percent additional tax on early distributions will not apply. The taxpayer must roll over into the Roth IRA the same property he or she received from the traditional IRA. The taxpayer can roll over part of the withdrawal into a Roth IRA and keep the rest of it. The amount he or she keeps will generally be taxable (except for the part that is a return of nondeductible contributions) and may be subject to the 10 percent additional tax on early distributions. 1221.34 A taxpayer cannot convert amounts that must be distributed from his or her traditional IRA for a particular year (including the calendar year in which the taxpayer reaches age 72 after December 31, 2022, and age 73 before Jan 1, 2033) under the required distribution rules. 115 INDIVIDUALS 1221.35 The taxpayer must include in his or her gross income distributions from a traditional IRA that he or she would have had to include in income if he or she had not converted them into a Roth IRA. These amounts are normally included in income on the taxpayer’s tax return for the year that he or she converted them from a traditional IRA to a Roth IRA. 1221.36 Recharacterizations A taxpayer may be able to treat a contribution made to one type of IRA as having been made to a different type of IRA. This is called recharacterizing the contribution. 1221.37 1221.38 To recharacterize a contribution, a taxpayer must have the contribution transferred from the first IRA (the one to which it was made) to the second IRA in a trustee‐to‐trustee transfer. If the transfer is made by the due date (including extensions) for the taxpayer’s tax return for the year during which the contribution was made, the taxpayer can elect to treat the contribution as having been originally made to the second IRA instead of to the first IRA. If a taxpayer recharacterizes his or her contribution, he or she must do all three of the following: a. Include in the transfer any net income allocable to the contribution. If there was a loss, the net income the taxpayer must transfer may be a negative amount; b. Report the recharacterization on his or her tax return for the year during which the contribution was made; and c. Treat the contribution as having been made to the second IRA on the date that it was actually made to the first IRA. Reconversions A taxpayer cannot convert and reconvert an amount during the same tax year or, if later, during the 30‐day period following a recharacterization. If a taxpayer reconverts during either of these periods, it will be a failed conversion. 116 INDIVIDUALS 1221.39 If a taxpayer converts an amount from a traditional IRA to a Roth IRA and then transfers that amount back to a traditional IRA in a recharacterization in the same year, the taxpayer may not reconvert that amount from the traditional IRA to a Roth IRA before: a. The beginning of the year following the year in which the amount was converted to a Roth IRA or; if later, b. The end of the 30‐day period beginning on the day on which the taxpayer transfers the amount from the Roth IRA back to a traditional IRA in a recharacterization. Example: On June 1, 2023, Christine properly and timely converted her traditional IRA to a Roth IRA. In December 2023, Christine decided to recharacterize the conversion and move the funds to a traditional IRA. In January 2024, to make the necessary adjustment to remove the conversion, Christine opened a traditional IRA with the same trustee. Also, in January 2024, she instructed the trustee of the Roth IRA to make a trustee‐to‐ trustee transfer of the conversion contribution made to the Roth IRA (including net income allocable to it since the conversion) to the new traditional IRA. She also notified the trustee that she was electing to recharacterize the contribution to the Roth IRA and treat it as if it had been contributed to the new traditional IRA. Because of the recharacterization, Christine has no taxable income from the conversion to report for 2023, and the resulting rollover to a traditional IRA is not treated as a rollover for purposes of the one‐rollover‐per‐year rule. 117 INDIVIDUALS 1222 Required Minimum Distributions (RMDs) 1222.01 A taxpayer cannot keep funds in a traditional IRA indefinitely. Eventually they must be distributed. If there are no distributions, or if the distributions are not large enough, the taxpayer may have to pay a 50 percent excise tax on the amount not distributed as required. The requirements for distributing IRA funds differ, depending on whether the taxpayer is the IRA owner or the beneficiary of a decedent’s IRA. 1222.02 The amount that must be distributed each year is referred to as the required minimum distribution. Amounts that must be distributed (required minimum distributions) during a particular year are not eligible for rollover treatment. 1222.03 IRA owners If the taxpayer is the owner of a traditional IRA, they must generally start receiving distributions from their IRA by April 1 of the year following the year in which they reach age 73 if they reach age 72 after December 31, 2022. April 1 of the year following the year in which they reach age 73 is referred to as the required beginning date. 118 1222.04 A taxpayer must receive at least a minimum amount for each year starting with the year they reach age 73 if they reach age 72 after December 31, 2022. If the taxpayer does not (or did not) receive that minimum amount in their 73rd year, then they must receive distributions for their 73rd year by April 1 of the next year. If an IRA owner dies after reaching age 73, but before April 1 of the next year, no minimum distribution is required because death occurred before the required beginning date. 1222.05 Even if a taxpayer begins receiving distributions before they reach age 73, they must begin calculating and receiving required minimum distributions by their required beginning date. If, in any year, a taxpayer receives more than the required minimum distribution for that year, they will not receive credit for the additional amount when determining the minimum required distributions for future years. This does not mean that the taxpayer does not reduce their IRA account balance. It means that if a taxpayer receives more than their required minimum distribution in one year, they cannot treat the excess (the amount INDIVIDUALS that is more than the required minimum distribution) as part of their required minimum distribution for any later year. However, any amount distributed in the taxpayer’s 73rd year will be credited toward the amount that must be distributed by April 1 of the following year. 1222.06 Distributions after the required beginning date The required minimum distribution for any year after the year a taxpayer turns age 73 if they reach 72 after December 31, 2022, must be made by December 31 of that later year. Example: A taxpayer reached age 72 on August 20, 2023. The taxpayer must receive the first required minimum distribution from their IRA, SEP IRA, or SIMPLE IRA by April 1, 2025. This is a special case due to the age change as a result of Secure Act 2.0. Taxpayers reaching 73 in 2024 also have until April 1, 2025. For all the subsequent years after the first required minimum distribution, the taxpayer must comply with their RMD requirement by December 31 of that year. In this instance, the taxpayer would take their subsequent distribution by December 31, 2026. 1222.07 Tax on early distributions from traditional and Roth IRAs To discourage the use of IRAs for purposes other than retirement, the law imposes a 10‐percent additional tax on early distributions from traditional and Roth IRAs unless an exception applies. Generally, early distributions are those received from an IRA before reaching age 59½. The 10‐percent additional tax applies to the part of the distribution that the taxpayer must include in gross income. It is in addition to any regular income tax on that amount. See 10‐percent early distribution penalty following. 1222.08 Tax on early distributions from retirement plans other than IRAs To discourage the use of retirement funds for purposes other than normal retirement, the law imposes a 10‐percent additional tax on certain early distributions of these funds. Early distributions are those a taxpayer receives from a qualified retirement plan or deferred annuity contract before reaching age 59½. 119 INDIVIDUALS 1222.09 120 The term “qualified retirement plan” means: a. A qualified employee plan under §401(a), such as a §401(k) plan; b. A qualified employee annuity plan under §403(a); c. A tax‐sheltered annuity plan under §403(b) for employees of public schools or tax‐exempt organizations; or d. An IRA. 1222.10 While an eligible state or local government §457 deferred compensation plan is not a qualified retirement plan, any distribution attributable to amounts the plan received in a direct transfer or rollover from one of the qualified retirement plans listed above would be subject to the 10‐percent additional tax. Distributions that are not taxable, such as distributions that a taxpayer rolls over to another qualified retirement plan or a distribution of a taxpayer’s designated Roth IRA contributions are not subject to this 10‐percent additional tax. 1222.11 There are certain exceptions to this additional tax. The following six exceptions apply to distributions from any qualified retirement plan. a. Distributions made to a beneficiary or estate on or after the owner’s death. b. Distributions made because the taxpayer is totally and permanently disabled. c. Distributions made as part of a series of substantially equal periodic payments over the taxpayer’s life expectancy or the life expectancies of the taxpayer and his or her designated beneficiary. If these distributions are from a qualified plan other than an IRA, the taxpayer must separate from service with this employer before the payments begin for this exception to apply. d. Distributions that are equal to or less than the taxpayer’s deductible medical expenses under §213, that is, the amount of the taxpayer’s medical expenses that is more than 10 percent of his or her adjusted gross income. The taxpayer does not have to itemize to meet this exception. INDIVIDUALS 1222.12 1222.13 e. Distributions made due to an IRS levy of the plan under §6331. f. Distributions to qualified reservists. Generally, these are distributions made to individuals called to active duty with the United States military. The following additional exceptions apply only to distributions from a qualified retirement plan other than an IRA: a. Distributions made to a taxpayer after he or she separated from service with his or her employer if the separation occurred in or after the year the taxpayer reached age 55, or distributions made from a qualified governmental defined benefit plan if taxpayer was a qualified public safety employee (state or local government) who separated from service on or after he or she reached age 55; b. Distributions made to an alternate payee under a qualified domestic relations order; and c. Distributions of dividends from employee stock ownership plans. Recognizing losses on IRA investments A taxpayer who has a loss on his or her traditional IRA investment can recognize the loss on his or her income tax return, but only when all the amounts in all his or her traditional IRA accounts have been distributed to him or her and the total distributions are less than his or her unrecovered basis, if any. A taxpayer’s basis is the total amount of the nondeductible contributions in his or her traditional IRAs. The taxpayer can claim the loss as a miscellaneous itemized deduction, subject to the 2 percent‐of‐ adjusted‐gross‐income limit that applies to certain miscellaneous itemized deductions on Schedule A, Form 1040. A similar rule applies to Roth IRAs. The rule applies separately to each kind of IRA. Thus, to report a loss in a Roth IRA, all the Roth IRAs (but not traditional IRAs) owned by the taxpayer must be liquidated, and to report a loss in a traditional IRA, all the traditional IRAs (but not Roth IRAs) owned by the taxpayer must be liquidated. 121 INDIVIDUALS 1222.14 10‐percent early distribution penalty A taxpayer can access his or her money inside a traditional IRA at any time, but a withdrawal is subject to ordinary income tax and a 10 percent early withdrawal penalty if he or she takes a distribution before reaching age 59½. Exceptions to the 10 percent early withdrawal penalties are: a. Death or disability; b. College expenses; c. First‐time home purchase (up to $10,000); d. Payment of health insurance premiums after 12 consecutive weeks of unemployment; e. Payment of medical expenses that exceed 7.5 percent of AGI; f. Systematic distributions [72(t)]; g. IRS levy; and h. Qualified reservist distribution. If a taxpayer takes a distribution after age 59½, he or she pays ordinary income tax on the withdrawal but does not pay a penalty. Required minimum distributions (RMDs) begin at age 73 after January 1, 2023. 1222.15 The owner of a Roth IRA account can access contribution dollars at any time without taxes or penalties. However, if the taxpayer has owned a Roth IRA, including converted accounts, for less than five years and withdraws earnings from the IRA before reaching age 59½, they may be subject to income tax and a 10 percent early withdrawal penalty on those earnings. 1222.16 Required minimum distributions from qualified plans RMDs generally are minimum amounts that a retirement plan account owner must withdraw annually starting with the year that he or she reaches 73 years of age or, if later, the year in which he or she retires. However, if the retirement plan account is an IRA or the account owner is a 5‐percent owner of the business sponsoring the retirement plan, the RMDs must begin once the 122 INDIVIDUALS account holder is age 73, regardless of whether he or she is retired. 1222.17 Retirement plan participants and IRA owners are responsible for taking the correct amount of RMDs on time every year from their accounts, and they face stiff penalties for failure to take RMDs. When a retirement plan account owner or IRA owner dies before RMDs have begun, different RMD rules apply to the beneficiary of the account or IRA. Generally, the entire amount of the owner’s benefit must be distributed to the beneficiary who is an individual either: (1) within five years of the owner’s death; or (2) over the life of the beneficiary starting no later than one year following the owner’s death. 1222.18 The RMD rules apply to all employer sponsored retirement plans, including profit‐sharing plans, 401(k) plans, 403(b) plans, and 457(b) plans. The RMD rules also apply to traditional IRAs and IRA‐ based plans such as SEPs, SARSEPs, and SIMPLE IRAs. The RMD rules also apply to Roth 401(k) accounts. However, the RMD rules do not apply to Roth IRAs while the owner is alive. 1222.19 An account owner must take the first RMD for the year in which he or she turns age 73 if they reach age 72 after December 31, 2022. However, the first RMD payment can be delayed until April 1 of the year following the year in which he or she turns 73. For all subsequent years, including the year in which the first RMD was paid by April 1, the account owner must take the RMD by December 31 of the year. 1222.20 Generally, an RMD is calculated for each account by dividing the prior December 31st balance of that IRA or retirement plan account by a life expectancy factor that the IRS publishes in three tables that may be found in IRS Publication 590: a. The Joint and Last Survivor Table is used by an account owner whose sole beneficiary of the account is his or her spouse and is more than 10 years younger than the account owner; b. The Uniform Lifetime Table is used by account owners whose spouse is not the sole beneficiary or whose spouse is not more than 10 years younger; and 123 INDIVIDUALS c. 124 The Single Life Expectancy Table is used by a beneficiary of an account. 