QekZVqmARlmpGVapgIZZmQ Module 5 Transcript Federal Taxation I Individuals Employees and Sole Proprietors

Federal Taxation I: Individuals, Employees, and Sole Proprietors
Professor Matthew Hutchens
Module 5: Deductions and Losses: In General
Table of Contents
Module 5: Deductions and Losses: In General ......................................................................... 1
Lesson 5-1: Deductions: For vs. From AGI ......................................................................................... 2
Lesson 5-1.1 Deductions: For vs. From AGI .......................................................................................................... 2
Lesson 5-2: Trade or Business Deductions: Concepts ...................................................................... 13

Lesson 5-2.1 Trade or Business Deductions: Concepts ...................................................................................... 13
Lesson 5-3: Timing of Deductions ................................................................................................... 24

Lesson 5-3.1 Timing of Deductions .................................................................................................................... 24
Lesson 5-4: Political Contributions, Lobbying, Executive Compensation .......................................... 33

Lesson 5-4.1 Political Contributions, Lobbying, Executive Compensation ......................................................... 33
Lesson 5-5: Investigation Costs ....................................................................................................... 38

Lesson 5-5.1 Investigation Costs ........................................................................................................................ 38
Lesson 5-6: Hobby Losses ............................................................................................................... 44

Lesson 5-6.1 Hobby Losses ................................................................................................................................. 44
Lesson 5-7: Vacation Home Rental Deductions ............................................................................... 55

Lesson 5-7.1 Vacation Home Rental Deductions ............................................................................................... 55
Lesson 5-8: Vacation Home Rental Deductions: Example ................................................................ 62