1222.21 An IRA owner must calculate the RMD separately for each IRA that he or she owns, but can withdraw the total amount from one or more of the IRAs. Similarly, a 403(b) contract owner must calculate the RMD separately for each 403(b) contract that he or she owns, but can take the total amount from one or more of the 403(b) contracts. However, RMDs required from other types of retirement plans, such as 401(k) and 457(b) plans must be taken separately from each of those plan accounts. 1222.22 If an account owner fails to withdraw an RMD, fails to withdraw the full amount of the RMD, or fails to withdraw the RMD by the applicable deadline, the amount not withdrawn is taxed at 50 percent. In such a case, the account owner should file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax‐Favored Accounts, with his or her federal tax return for the year in which the full amount of the RMD was not taken. The penalty may be waived if the account owner establishes that the shortfall in distributions was due to reasonable error and that reasonable steps are being taken to remedy the shortfall. 1222.23 The account owner is taxed at his or her income tax rate on the amount of the withdrawn RMD. However, to the extent the RMD is a return of basis or is a qualified distribution from a Roth IRA, it is tax free. INDIVIDUALS 1222.24 This comparison chart highlights the basic RMD rules as applied to IRAs and defined contribution plans [e.g., 401(k), profit‐sharing, and 403(b) plans]. Required Minimum Distributions for Account Owners IRAs including SEP, SIMPLE, and SARSEP IRAs Defined Contribution Plans When do I take my first RMD (the required beginning date)? The taxpayer must take their first RMD by April 1 of the year following the year in which they turn 73 if they reach 72 after December 31, 2022, regardless of whether they are still employed. April 1 of the year following the later of the year the taxpayer turns 73 if they reach 72 after December 31, 2022, or the year they retire (if allowed by their plan). If the taxpayer is a 5% owner, they must start RMDs by April 1 of the year following the year they turn 73 if they reach 72 after December 31, 2022. When do I reach age 73? Individuals who turned 70 ½ in 2020 no longer had to comply with the required minimum distribution requirement as the applicable age was increased to 72. As such, the new rule is that for individuals who will turn 72 in 2022, they will have the option to delay taking their first RMD until April 2023. Individuals who turn 72 after December 31, 2022 don’t have to take their first RMD until age 73. Same as IRA rule. What is the deadline for taking subsequent RMDs after the first RMD? After the first RMD, the taxpayer must take subsequent RMDs by December 31 of each year beginning with the calendar year containing their required beginning date. Same as IRA rule. 125 INDIVIDUALS Required Minimum Distributions for Account Owners IRAs including SEP, SIMPLE, and SARSEP IRAs How do I calculate my RMD? Your RMD is generally determined by dividing the adjusted market value of your IRAs as of December 31 of the preceding year by the distribution period that corresponds with your age in the Uniform Lifetime Table [Table III in IRS Publication 590, Individual Retirement Arrangements (IRAs)]. Defined Contribution Plans Same as IRA rule. Your plan sponsor/administrator should calculate the RMD for you. If your spouse is your sole beneficiary and is more than 10 years younger than you, you will use the Joint Life and Last Survivor Expectancy Table (Table II in IRS Publication 590). How should I take my RMDs if I have multiple accounts? If you have more than one IRA, you must calculate the RMD for each IRA separately each year. However, you may aggregate your RMD amounts for all of your IRAs and withdraw the total from one IRA or a portion from each of your IRAs. You do not have to take a separate RMD from each IRA. If you have more than one defined contribution plan, you must calculate and satisfy your RMDs separately for each plan and withdraw that amount from that plan. May I withdraw more than the RMD? Yes, an IRA owner can always withdraw more than the RMD. You cannot apply excess withdrawals toward future years’ RMDs. Same as IRA rule. May I take more than one withdrawal in a year to meet my RMD? You may withdraw your annual RMD in any number of distributions throughout the year, as long as you withdraw the total annual minimum amount by December 31 (or April 1 if it is for your first RMD). Same as IRA rule. What happens if I do not take the RMD? If the distributions to you in any year Same as IRA rule. are less than the RMD for that year, you are subject to an additional tax equal to 50 percent of the undistributed RMD. 126 Exception: If you have more than one 403(b) tax‐sheltered annuity account, you can total the RMDs and then take them from any one (or more) of the tax‐ sheltered annuities. INDIVIDUALS Note: There are no RMD requirements for a Roth IRA while the owner is alive. However, designated Roth accounts are subject to the RMD rules. The distributions to the beneficiaries of the Roth IRA will not be taxable. 1223 Prohibited Transactions and Tax Effects Relating to IRAs 1223.01 An IRA cannot purchase collectibles and life insurance. Collectibles are not allowed in an IRA account, meaning collectible coins are prohibited transactions, according to the IRS. The result of buying collectible coins with IRA assets is a distribution of the amount used to buy the coins. The distribution will be added to gross income and penalized 10 percent if the taxpayer is under age 59½. The IRS does allow investors to purchase certain coins minted by the U.S. Treasury, such as the one‐ounce gold eagle, along with certain bullion coins. However, in general, coins are considered prohibited collectibles. Other examples of prohibited collectibles include artwork, rugs, gems, stamps, metals, antiques, and alcoholic beverages. 1223.02 Minted coins exception The precious metals that are allowable with IRA investments are U.S. minted coins. The coins must contain a minimum amount of gold, silver, platinum, or palladium to qualify. Gold coins must maintain either one‐tenth, one‐quarter, one‐half, or full one‐ ounce gold mixture. One‐ounce minted silver coins are acceptable, as are designated bullion. 1223.03 In addition, an IRA owner cannot engage in prohibited transactions with his or her IRA. In general, a prohibited transaction is a transaction between a plan and a disqualified person. Generally, “disqualified persons” are defined to be the account holder, other fiduciaries, certain family members (lineal descendants and spouses of lineal descendants), and businesses under the account holder’s (or disqualified person’s) control. 127 INDIVIDUALS 1223.04 1223.05 Prohibited transactions are: a. A sale or exchange, or leasing of property between a plan and a related party; b. Lending of money between a plan and a related party; c. Furnishing goods, services or facilities between a plan and a related party; d. Transfer to, or use by, a related party of the income or assets of a plan; e. Act by a related party whereby he deals with the income or assets of a plan in his own interest or for his own account; and f. Receipt of any benefit for his or her own personal account by any related party in connection with a transaction involving the income or assets of the plan. A disqualified person is the IRA owner, his or her children, grandchildren, spouse, or parents. It is also any business owned 50 percent or more by any of the above. According to the IRS, siblings, aunts, uncles, cousins, and step relations are not included in the definition of disqualified persons. If a taxpayer engages in a prohibited transaction the IRS will consider the IRA fully distributed. 1223.06 128 Examples of prohibited transactions a. Taxpayer’s IRA buys a house and taxpayer, or another disqualified person, lives in the house. It does not matter if rent is paid or not. b. Taxpayer’s IRA buys a house and rents it to an outside party at a discount. The outside party agrees to provide some benefit to the taxpayer (such as adding an addition to the house) in exchange for that discounted rent. c. Taxpayer’s IRA buys a house and sells it to an outside party at a discount. The outside party agrees to provide some benefit to the taxpayer or another disqualified person in exchange for that discounted sales price. INDIVIDUALS d. Taxpayer’s IRA buys a house and runs out of cash to pay the mortgage. Taxpayer, or another disqualified person, puts up the money to cover the shortfall. e. Taxpayer wants to buy a house and half of the down payment comes from the taxpayer’s savings account. Taxpayer directs his or her IRA to invest the rest of the purchase price. f. Taxpayer takes out a loan and uses his or her IRA assets as collateral to secure the personal loan. g. Taxpayer loans money to the IRA so that the IRA has enough cash to buy a house. Loan is between two disqualified entities, taxpayer, and his or her IRA. 1224 Loans From IRC §401(k) Plans and Other Qualified Plans 1224.01 A loan that a qualified plan owner takes from his or her qualified plan is not considered a taxable distribution from a qualified plan if the following requirements are met: a. The amount of the loan does not exceed the amount limitation, generally the amount cannot be greater than $50,000 or 50 percent of the participant’s vested balance, whichever is less; b. The term of the loan does not exceed five years, unless the loan is used to purchase a principal residence; c. Substantially level repayments, made not less frequently than quarterly, are required over the term of the loan; and d. The loan is evidenced by a legally enforceable agreement that shows compliance with the three requirements listed above. If any of these four requirements is not met, the loan is subject to federal income tax. 129 INDIVIDUALS 1224.02 Failure to make required payments results in a deemed distribution to the participant. The amount of the deemed distribution equals the entire outstanding balance of the loan at the time of such failure to repay. The entire outstanding balance includes all the unpaid interest and the principal on the loan. However, the plan loan continues to exist, it remains a plan asset, and interest continues to accrue until the entire loan is repaid with principal and interest. The plan administrator may allow a cure period for loan payments. The cure period may not continue beyond the last day of the calendar quarter following the calendar quarter in which the required payment was due. 1224.03 Qualified charitable distributions Generally, a qualified charitable distribution (QCD) is an otherwise taxable distribution from an IRA (other than an ongoing SEP or SIMPLE IRA) owned by an individual who is age 70‐1/2 or over that is paid directly from the IRA to a qualified charity. Note that the Secure Act change for RMDs did not affect the QCD age. 1224.04 The taxpayer’s qualified charitable distributions can satisfy all or part of the amount of the required minimum distribution from their IRA. For example, if the 2023 required minimum distribution was $10,000, and the taxpayer made a $5,000 qualified charitable distribution for 2023, they would have had to withdraw another $5,000 to satisfy their 2023 required minimum distribution. 1224.05 To report a qualified charitable distribution on Form 1040 tax return, the taxpayer generally reports the full amount of the charitable distribution on the line for IRA distributions. On the line for the taxable amount, enter zero if the full amount was a qualified charitable distribution. Enter "QCD" next to this line. See the Form 1040 instructions for additional information. You must also file Form 8606, Nondeductible IRAs, if: 130  the taxpayer made the qualified charitable distribution from a traditional IRA in which they had basis and received a distribution from the IRA during the same year, other than the qualified charitable distribution; or  the qualified charitable distribution was made from a Roth IRA. INDIVIDUALS 1230 Property, Real and Personal 1231 Acquisition and Disposition of Assets Overview 1231.01 Two major types of property All property falls into one of two categories: real property or personal property. a. Real property (realty): Land and anything permanently attached to the land or very closely and exclusively associated with the use of the land; immovables Examples: Land, buildings, and growing trees b. Personal property (personalty): Property that is not real; movables Examples: Car, table, or book 1231.02 Conversion from real to personal property Conversion from real to personal property is called severance. Examples of severance: 1231.03 a. A growing tree is cut into firewood. While growing in the ground, the tree is real property. When cut into firewood, it becomes personal property. b. Sand is dug from the ground and put on a truck. While in the ground, the sand is real property. When dug from the ground and put on the truck, it is personal property. Conversion from personal to real property Conversion from personal to real property is called attachment. Examples of attachment: a. A brick is mortared into the wall of a building. While loose, the brick is personal property; when mortared into the wall, it becomes a part of the real property. b. A central air conditioning unit is installed in a house during construction. The unit is personal property until it is installed, then it becomes real property. 131 INDIVIDUALS 1231.04 For federal tax purposes, all property is either classified as ordinary income property or as a capital asset. Tax Treatment of Gains and Losses 132 1231.05 When a taxpayer has determined that the taxpayer has a gain or a loss to be recognized, the next step is to establish whether it is to be treated as a capital gain or loss or as an ordinary income or loss item. 1231.06 A capital gain or loss is that gain or loss arising from the sale or exchange of a capital asset. 1231.07 Capital assets are defined as all property, except for the following: a. Property held for resale (inventory) b. Depreciable property or real property used in a trade or business c. Accounts or notes receivable acquired in normal business operations d. A copyright or a literary, artistic, or musical composition in the hands of the creator or anyone who assumes the creator’s basis (property received through gift) e. U.S. government publications received from the government other than by purchase at the price that it is offered for sale to the public f. Certain commodities derivative instruments held by a commodities derivatives dealer g. Any hedging transaction that is clearly identified as such before the close of the day on which it is acquired, originated, or entered into h. Supplies of a type regularly used or consumed by the taxpayer in the ordinary course of a trade or business of the taxpayer INDIVIDUALS 1231.08 Real property subdivided for sale: a. b. Individuals and S corporations subdividing real estate for sale may qualify for capital gain treatment if the following conditions apply: (1) Subdivider must not be a real estate dealer. (2) No substantial improvements may be made to the lots sold. (3) Lots sold must be held at least five years (unless inherited). All gain is capital gain until the year the sixth lot is sold. Contiguous lots sold to one buyer are treated as one lot. (1) When the sixth lot is sold, 5% of the revenue from all lots sold that year is ordinary income. (2) This ordinary income is offset by any selling expenses to determine the net amount taxed as ordinary income. Any gain not taxed as ordinary income is capital gain. Section 1231 Assets 1231.09 Section 1231 of the Internal Revenue Code provides long‐term capital gain treatment for certain transactions involving noncapital assets (generally land, buildings, and equipment used in business). If there is a loss, the loss is treated as an ordinary versus a capital loss. 1231.10 Section 1231 transactions include the following: a. Sale or exchange of real or depreciable business property b. Involuntary conversion of: (1) real or depreciable business property (2) any capital asset that is held for more than one year and is held in connection with a trade or business or a transaction entered into for profit c. Certain farming transactions involving crops and livestock d. Certain transactions involving timber, iron ore, and coal 133 INDIVIDUALS 1231.11 To qualify as Section 1231 property, the property items listed must be held long enough to meet the long‐term capital gain and loss holding period requirement, greater than one year. 1231.12 Section 1231 benefits: a. Gains and losses from Section 1231 transactions must be grouped and compared. (1) If Section 1231 gains exceed Section 1231 losses, the net gain will be treated as ordinary income to the extent of net Section 1231 losses claimed by the taxpayer in the previous five years. Any remaining gain will receive long‐term capital gain treatment. (2) If Section 1231 losses exceed Section 1231 gains, the net loss will receive ordinary loss treatment. Example: The taxpayer has a net Section 1231 gain of $21,000 for the current year. This is the taxpayer’s first net Section 1231 gain in over six years. Looking back, the taxpayer was able to deduct $9,000 of net Section 1231 losses during the last five years. The gain is taxed as follows—$9,000 is taxed as ordinary income and the remaining gain of $12,000 is taxed as long‐term capital gain. b. 134 A special rule applies to casualty and theft losses on property used in the business and capital assets in the business held longer than one year. (1) Gains and losses from these involuntary conversions must be separately grouped and compared. (2) If casualty gains exceed casualty losses, these gains and losses are then grouped with Section 1231 items to compute the net Section 1231 gain or loss. (3) If casualty losses exceed casualty gains, the resulting net loss is treated as an ordinary loss. In this situation, these casualty gains and losses are not grouped with the Section 1231 items. INDIVIDUALS Depreciation 1231.13 1231.14 A deduction is allowed for wear, tear, exhaustion, and normal obsolescence of property held for the production of income or for property used in a trade or business a. This cost recovery process can take the form of depreciation, cost recovery, amortization, or depletion b. While depletion relates to natural resources, no depreciation, cost recovery, or amortization is available for the following: (1) Personal property not used in a trade or business (2) Inventory (3) Land For assets acquired after 1986, depreciation is computed using the modified accelerated cost recovery system (MACRS). Under this system, the full cost of the property (including salvage value) is written off over a prescribed recovery period: a. b. Revenue Procedure 87‐56 sets out a class life, recovery period, and alternative depreciation system life for classes of tangible property used in a trade or business or held for the production of income. (1) MACRS uses the recovery period. (2) Class life and alternative depreciation system lives have special purposes not generally affecting calculation of regular taxable income. MACRS depreciation cannot be used for intangible property and property not depreciated in terms of years (units‐of‐production method 135 INDIVIDUALS c. Real estate: (1) d. Under MACRS, real estate acquired after 1986 is depreciated using the straight‐line method over the following periods: Residential real estate 27.5 years Nonresidential real estate placed in service before May 13, 1993 31.5 years Nonresidential real estate placed in service after May 12, 1993 39.0 years (2) Real property acquisitions are subject to the mid‐ month convention. One‐half month’s cost recovery is allowed in both the month of acquisition and the month of disposition. (3) The Tax Cuts and Jobs Act of 2017 (TCJA) provides that a real property trade or business electing out of the limitation on the deduction for business interest is required to use ADS (alternative depreciation system) to depreciate any of its nonresidential real property, residential rental property, and qualified improvement property. Personal property (1) There are six recovery periods for personal property: 3, 5, 7, 10, 15, and 20 years. (a) Under MACRS, the 200% declining‐balance method is used for the 3‐, 5‐, 7‐, and 10‐ year properties. The 150% declining‐ balance method applies to the 15‐ and 20‐ year properties. Both methods switch to straight‐line depreciation when that method produces a larger deduction. (b) The 5‐ and 7‐year properties are most common. i. 136 The 5‐year class includes automobiles, general‐purpose light trucks, computers, and office INDIVIDUALS machinery (typewriters, calculators, copiers, etc.). ii. The 7‐year class includes heavy, special‐purpose trucks and office furniture and fixtures (desks, filing cabinets, etc.). (2) Generally, a half‐year’s recovery deduction is taken in the first year of use regardless of the month the property was placed in service (half‐year convention). (3) Basically, the recovery deduction is determined by applying a prescribed statutory percentage to the unadjusted basis of the property. The government provides tables listing the applicable percentages. (4) A mid‐quarter convention will apply to property acquired after 1986 if more than 40% of the value of all property acquired during a tax year is placed in service during the last quarter of the year. (a) If the mid‐quarter convention applies, property acquisitions must be grouped by the quarter they were acquired. (b) A cost recovery deduction for each of these groups is computed as follows: Acquisitions Depreciation Allowable 1st quarter 10.5 months 2nd quarter 7.5 months 3rd quarter 4.5 months 4th quarter 1.5 months These adjustments are built into the MACRS tax tables for the mid‐quarter convention. (5) Disposal of personal property generally results in a cost recovery deduction in the year of disposal. (a) In most cases, a half‐year of cost recovery is allowed in the year of disposition or retirement. 137 INDIVIDUALS (b) 138 If the mid‐quarter convention applies, the cost recovery will range from 1.5 months to 10.5 months of depreciation depending on which quarter the disposal of the property takes place. (6) The taxpayer may elect to use the straight‐line method of depreciation for personal property. This election is available on a class‐by‐class basis for each tax year. (7) Under Section 179 of the Internal Revenue Code, the taxpayer, other than an estate, a trust, or certain noncorporate lessors, may elect to deduct as an expense, rather than to depreciate, up to a specified amount of the cost of new or used tangible personal property or certain real property placed in service during the tax year in the taxpayer’s trade or business. (a) The basis of the asset(s) must be reduced by the amount expensed. The amount “expensed” cannot exceed the taxpayer’s aggregate taxable income from trade or business activities. Amounts in excess of trade or business income that would otherwise be deductible are carried forward indefinitely. (b) Under the Tax Cuts and Jobs Act of 2017 (TCJA), a taxpayer may expense $1,160,000. The phaseout threshold is now $2,890,000. There is also an index for inflation. For tax year 2023, the taxpayer may expense $1,160,000 and the phaseout threshold is $2,890,000. (c) The TCJA further clarifies that the cost of roofing; heating, ventilation, and air conditioning property; fire protection and alarm systems; and security systems can be deducted under IRC Section 179 as “qualified real property. INDIVIDUALS e. (8) “Bonus depreciation” refers to a special depreciation allowance for the first year that certain classes of property are placed in service. (9) Under the Tax Cuts and Jobs Act of 2017, bonus depreciation increases from 50% to 100% for property acquired and placed in service (both new and used, so long as the use is new to the taxpayer) after September 27, 2018, and before 2023. After 2023, there is a gradual decrease in the percentage: 80% for 2023, 60% for 2024, 40% for 2025, and 20% for 2026. The CARES Act modified the provisions of TCJA to include qualified improvement property in the asset class eligible for bonus depreciation. Alternative depreciation system: (1) After 1986, an alternative depreciation system (ADS) must be used in certain computations. (a) To compute that portion of depreciation treated as a tax preference item for purposes of the alternative minimum tax for property purchased before 1999 (b) To calculate depreciation for property: i. Used predominantly outside the United States ii. Leased or used by a tax‐exempt entity iii. Financed with the proceeds from tax‐exempt bonds iv. Imported from countries engaged in discriminatory practices v. Listed property used 50% or less in a qualified business use vi. Certain farming equipment 139 INDIVIDUALS (c) (2) Generally, depreciation under this method is calculated using the straight‐line method without regard to salvage value. (3) Depreciation of personal property for the alternative minimum tax is calculated by using 150% declining‐balance depreciation, switching to the straight‐line method when appropriate to maximize deductions. (4) Depreciation of real estate for the alternative minimum tax uses the mid‐month convention. (5) The recovery period for the ADS is generally the ADR midpoint life of the asset. (6) Taxpayers may elect to use ADS in lieu of MACRS. f. The government publishes tables that automatically provide for each of the special conventions that a taxpayer may use in the year of acquisition for both real estate and personal property. g. Listed property: (1) 140 To compute depreciation for earnings and profits purposes Special rules apply to property suitable for both business and personal use (e.g., automobiles, computers). (a) If business usage of such property is not more than 50%, the property does not qualify for regular (accelerated) MACRS, bonus, or the Section 179 first‐year expense. It must be depreciated under ADS using the straight‐line method. (b) If business usage exceeds 50%, the property is available for regular MACRS and Section 179 depreciation. If future business usage drops below 50%, a permanent switch to the straight‐line method is required. In addition, previous cost recoveries in excess INDIVIDUALS of straight‐line depreciation must be recaptured as additional income. (2) An additional limitation is placed on luxury automobiles. A dollar limit for depreciation is mandated for each year the car is in use. For tax years beginning after 2017, these limits will be adjusted for inflation using the automobile component of the consumer price index (CPI). (a) The depreciation limit under Sec. 280F(d)(7) assuming bonus depreciation is: Year 1 $20,200 Year 2 Year 3 19,500 11,700 Year 4 and after 6,960 (b) These limits must be reduced proportionately if business usage is less than 100%. (c) Trucks, SUVs, and vans weighing over 6,000 pounds are not subject to the luxury automobile limits. Likewise, ambulances, hearses, taxis, and limousines are not subject to these limits. Recovering the Cost of Leasehold Improvements and Intangible Assets 1231.15 Improvements made by the lessee that are made in lieu of rent are deductible as rent by the lessee and included as income by the lessor. 1231.16 Improvements made by the lessee that are not made in lieu of rent must be capitalized by the lessee and written off using the modified accelerated cost recovery system (MACRS). 1231.17 Taxpayers generally amortize the cost of intangibles acquired after August 10, 1993, over a 15‐year period on a straight‐line basis, beginning with the month acquired. a. Section 197 intangibles are a qualifying asset acquired and held in connection with the conduct of a trade or business. 141 INDIVIDUALS This includes goodwill, going‐concern value, trademarks, and franchises. b. Copyrights, patents, and covenants not to compete are included when acquired with the purchase of a business. c. Intangibles not required to be written off over 15 years are amortized over their useful lives. Such assets include copyrights and patents acquired separately, not acquired with the purchase of a business. d. Interests in land, financial interests, computer software, mortgage servicing, and leases of tangible personal property are excluded from the definition of Section 197 intangibles. e. A loss cannot be recognized on the disposition of Section 197 intangibles if the taxpayer retains other Section 197 intangibles acquired in the same transaction. f. Research and experimental expenditures may be (1) expensed in the year paid or incurred, (2) capitalized and amortized over a period of time not less than 60 months, or (3) capitalized and amortized ratably over 10 years and thereby avoiding alternative minimum tax considerations. Depletion 1231.18 Depletion is the process whereby owners of an economic interest in natural resources may recover the cost of their investment (e.g., oil, timber, gas, minerals). 1231.19 Two methods are available for computing depletion. Annually, the taxpayer must choose the method that gives the greatest depletion deduction for that year. a. 142 Cost depletion method: (1) Divide the estimated number of units in a resource deposit into the cost or other adjusted basis of the property to obtain the cost depletion per unit. (2) Multiply this quotient by the number of extracted units that were sold for that year to obtain the cost depletion deduction. INDIVIDUALS (3) b. Percentage depletion method: (1) c. Cost depletion is no longer applicable when the adjusted basis of the resource is reduced to $0. Percentage depletion is the lesser of the following two figures: (a) A flat percentage of gross receipts from the property; the percentage is specified by the government and varies according to the type of resource or (b) 50% of taxable income from the property before taking a depletion deduction. (2) Percentage depletion is not restricted to the cost basis of the resource. Consequently, taxpayers can recover through depletion deductions far more than they have invested in the resource. The excess taken becomes a tax preference for alternative minimum tax. (3) Some of the more common percentage depletion rates are: (a) 15% for copper, gold, silver, iron, and oil and gas; (b) 10% for coal and lignite; and (c) 5% for gravel, peat, sand, and pumice. The cost basis of the resource must be reduced each year by the amount claimed as depletion, whether determined by the cost or the percentage method. The basis will not be reduced below $0, however. 1231.20 Timber is not available for percentage depletion; the cost method must be used. 1231.21 Percentage depletion is generally not available for oil and gas wells. Exceptions include certain domestic gas wells and small independent producers and royalty owners. Special rules apply to these interests. 143 INDIVIDUALS Depreciation and Recovery Allowance Recapture 144 1231.22 Whereas IRC Section 1231 provides long‐term capital gain treatment for certain noncapital assets, IRC Sections 1245 and 1250 deny this special treatment, where the gain represents a recovery of some or all of the depreciation allowances previously deducted. IRC Sections 1245 and 1250 take precedence over IRC Section 1231. 1231.23 Section 1245 recapture: a. IRC Section 1245 requires that any gain on IRC Section 1245 property will be treated as ordinary income to the extent of all depreciation taken b. Any gain on IRC Section 1245 property which is not recaptured as ordinary income becomes IRC Section 1231 gain. c. IRC Section 1245 property refers primarily to equipment used in a trade or business. It also includes most buildings acquired during the ACRS (accelerated cost recovery system) recovery period (1981–1986). d. Depreciation recapture rules do not apply when property is disposed of by gift or by transfer at death. e. Gift property retains its ordinary income potential in the hands of the donee. f. The charitable contribution deduction for Section 1245 property must be reduced by the amount that would have been recognized as ordinary income if the item had been sold at its fair market value. g. In tax‐free exchanges and involuntary conversions of Section 1245 property, depreciation recapture is considered only to the extent that a gain is recognized on the exchange or conversion. h. Any depreciation recapture resulting from an installment sale is to be recognized in the year of sale even if no proceeds are received. INDIVIDUALS 1231.24 Section 1250 property rules: a. IRC Section 1250 applies to real property—buildings and their structural components b. IRC Section 1250 requires that excess depreciation (actual depreciation in excess of straight‐line depreciation) be recaptured as ordinary income. However, this provision no longer applies since straight‐line depreciation has been required on buildings acquired after 1986. Thus, there is no excess depreciation, and all of the depreciation is “unrecaptured.” c. The unrecaptured gain on the sale of a building becomes IRC Section 1231 gain. If Section 1231 gains exceed Section 1231 losses for the current and past five years, the remaining gain receives long‐term capital gain treatment. However, unrecaptured Section 1250 gain may be taxed at a special rate of 25%. (1) Unrecaptured Section 1250 gain is equal to the lesser of the gain or the total depreciation taken on the property. (2) Any gain not treated as unrecaptured Section 1250 gain is taxed at the long‐term capital gain rate applicable to the transaction based on the taxpayer’s tax bracket. Example: A commercial building acquired at a cost of $2,028,000 was sold in 2023 for $3 million after deducting straight‐line depreciation of $650,000 over the years. Assuming that no other Section 1231 events affect this transaction, the taxation of the $1,622,000 gain is as follows. Because straight‐line depreciation was used, no depreciation is recaptured as ordinary income. Consequently, there is unrecaptured Section 1250 gain of $650,000. This portion of the gain is taxed at 25%. The remaining gain of $972,000 is taxed at 20%, assuming the taxpayer is an individual with taxable income in excess of $492,301 in 2023.. 145 INDIVIDUALS Amount realized Less: Adjusted basis Cost Less: Straight‐line depreciation Realized gain $3,000,000 $2,028,000 (650,000) Recognized gain: As ordinary income As unrecaptured Section 1250 gain taxed at 25% rate As Section 1231 long‐term capital gain taxed at 20% rate Total recognized gain d. (1,378,000) $1,622,000 $ 0 650,000 972,000 $1,622,000 Additional rule for corporations (IRC Section 291): (1) A corporation’s ordinary income from the sale of IRC Section 1250 real property will be increased by 20% of the lesser of (1) depreciation taken or (2) the recognized gain. Example: Over the years, $30,000 of straight‐line depreciation was taken on a building costing $10,000. If this property is sold for $110,000, a gain of $40,000 results ($110,000 – ($100,000 – $30,000)). The corporation must recognize $6,000 ($30,000 × 20%) of this gain as ordinary income under IRC Section 291. Amount realized Less: Adjusted basis Cost Less: Straight‐line depreciation Realized gain Recognized gain: As ordinary income, Section 291: Lesser of: $30,000 × 0.20 = $6,000 or $40,000 × 0.20 = $8,000 As Section 1231 long‐term capital gain Total recognized gain (2) 146 $110,000 $100,000 (30,000) (70,000) $ 40,000 $ 6,000 34,000 $ 40,000 This provision does not affect Subchapter S corporations. INDIVIDUALS 1232 Taxable and Nontaxable Dispositions 1232.01 Once the amount of gain or loss has been calculated, the amount of the gain or loss to be recognized for tax purposes must be computed. a. Generally, gains on property transactions are recognized, but the recognized gain never exceeds the realized gain. b. Losses on the sale, exchange, or condemnation of personal use assets are not recognized. c. Losses on the sale of income‐producing property to certain related parties are not recognized. However, the disallowed loss may be used by the related purchasing party to offset any gain on a later disposition of this property. d. Gains are generally recognized in the year of the sale. e. (1) Taxpayers using the installment method of reporting sales recognize and report their gain as the payments are received. (2) The gain reported each year is determined by multiplying the gross profit percentage on the sale by the payments received that year. (3) The installment method cannot be used to report losses. In certain transactions, some or all of the gain or loss may be postponed. (1) Postponement is possible in these transactions only if replacement property is acquired. (2) Postponement is accomplished by modifying the basis of the new property according to the following guidelines: (a) Postponed gains: Decrease the basis (fair market value (FMV)) of the new asset by the amount of the unrecognized gain. 147 INDIVIDUALS (b) 1232.02 1232.03 Property transactions in which the gain or loss may be postponed by adjusting the basis of the replacement property include the following: a. Tax‐free exchange b. Involuntary conversions (condemnation, casualty, theft) c. Wash sale Tax‐free exchange: a. To postpone a gain or loss, property held for productive use in a trade or business, or for investment, must be exchanged for property of like kind to be held for business or investment purposes. Under the Tax Cuts and Jobs Act of 2017, the tax‐free exchange provision applies only to real estate and no longer applies to personal property. b. Treatment of gains and losses: c. 148 Postponed losses: Increase the basis (FMV) of the new asset by the amount of the unrecognized loss. (1) If a gain is realized on the exchange of properties, the gain is recognized to the extent of the lesser of the gain realized or the fair market value (FMV) of the boot (cash or other assets) received. Any unrecognized gain is postponed. (2) A loss incurred in a tax‐free exchange is generally not recognized. The unrecognized loss is postponed. (3) If boot is given in the exchange, gain or loss on the boot is recognized to the extent that the boot has appreciated or depreciated in value. The following property items are not tax‐free exchange items: (1) Property held primarily for sale (2) Securities INDIVIDUALS d. e. The following items do not qualify as like‐kind items: (1) Real property for personal property (2) Livestock of different sexes (3) Interests in a partnership (4) After December 31, 2017, any property other than real property Tax‐free exchanges do include the following special items: (1) Exchanges of the same type of stock in the same corporation (2) Transfer of property to a controlled corporation (80% owned) (3) (a) No gain or loss is recognized if property is exchanged solely for stock or securities. (b) If cash or other property is received in addition to the securities, gain is recognized to the extent of the lesser of the gain realized or the cash or FMV of the other property received. Certain types of corporate reorganizations, including the following: (a) A statutory merger or consolidation (Type A) (b) An exchange of stock for voting stock (Type B) (c) An exchange of assets for voting stock (Type C) (d) A divisive reorganization—spin‐offs, split‐ offs, split‐ups (Type D) 149 INDIVIDUALS f. 1232.04 (1) the amount derived when the unrecognized gain is subtracted from the FMV of the new asset or (2) the amount derived when the unrecognized loss is added to the FMV of the new asset. Involuntary conversions (condemnation, casualty, theft): a. b. 150 The basis of property acquired in a tax‐free exchange is equal to the adjusted basis of the property surrendered, or: Gains: (1) Taxpayer may elect to recognize the gain. (2) Taxpayer may elect postponement. (IRC Section 1033) (3) Taxpayer must recognize gains to the extent that there are proceeds left over after replacement of the asset. Losses: (1) If income‐producing property, the loss is recognized. (2) If non‐income‐producing property, the loss is recognized only to the extent that the casualty or theft (but not a condemnation) exceeds $100 for each event. (a) The deduction for casualty and theft losses on nonbusiness property is further limited to the excess of the loss over 10% of the adjusted gross income (AGI). (b) For tax years beginning after December 31, 2017, and before January 1, 2026, the personal casualty and theft loss deduction is limited to a loss incurred in a disaster declared by the president under section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act. INDIVIDUALS (3) c. (c) However, when a taxpayer has personal casualty gains, losses may be offset against the gains. (d) Taxpayers experiencing several allowable losses during the year may deduct the amount by which the combined losses (reduced by $100 per event) exceed 10% of AGI. In calculating the loss: (a) The loss is limited to the difference in the fair market value immediately before and immediately after the event or the adjusted basis of the property, whichever is smaller. (b) If business or income‐producing property is completely destroyed, the adjusted basis may be deducted if it is greater than the fair market value immediately preceding the casualty. (c) Insurance and/or other compensation received acts to reduce the loss. Taxpayers must also net gains and losses when there are both recognized gains and recognized losses from the involuntary conversion of trade or business property held for more than one year. (1) If the gains exceed the losses, all casualty and theft gains and losses are combined with the other Section 1231 transactions. (2) If the losses exceed the gains, the net loss is deductible as an ordinary loss. d. The basis of any replacement property is equal to the cost of the property reduced by any unrecognized gain. e. Replacement must take place within a period that begins on the date of destruction or condemnation, or the date when the property was first threatened with condemnation, whichever is earlier. 151 INDIVIDUALS 1232.05 The period ends two years after the close of the tax year in which some part of the gain is realized. (2) On the condemnation (as opposed to casualty and theft) of business and investment real property, the replacement period ends three years after the close of the tax year in which some part of the gain is realized. (3) The replacement period for the involuntary conversion of a personal residence in a declared federal disaster area is extended to four years beyond the year of gain. Sale or exchange of a principal residence: a. 152 (1) Individuals may exclude $250,000 ($500,000 on a joint return) of gain on the sale or exchange of a principal residence. Gains in excess of the excludible amount will be taxed. These excess gains may not be postponed by adjusting the basis of a replacement residence. (1) The residence must have been owned and occupied by the taxpayer for an aggregate of at least two of the five years before the sale or exchange. (2) The exclusion may be used only once every two years. (3) The $500,000 exclusion is available to married taxpayers filing jointly if (a) either spouse satisfies the ownership test, (b) both spouses meet the occupancy test, and (c) neither spouse has used the exclusion within the last two years. (a) When the spouse has used the exclusion within the past two years, an eligible taxpayer may still exclude $250,000 on either a joint return or a separate return. (b) When a husband and wife each sell a principal residence, they are each eligible to exclude $250,000 on the sale of their INDIVIDUALS residences. They may claim their exclusions on either a joint return or separate returns. (c) 1232.06 1232.07 A surviving spouse can exclude up to $500,000 from the sale of a principal residence if the sale is within two years of the date of death and the other requirements were met on the date of death. (4) If the ownership and occupancy tests are not met, a prorated exclusion is available if the sale or exchange is the result of (a) change of place of employment, (b) health, or (c) unforeseen circumstances. (5) An individual is treated as using property as his or her principal residence during any period of ownership while the individual’s spouse or former spouse is granted use of the property under a divorce decree or separation instrument. b. Losses are not recognized; neither are they postponed. c. The basis of any new residence is its cost. There is no basis adjustment for unrecognized gains and losses. Wash sale: a. A wash sale takes place when securities are sold at a loss and replaced with substantially identical securities within 30 days before or after the sale. b. Such losses are not recognized—they are postponed. The disallowed loss increases the basis of the stock or securities acquired. c. This law does not apply to dealers. Section 1202: Depending on the acquisition date of qualified small business stock (QSBS), IRC Section 1202 permits noncorporate investors to exclude a percentage of gain they realize on the disposition of QSBS issued after August 10, 1993, under certain conditions. 153 INDIVIDUALS 1232.08 Qualified small business stock (QSBS): For a small business stock to qualify under IRC Section 1202:Error! Bookmark not defined. 1232.09 a. The business must be a United States C corporation with $50 million or less in capital. Exceeding the $50 million limit does not disqualify otherwise qualifying stock, but the corporation can never again issue qualified stock. b. The stock must have been directly acquired as an original issuance from the C corporation (or via gift or inheritance from the original acquirer). c. The stock must be held for more than five years from the date of acquisition. d. Eighty percent (80%) of the value of the corporate assets must be used in the active conduct of business. e. The company must provide services in an eligible sector— those in personal services, law, banking, finance, leasing, hospitality, health, farming, or mining are not eligible for this exclusion. QSBS capital gain exclusions: Acquisition Date Capital Gain Exclusion Percentage 8/10/1993 and Before 2/18/2009 50% 2/18/2009–9/27/2010 75% After 9/27/2010 (see PATH Act) 100% 1232.10 The PATH Act: In December 2015, the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) was signed into law. a. 154 The PATH Act made the small business stock gains exclusion permanent; 100% of the gain on the sale or exchange of QSBS (qualified small business stock) acquired after September 27, 2010 and held for more than five years is excluded from taxable income, with certain limitations. INDIVIDUALS 1232.11 b. The PATH Act also permanently extended the rule that eliminates the 100% excluded QSBS gain as a preference item for alternative minimum tax (AMT) purposes. c. In addition, QSBS gain excluded from income is not subject to the 3.8% “Obamacare” tax on “net investment income” from capital gains (and other investment income) on high‐ income taxpayers. Per‐issuer limitation on gain exclusion: a. 1232.12 Eligible gain from any one corporate issuer in any given tax year cannot exceed the greater of: (1) $10 million reduced by the aggregate amount of eligible gain taken into account by the taxpayer in prior years from the same issuer or (2) 10 times the adjusted basis of all qualified stock of the issuer that the taxpayer disposed of during the tax year. b. The $10‐million limitation is applied on a shareholder‐by‐ shareholder basis and any property contributed to the issuing corporation is its fair market value as of the contribution date. c. Married taxpayers filing separately have $5 million of eligible gain for each spouse. Section 1244 stock: IRC Section 1244 allows losses from the sale of shares of small, domestic corporations to be deducted as ordinary losses instead of as capital losses up to a maximum of $50,000 for individual tax returns or $100,000 for joint returns. a. The corporation’s aggregate capital must not have exceeded $1 million when the stock was issued. b. The corporation must not derive more than 50% of its income from passive investments. c. The shareholder must have paid for the stock and not received it as compensation. 155 INDIVIDUALS d. Only individual shareholders who purchase the stock directly from the company qualify for the special tax treatment. e. Losses in excess of the maximum can then be deducted as a capital loss on Schedule D (IRS Form 1040). 1233 Amount and Character of Gains and Losses, and Netting Process 1233.01 The following summarizes the tax treatment of gains and losses. 1233.02 The gain or loss on the disposal of property is computed by comparing the value of the assets received with the investment in the property given up. – = 156 Amount realized Adjusted basis Gain or loss INDIVIDUALS 1233.03 The amount realized on the disposition of property is equal to the net proceeds received for that property. – = a. b. 1233.04 Gross selling price Selling expenses Amount realized The gross selling price includes everything received for the property given up, including the following: (1) Cash (2) Fair market value of property and services received (3) Amount of mortgage, assumed by buyer, on property given up Selling expenses include advertising, legal fees, commissions, and any other costs required to effect the transfer of property. All items receiving capital gain or loss treatment should be classified as short term or long term and summarized as follows: The result is either a net gain or a net loss. 1233.05 Net gains for individuals, estates, and trusts: a. Any of the net gain arising from short‐term sales and exchanges receives ordinary income treatment. A short‐ term capital gain is from a capital asset that is held 1 year or less. A long‐term capital gain is from a capital asset this is held for longer than 1 year. b. Capital gain is subject to one of three rates depending on the nature of the asset responsible for the gain. Maximum rates are 25% on recaptured depreciation on real property, 28% on gains from the sale of collectibles and IRC Section 1202 stock, and—finally—20% on all other “regular” gains. 157 INDIVIDUALS c. 1233.06 158 Maximum capital gain tax rates are 0% for individuals with income up to $44,625 ($59,750 for head of household, $89,250 for married filing jointly), 15% for individuals with income up to $492,300 ($523,050 for head of household, $553,850 for married filing jointly), and 20% for individuals earning over $492,301 ($523,301 for head of household, $553,801 for married filing jointly). These same breakpoints apply to qualified dividends. Breakpoints will change with inflation. Do not forget the following exceptions: (1) Unrecaptured IRC Section 1250 gain (gain up to the original cost of real property) will be taxed at a maximum rate of 25%. Any excess of sales price over original cost of real property used in a trade or business is regular gain taxed at 0%, 15%, or 20%. (2) Taxable gains arising from the sale of collectibles (e.g., art, coins, and antiques) and Section 1202 stock will be taxed at a maximum rate of 28%. Net capital losses for individuals, estates, and trusts: a. If the taxpayer has a net capital loss, up to $3,000 may be deducted in the current year as a deduction from adjusted gross income (reported on Schedule D of IRS Form 1040). b. Short‐term losses are used before long‐term losses. c. Both short‐term (STCL) and long‐term (LTCL) losses are deductible dollar‐for‐dollar. d. Any remaining capital loss will be carried forward indefinitely. e. The carryover will be treated as STCL or LTCL depending on its origin. INDIVIDUALS 1233.07 Special netting procedures: a. Long‐term capital gain and loss items are netted in the following manner. Separately list 28% gains (losses), 25% gains, 15%/20% gains (losses), then: (1) offset any 28% losses against 25% gains, then against 15%/20% gains. If a loss still exists, offset it against any available net short‐term gain. Any remaining loss is eligible for the $3,000 deduction. A loss in excess of $3,000 carries forward indefinitely. (2) offset any 15%/20% losses against 28% gains, then 25% gains. Offset any remaining loss against available net short‐term gain. If a loss remains, it is eligible for the $3,000 deduction. A loss in excess of $3,000 carries forward indefinitely. While losses can result from the sale of 28% and 15%/20% items, the 25% situation involves only gains (by definition). Summary of the netting process for long‐term capital gains and losses: 15%/20% When the netting process produces a net long‐term capital gain, the gain is used to absorb any net short‐term capital loss. Any remaining 28%, 25%, or 15%/20% gains will be taxed at those rates (see short‐term netting process in part b., following). 159 INDIVIDUALS Example: A taxpayer with $250,000 of taxable income (35% tax bracket in 2023) has no short‐term gains and losses, but does have the following long‐term capital gains and losses: (a) 28% gain from the sale of stamp collection: $4,000 (b) 25% gain from unrecaptured depreciation on sale of a commercial building: $105,000 (c) 15%/20% loss from sale of stock held as investment: $65,000 In this situation, the taxpayer first offsets the $65,000 loss against the $4,000 gain. The remaining loss of $61,000 then offsets the 25% gain of $105,000. The remaining NLTCG (net long‐term capital gains) of $44,000 is taxed at 25%. b. Short‐term capital gains and losses are netted to produce a net short‐term gain or loss. (1) If the result is a gain, the gain is used to absorb any net long‐term capital loss. Any remaining short‐ term capital gain is taxed as ordinary income. (2) If the netting process results in a net short‐term capital loss, the loss will offset available net long‐ term capital gain in the following order: 28% gains, 25% gains, and 15%/20% gains. If a loss remains, up to $3,000 may be deducted as a deduction for adjusted gross income (AGI). Any additional loss is carried forward indefinitely. Example: If the taxpayer in the preceding example also had a net short‐term capital loss of $15,000, the loss would offset the NLTCG of $44,000. The remaining $29,000 gain would be taxed at 25%. (3) 160 Capital losses of individuals carry forward as either long‐term or short‐term depending on their origin. However, short‐term losses are used first in calculating the $3,000 deduction. INDIVIDUALS 1233.08 1233.09 Net capital gains for corporations: a. Corporate capital gains are taxed at the same tax rate as ordinary income. b. Before 1987, corporate capital gains received favorable tax treatment through an alternative tax. Net capital losses for corporations: a. Corporations are not allowed to deduct capital losses in excess of capital gains from ordinary income. b. Capital losses of a corporation can only be used to offset capital gains. c. All net capital losses carry back three years and forward five years as capital losses. d. Ordering of losses: (1) If carrying losses from more than one year, use the earlier losses first. (2) Loss carryback/carryforward rules operate as follows: (a) First, carry back to the third prior year. (b) Next, carry back what is left to the second prior year. (c) Next, carry back to the year immediately preceding the loss. (d) Then, whatever loss remains is carried forward for the five years following the year of loss. (e) Finally, any loss remaining after five years is lost. 161 INDIVIDUALS 1234 Basis and Holding Periods of Assets 1234.01 In determining the taxpayer’s investment (adjusted basis) in an asset, several cost factors must be considered. Original basis 1234.02 162 + Capital additions – Capital recoveries = Adjusted basis a. The basis of property must be adjusted by the cost of any improvements made since its acquisition. Real property taxes and mortgage interest on unimproved and unproductive real property may be capitalized at the election of the taxpayer. b. The basis of property must be reduced for depreciation and depletion along with other recoveries such as casualty losses. Establishing the basis of property acquisitions depends primarily on the method by which the property was acquired. a. Standard purchase—Basis is cost. b. Group purchase—The cost is allocated to the individual assets in proportion to their fair market values. c. Bargain purchase—Basis is the cost plus the bargain (fair market value at the date of the bargain purchase). d. Inherited property—Basis is usually the fair market value at date of death. (1) Fair market value (FMV) six months after death is an alternative for an estate tax return if this produces a lower value for the gross estate and a lower estate tax liability. The FMV at six months after death can only be used for basis if an estate tax return is filed using that FMV. (2) If the alternative value is chosen and property is disposed of before the six‐month period has expired, that property shall be valued at the fair market value at the date of disposition, the sale price. INDIVIDUALS e. Gift property acquired since January 1, 1921: (1) (2) Basis to compute gain—donor’s basis (a) On gifts made before 1977, any gift taxes paid by the donor could be added to the donor’s basis as long as the addition of the taxes did not cause the basis of the property in the donee’s hands to exceed the fair market value of the property at the date of the gift. (b) On gifts made after 1976, the basis of the property is increased by the gift tax attributable to the net appreciation in the value of the gift property, but the donee’s basis cannot be increased beyond the fair market value of the property at the date of the gift. Basis to compute loss—lower of: (a) donor’s basis plus the gift tax adjustment or (b) fair market value at date of gift In certain situations, neither a gain nor a loss can be computed on the sale of property received by gift. In such a situation, the selling price is less than the basis for gain and more than the basis for loss. f. (3) Basis for calculating depreciation—Use the gain basis. (4) Basis of gifts made prior to 1921—fair market value at date of gift Personal property converted to income production: (1) Basis for gain—adjusted basis of the asset at conversion minus allowable depreciation after conversion (2) Basis for loss—lower of: (a) the adjusted basis of the asset at conversion minus allowable depreciation or 163 INDIVIDUALS (b) (3) (a) the adjusted basis of the asset at conversion or (b) fair market value at conversion Property received as compensation for services: Basis is the fair market value of the property when received. h. Property transferred to a controlled corporation: (1) The basis of stock received for property transferred to a controlled corporation is equal to the basis of the property exchanged plus any recognized gain on the exchange minus any cash and/or other property received (2) The basis of property acquired by the corporation is the same as it was in the possession of the transferor plus any gain recognized by the transferor on the exchange. (3) To qualify as a controlled corporation, persons transferring property to a corporation for its stock or securities must own 80% of the voting stock plus 80% of all other stock of the corporation immediately after the exchange. Taxable exchange—Basis is the fair market value of the property received. Capital gains and losses, once determined, must be classified as either short term or long term depending on the holding period of the asset given up. a. b. 164 Basis for calculating depreciation—lower of: g. i. 1234.03 fair market value at conversion minus allowable depreciation thereafter Holding period requirements: (1) One year or less—short term (2) More than 12 months—long term The holding period for long‐term capital gains and losses is measured as follows: INDIVIDUALS (1) As a minimum, property must be held to that day of the 12th month following the month of acquisition that is numerically one day later than the date acquired. (2) If property is purchased on the last day of the month, it must be held to at least the first day of the 13th month. c. The holding period normally begins on the day that the basis originated. d. In transactions in which some portion of the basis of an asset carries forward, the holding period begins at the time the carryover basis originated. Example: If the donor’s basis is used to establish the basis of gift property, the holding period for the donee begins at the time the donor’s basis originated. If the fair market value is used as the basis of gift property (a loss situation), the holding period begins at the date of the gift. e. The Internal Revenue Code provides that inherited property disposed of within one year shall be considered to have been held for more than one year. f. If any security, which is a capital asset, becomes worthless during the taxable year, the loss resulting therefrom shall be treated as a sale or exchange of a capital asset on the last day of the taxable year. 165 INDIVIDUALS 1235 Basis of Stock After Stock Splits and/or Stock Dividends 1235.01 Corporations may increase the number of shares outstanding (and at the same time reduce the value of each share) by issuing stock dividends or stock splits. These events are usually non‐taxable but change the number of shares you own and the basis of those shares. A stock dividend is generally declared in terms of a percentage. For example, in a 5 percent stock dividend, a taxpayer will receive one additional share for every 20 shares he or she already owns. A stock split is usually declared as a fraction. In a 2‐ for‐1 split, the taxpayer receives one additional share for every share he or she owns (so that the taxpayer ends up owning two shares for every one he or she owned before the split). Stock splits can occur at odd fractions. For example, if a stock splits 3‐ for‐2, the owner receives one additional share for every two he or she owned before the split (and end up owning three for every two he or she had before). A 3‐for‐2 stock split is the same as a 50 percent stock dividend. 1235.02 When a taxpayer receives additional shares as a result of a non‐ taxable stock dividend or split, the total basis in the stock remains the same. The basis is divided among the shares already owned and the new shares in proportion to the value of the shares. In the usual case, where the new shares are exactly the same as the old ones, the value is the same, and basis is allocated equally to each share. Example 1: Taxpayer owns 400 shares of XYZ with a basis of $33 per share (total basis of $13,200). XYZ declares a 10 percent stock dividend. He receives 40 additional shares and now owns a total of 440 shares. Taxpayer’s total basis is unchanged, so his basis per share is now $13,200 divided by 440, or $30. Example 2: Taxpayer owns 150 shares of ABC with a basis of $24 per share, and another 100 shares of ABC with a basis of $28 per share. The stock splits 2‐for‐1. After the split, she owns 300 shares with a basis of $12 per share, and 200 shares with a basis of $14 per share. (This is true even if the taxpayer receives a single certificate representing her 250 new shares.) 166 INDIVIDUALS 1235.03 Holding period A taxpayer is treated as if he or she held the new shares as long as he or she held the old shares. Example: A taxpayer bought 400 XYZ on June 10, 20X4 and received 40 new shares in a non‐taxable stock dividend on November 10, 20X9. Any gain or loss on a sale of the 40 new shares will be treated as a long‐term capital gain even if the taxpayer sold them immediately after he or she acquired them. 1235.04 Publicly traded partnerships (PTP) A publicly traded partnership (PTP) is a business organization owned by two or more co‐owners whose shares are regularly traded on an established securities market. A publicly traded partnership is a type of limited partnership that is managed by two or more general partners who can be individuals, corporations or other partnerships, and that is capitalized by limited partners who provide capital but have no management role in the partnership. That capital is typically in the form of cash. 1236 Sale of Personal Residence 1236.01 Section 121(a) provides that a taxpayer may exclude gain realized on the sale or exchange of property if the property was owned and used as the taxpayer’s principal residence for at least two years during the five‐year period ending on the date of the sale or exchange. The amount of the exclusion is limited to $250,000 ($500,000 for certain joint returns). Any gain attributable to depreciation adjustments for periods after May 6, 1997, is not eligible for the exclusion. This limitation applies only to depreciation allocable to the portion of the property to which the §121 exclusion applies. 1236.02 To exclude gain on the disposition of a home from income under §121, a taxpayer must own and occupy the property as a principal residence for two of the five years immediately before the sale. However, the ownership and occupancy need not be concurrent. The law permits a maximum gain exclusion of $250,000 ($500,000 for certain married taxpayers). A taxpayer is considered to have owned and used a home as a principal residence during the time 167 INDIVIDUALS his or her deceased spouse used the home as a principal residence. This rule applies as long as on the day the home is sold the taxpayer’s spouse is deceased and the taxpayer has not remarried. Divorced spouses can also benefit from the ownership and use periods of former spouses to satisfy the exclusion requirements. 1236.03 If a taxpayer excludes the entire gain on the sale from income, the transaction is not reported on his or her tax return. If any part of the gain is taxable, he or she reports the sale on Schedule D of Form 1040. Alternatively, a taxpayer can elect to include the gain from a sale by reporting it on his or her tax return. For example, someone who realizes gains on the sale of two principal residences within two years can exclude the gain on only one. Most would want to recognize the smaller gain and exclude the larger. Since the exclusion applies automatically to the first disposition, a taxpayer would need to elect to be taxed on this one if it is the smaller of the two. 1236.04 Principal residence requirement The rules define the term “residence” fairly broadly—it includes a houseboat, house trailer, or stock held by a tenant‐stockholder in a cooperative housing corporation. Personal property that is not a fixture under local law will not qualify as a residence. Consequently, EAs should consult local law, particularly on the status of mobile dwellings. If a taxpayer owns more than one home, practitioners will find the determination as to which home is the taxpayer’s principal residence depends on all of the facts and circumstances. The home a taxpayer uses for the majority of the time during the year will be considered his or her principal residence for that year. Example: For the period 2019 to 2023, Albert owns a home in Michigan and a home in Florida. During each of these years, Albert lives in the Michigan home for seven months and in the Florida home for five months. If Albert decides to sell one of the homes in 2023, only the Michigan home will qualify for the gain exclusion. Because he lives in Michigan for the majority of each year, that home is Albert’s principal residence for 2019 to 2023. 168 INDIVIDUALS 1236.05 Ownership and use requirements The ownership and use requirements are based on the total number of days or months the taxpayer owns and uses the property as a principal residence during the five‐year period ending on the date of disposition. The gain on the sale of a home is excluded from income only if, during that five‐year period, the taxpayer owns and uses the property as a principal residence for periods totaling two years or more. Either 24 full months or 730 days will satisfy the two‐year ownership and use requirements. The ownership and use periods do not need to be concurrent. Example 1: On January 1, 2020, Barbara bought a home and began to live in it. On January 1, 2022 (24 months after purchasing the home), Barbara moved out of town and began to lease the home. On December 28, 2023, she sells the property. Because Barbara owned and used the home as a principal residence for 24 months during the five‐year period ending on the date of sale, she is eligible for the gain exclusion. If, however, Barbara sells her house on February 1, 2023, the five‐year period would have begun on February 1, 2019. In this case Barbara would not be eligible for the gain exclusion because she would have lived in the home for only 23 months during the five‐year period before the date of sale. Example 2: Carmella rented a home from January 1, 2019 to January 1, 2021. She purchased the home on January 1, 2021 and lived in it until February 1, 2021. On March 1, 2023, Carmella sold the home. During the five‐year period ending on the date of sale (March 1, 2018 to March 1, 2023), Carmella owned the home for at least two years (January 1, 2021 to March 1, 2023) and lived in it for at least two years (January 1, 2019 to February 1, 2021). Therefore, Carmella is eligible for the gain exclusion even though she did not live in the residence during the same two years she owned it. 1236.06 If a taxpayer owns two homes during the five‐year period, both may qualify for the exclusion if the taxpayer uses each of them as a principal residence for at least two years during the five‐year period. However, usually the gain on only one of the two otherwise qualified homes can be excluded during any two‐year period. 169 INDIVIDUALS Example: For the period January 1, 2018, to December 31, 2023, David owns a home in Kansas and also in Texas. David lived in the Kansas home during 2019, 2020, and 2021 and in the Texas home during 2021 and 2022. David’s principal residence for 2020, 2021, and 2022 was the Kansas property. His principal residence for 2021 and 2022 was the Texas home. If David decides to sell one of the homes during 2023, both qualify for the gain exclusion because he owned and used each one as a principal residence for at least two years during the five‐year period before the sale date. To satisfy the use requirement, the taxpayer must physically occupy the home. However, short temporary absences, such as vacations, are counted as periods of use even if the home is rented during that time. 1236.07 Deceased spouse For the ownership and use requirements, a taxpayer is considered to have owned and used a home as a principal residence during the time his or her deceased spouse owned and used the home (before death) as a principal residence, as long as on the day the home is sold the taxpayer’s spouse is deceased and the taxpayer has not remarried. 1236.08 Former spouse In cases of divorce, taxpayers can benefit from both the ownership and use periods of former spouses to satisfy the requirements. If a taxpayer receives a home as part of a divorce property settlement, the taxpayer’s ownership period will include the time the spouse or former spouse owned the home. In addition, a taxpayer is treated as having used the home as a principal residence during the time the taxpayer owned the residence and the taxpayer’s spouse or former spouse was permitted to use it ‐‐under a decree of divorce or separation ‐‐ as a principal residence. Example: On January 1, 2021, Harry bought a home and began to live in it with his spouse, Jennifer. On January 1, 2023, Harry and Jennifer were divorced. Under the divorce decree, Jennifer is allowed to live in the home until February 1, 2023. Harry sells the home on March 1, 2023. Harry and Jennifer could both meet the two‐year ownership and use requirements. Although Harry lived in the home for only 12 months, if he continues to own it, he is also 170 INDIVIDUALS considered to have lived in the home for the 13 months Jennifer lived there. If Jennifer owns the residence after January 1, 2023, her ownership period includes Harry’s ownership from January 1, 2021 to January 1, 2023. 1236.09 Disallowance for use as a nonresidence If a taxpayer also uses a home for purposes other than as a principal residence, the gain exclusion does not apply to the extent of depreciation taken on the home after May 6, 1997. Example: On January 1, 2019, Kelly bought a home and rented it to tenants for two years. During the rental period, Kelly takes depreciation deductions of $14,000. On January 1, 2021, Kelly moves into the home and begins to use it as a principal residence. On February 1, 2023, after owning and using the home as a principal residence for more than two years, she sells the home at a $40,000 gain. Only $26,000 ($40,000 realized gain minus $14,000 depreciation) of the gain is eligible for the exclusion. Kelly must recognize the remaining $14,000. The gain is an unrecaptured §1250 gain taxable at up to 25 percent. If a taxpayer uses a home partially for business purposes, only the part of the gain attributable to the residential portion of the home is excluded from income. Also, the gain exclusion does not apply to the extent depreciation allowable after May 6, 1997, with respect to the home, exceeds the gain on the home allocable to the business‐use portion. Therefore, pre‐May 7, 1997, depreciation does not reduce the amount of gain excludable under §121 on the residential portion in any circumstances. However, post‐May 6, 1997, depreciation allowable on nonresidential use can trigger gain recognition on the residential‐ use part of the house. 171 INDIVIDUALS 1236.10 Overall dollar limitation The maximum gain exclusion for an individual taxpayer is $250,000. This amount is not adjusted for inflation. Taxpayers who jointly own a principal residence, but file separate returns, may each exclude up to $250,000 of the gain attributable to their interest in the home. A husband and wife who file a joint return may exclude up to $500,000 of the gain if: a. Either spouse meets the two‐year ownership requirement. b. Both spouses meet the two‐year use requirement. c. Neither spouse excluded gain from a prior sale or exchange of a principal residence within the last two years. If the taxpayers do not meet any one of these requirements, the maximum exclusion amount a married couple can claim on a joint return is the sum of each spouse’s exclusion amount, determined as though: (1) the spouses were not married; and (2) each spouse owned the home during the period that either spouse owned the home. Although one spouse’s ownership is attributed to the other for purposes of determining a separately calculated exclusion, both spouses must actually use the house as a principal residence to qualify for their own $250,000 exclusion. Example: Nancy and Oscar marry in 20X1 and move into an apartment. The couple each separately owned and used a home for at least two years before marrying. Nancy and Oscar sell their separate homes in 20X1. Nancy realizes a gain of $225,000 on the sale of her home and Oscar realizes a gain of $275,000 on his sale. Although Nancy and Oscar do not meet the requirements to exclude up to $500,000 of gain on their joint return, each spouse may exclude up to $250,000. Therefore, Nancy and Oscar will exclude $225,000 from the sale of Nancy’s home and $250,000 from the sale of Oscar’s home. Because Oscar cannot use any of Nancy’s unused exclusion, the couple must include $25,000 of the gain on his home in income. The result would be the same if Nancy and Oscar each had sold their homes before marrying. If a married couple meets the ownership and use requirements to qualify for the $500,000 gain exclusion and one spouse dies, the $500,000 exclusion will continue to apply if the surviving spouse sells the house in a year in which he or she can file a joint return 172 INDIVIDUALS with the deceased spouse. Further, if the surviving spouse has not remarried, both the deceased spouse’s ownership and use as a principal residence are attributed to the survivor. Example: Peter and Quill, a married couple, have owned and used their home as a principal residence since 2019. Peter dies on June 1, 2023. On November 1, 2023, Quill sells the home at a $280,000 gain. The entire $280,000 is eligible for the gain exclusion if she files a joint return for 2023. If, however, Quill sells the home on January 10, 2024, only $250,000 of the gain is eligible for the exclusion because Peter and Quill cannot file a joint return in 2024. 1236.11 Once‐every‐two‐years limitation A taxpayer cannot use the gain exclusion if, during the two‐year period ending on the date of the sale or exchange, he or she sold another home and excluded the gain on that home. However, as discussed below, a reduced exclusion may be allowed. Example: Robert buys a home that he uses as a principal residence in 2020 and 2021. In 2022, he bought a condo that he uses as a principal residence in 2022 and 2023. He then sold the original home in 2023 and excludes that gain from income. If Robert sells the condo in 2024, he cannot exclude the gain on that sale ‐‐ even though he satisfies the two‐year ownership and use requirements ‐‐ because he excluded the gain on the sale of the home within the prior two years. 1236.12 Reduced exclusion Taxpayers who sell their principal residence, but do not meet the ownership and use requirements, or who sell their home within two years of selling another home, may be eligible for a reduced exclusion. The reduced exclusion is available if a change in place of employment, health, or unforeseen circumstances necessitated the sale. Neither the Internal Revenue Code nor the proposed regulations define the change in place of employment, health problems, or unforeseen circumstances that would allow taxpayers to qualify for the reduced exclusion. The reduced exclusion would be calculated by multiplying the maximum dollar limitation ($250,000 or $500,000 for qualifying married taxpayers) by a fraction. The numerator of the fraction is 173 INDIVIDUALS the shortest of: (1) the time the taxpayer owned the home during the five‐year period ending on the date of the home’s sale; (2) the time the taxpayer used the home during the five‐year period ending on the date of sale; or (3) the time between the date of the prior sale for which gain was excluded and the date of the current sale. The numerator and denominator are expressed in either days or months. If the measure is days, the denominator is 730 days (365 days × 2 years). If the measure is months, the denominator is 24 months. Example 1: On January 1, 2022, Sally, an unmarried taxpayer, buys a home and uses it as a principal residence. On July 1, 2023, 18 months later, Sally sells the home because her employer transfers her to an office in another state. Sally may exclude up to $187,500 (250,000 × 18/24) of the gain on the sale of her home. Example 2: On January 1, 2020, Tom buys and begins to live in a home. On January 1, 2022, Tom marries Ursula and she moves into Tom’s home. On January 1, 2023 (12 months after Ursula began residing in the home), they sell the home because their employers transfer them to another state. Because only Tom has satisfied the two‐ year use requirement, the couple cannot use the $500,000 exclusion. Rather, their exclusion is determined by calculating the limitation amount for each spouse as if they had not been married. Therefore, Tom can exclude up to $250,000 of gain because he meets both the ownership and use requirements. Although Ursula does not meet these use requirements, she can claim the reduced exclusion because the sale is due to a job change. Ursula can exclude up to $125,000 (250,000 × 12/24) of the gain. Therefore, Tom and Ursula can claim a combined exclusion of $375,000. A taxpayer must recognize any gain on a portion of a residential property they do not use for residential purposes. Any post‐May 6, 1997, depreciation allowable on the property triggers recognition of otherwise excludable gain. A taxpayer can claim only one §121 exclusion every two years. However, a taxpayer who disposes of more than one residence within two years or who otherwise fails to satisfy the requirements, for example, due to a job change or health problem, may qualify for a reduced exclusion amount. A taxpayer who uses a portion of a property for residential purposes and a portion of the property for business 174 INDIVIDUALS purposes is treated as using the entire property as the taxpayer’s principal residence for purposes of satisfying the two‐year use requirement if the residential and business portions of the property are within the same dwelling unit. If; however, the business portion of the property is separate from the dwelling unit used for residential purposes, the gain allocable to the business portion of the property is not excludable unless the taxpayer has also met the two‐year use requirement for the business portion of the property. 1237 Installment Sales 1237.01 Installment sales (in general) a. Generally, a taxpayer is required to recognize the gain or loss from the sale or exchange of property at the time of the sale or exchange. b. Under the installment sales method, a taxpayer elects to report capital gain from an installment sale over the period during which payments are received. The installment sale rule does not apply to the reporting of losses or ordinary income. c. The installment method generally applies to sales in which the taxpayer has a gain if at least one payment will be received after the tax year in which the sale occurs. d. The installment sale reporting method may not be used: e. (1) to report gains on property held for sale in the ordinary course of business (inventory), (2) for gain that must be recaptured as ordinary income under IRC Section 1245 or 1250, or (3) for any gain on stocks or securities that are traded on an established securities market. However, the installment method can be used to report gain on the sale of: (1) time‐share units, 175 INDIVIDUALS f. 1237.02 (2) residential real estate lots if the seller has made no improvements to the lots, and (3) property used or produced in farming. If the installment method applies to a sale, the taxpayer generally must use that method unless they elect out. Electing out is done by simply reporting the entire gain from a transaction in the year of origin. Computation of gain a. The gain recognized under the installment method is computed using the following formula: Total gain Contract price 1237.03 176  Payments received during the tax year = Gain recognized b. Total gain is the selling price of the property reduced by the adjusted basis of the property and any selling expenses. c. The contract price is the selling price of the property reduced by any of the seller’s liabilities that are assumed by the buyer as part of the sale. Installment sales: Other issues a. Generally, if a taxpayer disposes of the installment obligation, the remainder of the gain under the installment sale is accelerated and must be recognized in the year of the disposition of the obligation. b. A taxpayer can make an election not to use the installment reporting method. This election is made by reporting all of the recognized gain from the installment sale in the tax year of the sale. c. A taxpayer must receive IRS permission to revoke an election not to use the installment sales reporting method. INDIVIDUALS 1237.04 1237.05 Stock Options: a. An employee receiving a qualified incentive stock option will not recognize income when it is granted. b. A sale of the stock will produce long‐term capital gain if the sale occurs more than one year after exercise and two years after grant. c. However, when computing the alternative minimum tax, generally must include the excess of the fair market value of the incentive stock options exercised during the year over the option price. d. A nonqualified stock option plan requires employee recognition of the bargain element on the exercise date. The bargain element is the difference between the stock price and the fair market value on the exercise date. Stock Rights: a. b. Generally, the distribution of stock rights does not constitute income. Exceptions include the following: 1) The option to receive case or other property in lieu of money 2) A distribution of stock rights made on preferred stock Nontaxable stock rights: 1) No income is recognized when rights are received. 2) The basis of the rights received is generally $0. i. The taxpayer may elect to allocate a portion of the basis of the underlying stock to the rights according to the relative fair market values of each at the time of distribution. ii. If the fair market value of the rights at the date of distribution is 15% or more of the fair market value of the stock on which they are issued, the basis of the stock must be allocated between the stock and the rights 177 INDIVIDUALS according to the relative fair market values of each. 3) c. d. The holding period for stock acquired through the exercise of the rights begins at the date of exercise. Taxable stock rights: 1) Gross income is realized to the extent of the fair market value of the rights at the time of distribution. 2) The basis of the rights received is equal to the fair market value of the rights. 3) The holding period for stock acquired through exercise of the rights begins at the date of exercise. The basis of the stock acquired through the exercise of the rights is equal to the subscription price plus the basis of the rights. 1238 Nonbusiness Bad Debts 1238.01 If someone owes a taxpayer money that he or she cannot collect, he or she may have a bad debt. To deduct a bad debt, the taxpayer must have previously included the amount in his or her income or loaned out his or her cash. If the taxpayer is a cash basis taxpayer, he or she may not take a bad debt deduction for money he or she expected to receive, but did not (for example, for money owed to him or her for services performed, or rent) because that amount was never included in his or her income. For a bad debt, the taxpayer must show that there was an intention at the time of the transaction to make a loan and not a gift. If a taxpayer lent money to a relative or friend with the understanding that it may not be repaid, it is considered a gift and not a loan. There are two kinds of bad debts: business and nonbusiness. 178 INDIVIDUALS 1238.02 A debt becomes worthless when the surrounding facts and circumstances indicate there is no reasonable expectation of payment. To show that a debt is worthless, a taxpayer must establish that he or she has taken reasonable steps to collect the debt. It is not necessary to go to court if a taxpayer can show that a judgment from the court would be uncollectible. A taxpayer may take the deduction only in the year the debt becomes worthless. A taxpayer does not have to wait until a debt is due to determine whether it is worthless. 1238.03 A nonbusiness bad debt is reported as a short‐term capital loss on Form 8949 and Schedule D. It is subject to the capital loss limitations. A nonbusiness bad debt deduction requires a separate detailed statement attached to the taxpayer’s tax return. This includes losses or gains attributable to condemnation. 1239 Digital assets 1239.01 Digital assets have renamed cryptocurrency and are defined by the IRS as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” Digital assets are virtual currency that has an equivalent value in real, tangible currency. Digital assets area specific type of virtual currency that uses “cryptography” to validate the secure transactions that are digitally recorded on a distributed ledger or record keeper. 1239.02 A blockchain is a type of virtual currency that uses “cryptography” to validate and secure transactions that are digitally recorded on a distributed ledger or record keeper. Individual blocks make up the blockchain and contain information about transactions including the date, time, and dollar amount of the transaction. Individual blocks also contain information about the parties participating in the transaction via unique digital signatures. A single block can hold up to a few thousand transactions. 179 INDIVIDUALS 180 1239.03 Digital asset transactions are pseudonyms and not connected to individual identities. One cannot easily connect the identity of a user with an address or transaction. Each transaction must be confirmed by a miner who solves a cryptographic puzzle in order to validate the transaction. Once a miner successfully solves the cryptologic puzzle and confirms the transaction, he or she is rewarded with a specific amount of a digital asset. This is an incentive for solving the problem and verifying the transaction. The entire legitimacy of the digital asset network depends on the underlying blockchain. 1239.04 In May 2013, the GAO issued its first report on digital assets, indicating the various ways that virtual currency exchanges can produce taxable income. INDIVIDUALS 1239.05 The IRS issued Notice 2014‐21 in the form of an FAQ document for taxpayers. They established digital assets as property for federal tax purposes, and as such is subject to general tax principles applicable to property transactions. It is critical for individuals to track the underlying basis for each unit of a digital asset to correctly calculate any potential gain or loss triggered upon sale or transfer. In a broad sense, digital assets can be taxed as either capital gain/loss or ordinary income/loss. 181 INDIVIDUALS 182 1239.06 Taxpayers who do not properly report the income tax consequences of digital asset transactions are, when appropriate, liable for tax, penalties, and interest. In some cases, taxpayers could be subject to criminal prosecution. Practitioners must remember digital assets are an ongoing focus area for IRS Criminal Investigation. 1239.07 Unlike certain stock market investors who are issued a Form 1099‐B for tax reporting purposes, there is very little regulation in the digital asset community. Some U.S. taxpayers may receive a Form 1099‐K, Payment Card and Third‐Party Network Transactions, from an exchange. The American Rescue Plan Act (ARPA) amended the de minimis threshold for Form 1099‐K reporting. Through December 31, 2021, a two‐step de minimis standard exists in which Third‐Party Settlement Organizations are required to report third‐party network transactions of a participating payee on Form 1099‐K if the amount that would otherwise be reported exceeds $20,000 and there were over 200 transactions. Beginning on January 1, 2022, the Third‐Party Settlement Organizations will be required to file a Form 1099‐K for participating payees receiving over $600. This new change mirrors the Form 1099‐MISC and Form 1099‐NEC reporting requirements for payments of compensation of $600 or more. This was delayed for 2022 and 2023 on the federal level; however, some states have adopted the $600 threshold. INDIVIDUALS 1239.08 Compensation – As with any other form of compensation, any individual who receives compensation in the form of digital assets must include the compensation on Form 1040, taxed at ordinary rates. This applies to both employees (W‐2), contractors (Form 1099), or any other individual receiving compensation. Even if the employer does not issue a W‐2 or Form 1099, the individual receiving compensation in the form of digital assets must report them at the FMV (fair market value) at the time of receipt. 1239.09 Charitable donations of digital assets – An individual who donates digital assets to a qualified organization will not recognize income, gain, or loss from the donation. If the individual held the digital assets for more than a year, the amount of the charitable deduction is equal to the FMV of the digital asset at the time of donation. If the individual held the digital asset for less than a year, the amount of the charitable deduction is equal to the lesser of the basis in the digital asset or the FMV of the digital asset at the time of donation. 1239.10 Receipt of digital assets after purchase from exchange – If an individual purchases a digital asset on an exchange, it is not a taxable event. However, this purchase will be helpful for calculating basis. The individual must check “Yes” to the Form 1040 question whether or not the individual received, sold, exchanged, gifted or otherwise disposed of a digital asset or financial interest in a digital asset. 1239.11 Gifting digital assets – The gifting of digital asset is not a taxable event. The donor must check “Yes” to the Form 1040 question regarding whether or not the recipient received, sold, exchanged, gifted or otherwise disposed of a digital asset or financial interest in a digital asset. 1239.12 Receipt of digital assets as a gift – Receiving digital assets as a gift does not constitute a taxable event. The recipient must note the FMV of the digital asset on the date the gift was made as well as the donor’s basis in the gifted digital asset. These items are critical for future basis calculations. The donor must check “Yes” to the Form 1040 question regarding whether or not the recipient received, sold, exchanged, gifted, or otherwise disposed of a digital asset or financial interest in a digital asset. 183 INDIVIDUALS 1239.13 The following table summarizes some of the forms and schedules that taxpayers involved with digital assets should consider when reviewing digital asset compliance obligations. Digital Asset Compliance 184 Form 1040  Digital Asset “check the box” question  Report ordinary income (wages/compensation) ‐ Line 1  Report capital gains/losses ‐ Line 6 Schedule 1  Report other income (staking) ‐ Line 8 Schedule A  Report charitable deductions of digital asset donations ‐ Line 12 Schedule B  Report interest income ‐ Part I  Report rewards (not reported elsewhere) ‐ Part I Schedule C  Report income generated as part of §162 trade or business ‐ Line 1  Deduct any expenses associated with §162 trade or business ‐ Part 2 Schedule D  Summarize digital asset capital gains/losses from Form 8949 Form 8949  Report digital asset gains/losses INDIVIDUALS 1240 Adjustments to Income 1241 Self‐Employment Tax 1241.01 Self‐employment tax is a tax consisting of Social Security and Medicare taxes primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners. The taxpayer calculates self‐ employment tax using Schedule SE (Form 1040). Social Security and Medicare taxes of most wage earners are calculated by their employers. Also, the taxpayer can deduct the employer‐ equivalent portion of their self‐employment tax in calculating their adjusted gross income. 1241.02 Self‐employment tax rate: The self‐employment tax rate is 15.3%. The rate consists of two parts: 12.4% for Social Security and 2.9% for Medicare. For 2023, the first $162,000 of the taxpayer’s combined wages and tips, and net earnings is subject to any combination of the Social Security part of the self‐employment tax. All combined wages, tips, and net earnings are subject to any combination of the 2.9% Medicare part of the self‐employment tax. An additional Medicare tax of 0.9% applies to wages, compensation, and self‐employment income above $250,000 for those filing married jointly, $125,000 for those filing married separate, and $200,000 for all remaining filing statuses. 1241.03 Self‐employment tax deduction: The taxpayer may deduct the employer‐equivalent portion of the self‐employment tax in calculating adjusted gross income. This deduction only affects the taxpayer’s income tax. It does not affect either net earnings from self‐employment or self‐employment tax. 1241.04 Who must pay self‐employment tax? Taxpayers must pay self‐ employment tax and file Schedule SE (Form 1040) if either of the following apply: a. b. Net earnings from self‐employment (excluding church employee income) were $400 or more Church employee income of $108.28 or more. Generally, net earnings from self‐employment are subject to self‐ employment tax. If the taxpayer is a sole proprietor or independent contractor, a Schedule C or C‐EZ is used to calculate net earnings from self‐employment. The self‐employment tax 185 INDIVIDUALS rules apply no matter the age of the taxpayer and even if they are already receiving Social Security or Medicare. 1242 Retirement Contribution Limits and Deductibility 1242.01 Roth IRAs a. For 2023, taxpayers who qualify may make nondeductible contributions of up to $6,500 each year to a Roth IRA. A qualifying taxpayer over age 50 may add $1,000 to that amount for total contribution of $7,500. That $1,000 is referred to as a “catch‐up amount.” b. Contributions from taxpayers age 73 or older are allowable. c. Distributions before death are not required. d. Contributions limits: i. ii. 186 The 2023 contribution limit of $6,500 ($7,500) is phased out proportionately between the following AGI levels: 1. Singles and head of households: $138,000– $153,000 2. Joint filers: $218,000–$228,000 3. For 2023, for married individuals filing a separate return, the phaseout is not subject to annual cost‐of ‐living adjustment and remains $0 to $10,000. For 2023, the limit for total contributions to Roth IRAs and traditional IRAs combined is $6,500 ($7,500) (before phaseout), not counting rollover contributions. INDIVIDUALS 1242.02 Traditional IRAs a. For 2023, taxpayers who qualify may make deductible contributions of up to $6,500 each year to a traditional IRA. A qualifying taxpayer over age 50 may add $1,000 to that amount for total contribution of $7,500. That $1,000 is referred to as a “catch‐up amount.” i. A portion of the taxpayer’s IRA contribution may be deductible even if they are covered by a retirement plan through their employer. 1. 2. 3. ii. For those filing as single or head of household with modified AGI of: a. Up to $73,000, fully deductible b. Over $73,000 but less than $83,000, partially deductible. c. $83,000 or more, not deductible. For those filing as married jointly with modified AGI of: a. Up to $116,000, fully deductible b. Over $116,000 but less than $136,000, partially deductible c. $136,000 or more, not deductible For those filing married separately with modified AGI of: a. Less than $10,000, partially deductible b. $10,000 or more, not deductible Deduction amounts for taxpayers not covered by a retirement plan at work. 1. For those filing as single or head of household earning any amount, it is fully deductible. 187 INDIVIDUALS 2. For those filing as married jointly or separately with a spouse who is not covered by a plan at work, it is fully deductible. 3. For those filing married jointly with a spouse who is covered by a plan at work with modified AGI of: 4. 188 a. $218,000 or less, fully deductible b. Over $218,000 but less than $228,000, partially deductible c. $228,000 or more, not deductible For those filing married separately with a spouse who is covered by a plan at work with modified AGI of: a. Less than $10,000, partially deductible b. $10,000 or more, not deductible b. Contributions from taxpayers of any age are allowed beginning in 2020. For earlier years, they were not allowed. c. The taxpayer must start taking distributions by April 1 following the year in which they turn age 73 if they reach age 72 by December 31, 2022, and by December 31 of later years. INDIVIDUALS 1242.03 SIMPLE retirement plan for small businesses: a. b. c. The Savings Incentive Match Plan for Employees (SIMPLE) simplifies complexities of retirement plans. It can be established by employers, including self‐employed individuals. The SIMPLE plan allows eligible employees to contribute part of their pretax compensation to the plan. 1. The amount an employee contributes from his or her salary to a SIMPLE IRA cannot exceed $15,500 for 2023. An additional $3,500 contribution is permitted for employees age 50 or over. 2. If an employee participates in any other employer plan during the year and has elective salary deductions under those plans, the total amount of the salary reduction contributions that an employee can make to all the plans he or she participates in is limited to $22,500 in 2023. 3. If permitted by the SIMPLE IRA plan, participants who are age 50 or over at the end of the calendar year can also make catch‐up contributions. The catch‐up contribution limit for SIMPLE IRA plans is $3,500 in 2023. SIMPLE plans can be adopted by employers having 100 or fewer employees. 1. The employee must not be part of another employer‐sponsored retirement plan. 2. All contributions are fully vested immediately. 3. Employee contributions are deductible for AGI, and taxation on accumulations is deferred until distributed. CAUTION: Distributions before age 59‐1/2 are subject to an additional tax of 10% (25% if taken during the two‐year period beginning on the date the individual first participated in any SIMPLE IRA plan of the employer). Exceptions include distributions for the following: 189 INDIVIDUALS 1242.04 Death 2. Disability 3. Deductible medical expenses 4. Health insurance of an unemployed individual 5. Qualified higher education expenses: a. Included tuition, fees, books, supplies, equipment, and room and board for postsecondary education (includes graduate‐level courses), b. Applies to taxpayer, spouse, children, and grandchildren, and c. Expenses are reduced by scholarships and similar excludible funding. 6. First time homebuyer expenses ($10,000) limit 7. Qualified birth or adoption ($5,000 limit per individual or $10,000 limit for married couples filing a joint return) 401(k) a. 190 1. A 401(k) plan is a qualified employer‐sponsored retirement plan that eligible employees may make tax‐ deferred contributions from their salary or wages to a post‐tax and/or pre‐tax basis. Employers offering a 401(k) plan may make matching or non‐elective contributions to the plan on behalf of eligible employees and may also add a profit‐sharing feature to the plan. Earnings in a 401(k) plan accrue on a tax deferred basis. 1. The amount an employee contributes from his or her salary to a 401(k) cannot exceed $22,500 for 2023. An additional $7,500 contribution is permitted for employees age 50 or over. 2. There are two types of 401(k) plans: traditional and Roth. INDIVIDUALS b. i. A traditional 401(k) uses pre‐tax dollars and earnings are tax deferred. ii. A Roth IRA uses post‐tax dollars and earnings are tax‐exempt. 401(k) plans can be adopted for any size company, including self‐employed. 1. Participation is optional for all employees. 2. Employee salary deferrals are immediately 100 percent vested – that is, the money the employee has put aside through salary deferrals cannot be forfeited. When an employee leaves employment, they are entitled to those deferrals, plus an investment gains (or minus losses) on their deferrals. In a traditional 401(k) plan, the employer designs their plan to that contributions become vested over time, according to a defined vesting schedule. 3. Nondiscrimination testing: 401(k) plan tax benefits require that plan provide substantive benefits for rank‐and‐file employees, not only for business owners and managers. These requirements are referred to as nondiscrimination rules and cover the level of plan benefits for rank‐and‐file employees compared to owners/managers. Traditional 401(k) plans are subject to annual testing to assure that the amount of contributions made on behalf of rank‐and‐file employees is proportional to contributions made on behalf of owners and managers. Safe harbor 401(k) plans and SIMPLE 401(k) plans are not subject to annual nondiscrimination testing. c. Contributions can continue up until retirement. d. The taxpayer must start taking distributions by April 1 following the year in which they turn age 73 if they turn 72 after December 31, 2022, and by December 31 of later years or when the taxpayer retires, whichever comes first. 191 INDIVIDUALS e. 1243 Health Savings Accounts 1243.01 Health savings accounts 1243.02 192 Contributions limits: For 2023 the contribution limit is $22,500 ($30,000 for taxpayers age 50 or older). a. Within limits, employer contributions to an employee’s health savings account (HSA) are excluded from the employee’s income. b. Both employer and employee contributions are combined to determine the maximum allowable contribution. c. Contributions to an HSA are limited: 1. For 2023, the contribution limit for families is limited to $7,750 and $3,850 for singles for the year. For 2023, taxpayers age 55 and older may contribute an additional $1,000 per year. This makes the contributions limit for these families $8,750 and $4,850 for singles. 2. Employer contributions to an employee’s HSA are excluded from income. However, both employer and employee contributions are combined to determine the maximum allowable contribution. Health care flexible spending accounts (FSAs): a. A taxpayer’s employer’s plan can allow a $610 carryover balance to the following year for money not used for allowed purposes, or b. Allow a grace period through March 15 of the following year. c. For 2023, the dollar limit on amounts an employee may contribute through salary reduction contributions is $3,050 per year. INDIVIDUALS 1244 Other Adjustments to Income 1244.01 Student loan interest: Qualified student loan interest up to $2,500, made permanent by the American Taxpayer Relief Act of 2012. For taxable years beginning in 2023, the $2,500 maximum deduction begins to phase out for joint filers with modified adjusted gross income (MAGI) in excess of $155,000 and for single filers with gross income in excess of $75,000. It is completely phased out for MAGI of $185,000 for joint filers and $90,000 for single filers. 1244.02 Alimony: NOTE: The TCJA of 2017 changes the treatment of alimony and separate maintenance payments negotiated after December 31, 2018. See f. below. a. b. c. Excluding the portion that is designated for child support, qualified payments are included in the gross income of the recipient and deductible from gross income by the payor if the payments are made after: 1. Decree of divorce or separate maintenance, 2. Written separation agreement, or 3. Decree for support (this applies to periods pending finality of divorce or legal separation). Qualified payments are required to meet the following guidelines: 1. Payments must be in cash. 2. Payments must terminate at the death of the recipient. 3. Payments cannot be made to a payee who lives in the same household as the payor. 4. Payments cannot be specified as something other than alimony. Special rules apply if alimony payments in the second‐ or third‐year decrease by more than $15,000 from the payments made in the previous year. 193 INDIVIDUALS d. 1244.03 194 1. If the change in payments exceeds statutory limits, recapture of excessive alimony payments will result. 2. All of the recapture will take place in the third year. i. The payor must include the excess amounts in gross income. ii. The payee is allowed to deduct the excess payments from gross income to arrive at adjusted gross income. Any amount that can be identified as child support cannot be treated as alimony. 1. Child support payments are neither deductible by the payor nor income to the recipient. 2. If both child support and alimony are provided for in the agreement, any amounts paid are first considered to be child support until that obligation is met. e. The transfer of property between divorcing spouses in exchange for release from marital obligations is nontaxable. The basis of the transferred property to the transferee will be the same as it was to the transferor. f. For any divorce or separation agreement executed after December 31, 2018 (not 2017), or executed before that date but modified after it (if the modification expressly provides that the new amendment applies), alimony and separate maintenance payments are not deductible by the payor spouse nor includible in income of the payee spouse. Moving expenses: The TCJA suspended the deduction for moving expenses for taxable years 2018 through 2025. However, during that suspension period, the provision retains the deduction for moving expenses (and reimbursements or allowances for these expenses) for members of the Armed Forces (or their spouse or dependents) on active duty that move pursuant to a military order and incident to a permanent change of station. The INDIVIDUALS suspension of the deduction for moving expenses does not apply to taxable years beginning after December 31, 2025. 1245 Self‐Employed Health Insurance 1245.01 Self‐employed taxpayers may deduct 100% of the medical and long‐term care insurance premiums paid for themselves and their families. This deduction cannot exceed the net earnings from the business. IRC Section 213(d)(10)(A) provides for limitations on the amount of eligible long‐term care insurance premium deduction allowed per person based on age at the end of the year. 1245.02 No deduction is available to those self‐employed taxpayers who are eligible to participate in an employer’s subsidized health insurance program. The employer may be the employer of the taxpayer of the spouse. 195