Lesson 5-8.1 Vacation Home Rental Deductions: Example ................................................................................ 62
1
Lesson 5-1: Deductions: For vs. From AGI
Lesson 5-1.1 Deductions: For vs. From AGI
Welcome back. In the next series of videos, we'll examine deductions more closely.
First, recall that deductions are essentially the tax word for expense that can reduce the
tax base. Recall that Section 61 defines income as broadly conceived. That is the
taxpayer should assume everything is income unless Congress says it's not. But with
deductions, on the other hand, we should always assume deductions are disallowed.
That is, we cannot reduce income by them unless a specific provision permits the
deduction. The courts have generally held that whether and to what extent deductions
are allowed depends on legislative grace. That is what Congress has decided to
legislatively decree what is an allowable expense that can reduce the tax base. As a
result, deductions are defined quite narrowly and have many rules associated with
them. This is for a good reason since the risk is that taxpayers might abuse deductions
and reduce their tax base by too much, leaving less money to the government to fund
its operations and investments.
2
Another important aspect of deductions is substantiation. This means that the taxpayer
has the burden of proof for supporting whether all deductions claimed on the tax return
are legitimate. To do so taxpayers must maintain adequate records. For example, if
you're a small business owner and have legitimate business expenses associated with
travel, hotel, maybe advertising, it's incredibly important that you keep receipts and the
invoices to prove that these expenses are legitimate in case the IRS decides to audit
you or your tax return. This is the proverbial behavior of sticking all my receipts in a
shoebox. We need these receipts to the extent we want to claim certain deductions and
must substantiate the legitimacy for those deductions.
3
So let's look back at the income tax formula. We've already discussed gross income
and so the first set of deductions we'll look at is called Deductions for Adjusted Gross
Income or deductions for AGI. These deductions are subtracted from gross income to
then yield Adjusted Gross Income. Recall that this subtotal, AGI, is very important
because it determines floors and ceilings in terms of the amount of many other
deductions that we'll see later that can be claimed on a taxpayer's tax return. AGI also
affects the size of tax credits that can be claimed as well. As a result, we need to make
sure we can identify the right expenses as deductions for AGI.
4
Broadly speaking, what are deductions for AGI? Because they're subtracted from gross
income to determine Adjusted Gross Income, they're also called above the line
deductions or above AGI. These expenses can be deducted even if a taxpayer does not
itemize. That is, even if a taxpayer takes the simple standard deduction and does not
keep track of itemized deductions like medical expenses or donations to charity. If a
taxpayer does itemize, then the for AGI deductions will determine the size of some of
those itemized deductions. For example, medical expenses are deductible only to the
extent they exceed 7.5 percent of AGI.
5
So specific to the actual deductions for AGI, they can essentially be placed into two
broad categories.
The first is expenses related to business activities whether they're direct or indirect
expenses. This includes business expenses related to running a business as a sole
proprietor or a partner in a partnership. For example, sole proprietor expenses are
6
reported on a Form 1040 Schedule C. Expenses related to partnership business
activities or rental activities are reported on Schedule E.
The second category is expenses that subsidize specific activities. For example, paying
alimony, paying for education-related tuition and fees, paying interest on a student loan,
or contributing funds into a Traditional Individual Retirement Account or IRA. These are
all activities that Congress has deemed to deserve a deduction that offsets gross
income. Thus they lower the individual's tax base.
7
So after subtracting for AGI deductions from gross income in yielding Adjusted Gross
Income, the taxpayer has the choice to deduct the greater of either itemized deductions,
also known as from AGI deductions or the standard deduction. We've already discussed
the standard deduction in a previous video. So let's focus on from AGI deductions here.
If the taxpayer selects to deduct itemized deductions, he or she has to report them on
Schedule A of the Form 1040. From AGI deductions here include medical expenses to
8
the extent they exceed 7.5 percent of AGI. State and local taxes up to a $10,000 cap,
for example, the income taxes I pay to the state of Illinois are a deduction on my federal
tax return up to the cap. Contributions to qualify charities, for example, the American
Red Cross or American Cancer Society. Gambling losses, some types of personal
interest expense such as home mortgage interest and investment interests, and
personal casualty losses but only if they are attributable to a federally declared disaster
area. Again note that some AGI thresholds apply in calculating these deductions. So
they may not be necessarily be fully deductible after all is said and done.
It's also important to mention Section 212 here. Section 212 allows deductible treatment
for expenses that are what's known as ordinary and necessary. That is, related to the
production or collection of income, the management, conservation, or maintenance of
property held for the production of income, and expenses paid in connection with the
determination, collection, or refund of any tax. So what does this actually mean? What
are some examples here? Well, IRC Section 212 allows some expenses to be
deductible.
9
In particular, deductible for AGI if their expenses related to producing rent or royalty
income. For example, you own an office building that you rent out, but you have some
expenses associated with the office building like utilities, maintenance, and insurance,
these expenses will be deductible for AGI. Other examples could be expenses paid to
determine the taxpayer's tax liability related to their business, rent, royalty, or farming
operations. For example, if the sole proprietor hires an accountant to calculate the
income tax and file a tax return, the payment made by the sole proprietor for the
accountant will be a for AGI deduction.
10
So where do trade or business-related expenses show up on the tax return? First, their
details are reported on Schedule C, E, or F. Schedule C details the profit or loss from a
business of a sole proprietor, or a one-owner business. It could be a taxpayer's main
source of income, for example, a business selling goods or services, or it could be a
business activity on the side. For example, if you're a freelance artist, or author on the
side, or a part-time consultant. In any of those cases, you would report the income
generated and related expenses on Schedule C. The key here, however, is that the
deductions must be directly connected to generating the income in that business
activity. Schedule E details the income and losses from other activities such as from
rental properties or royalty activities or for partnerships or being a shareholder in what's
known as an S-Corporation. These types of businesses, as well as a sole
proprietorship, are broadly known as pass-through entities. Here the income and
expenses are not taxed at the business entity level, but rather are passed through to the
individual owner or investor to be taxed only at the individual's level. Therefore, there's
only one layer of tax. Contrast this with a typical C-Corporation - think Microsoft or Ford
Motor Company - where the corporation pays an entity-level tax, but then when it
distributes dividends to their shareholders, the shareholders pay tax on the dividend
income as well. People refer to this structure as the double taxation of corporate
income. But what gets reported on Schedule C and E is income and losses from pass-
through businesses. In fact, profit and losses from farming reported on Schedule F also
represent pass-through activities. Here, the farmer reports the various income and
expenses related to farming, then reports the net amount on the individual tax return.
For all these activities, the net amount appears on the face of the Form 1040.
11
In particular, these are the exact spots where the individual's business income is
reported on the individual tax return whether it be from Schedule C, E, or F. These net
profits or losses are summarized on the face of the Form 1040 to be combined with
other income items. Because expenses associated with these business activities are
deducted before arriving at AGI, they are all considered for AGI deductions. So in all, in
this video, we've gone through, at a very high level, the distinction between for and from
AGI deductions as most touched on business-related and investment-related expenses.
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Lesson 5-2: Trade or Business Deductions: Concepts
Lesson 5-2.1 Trade or Business Deductions: Concepts
Welcome back. In this video, we'll examine a specific class of deductions; namely, trade
or business deductions. Recall the taxpayers must assume deductions are not
allowable unless Congress allows the deduction due to legislative Grace. In this spirit,
for related trade and business expenses, Internal Revenue Code Section 162(a) states
that "There shall be allowed as a deduction all the ordinary and necessary expenses
paid or incurred during the taxable year and carrying on a trade or business". In reading
this part of the internal revenue code, there are a few items that need to be defined.
First of all, what is a trade or business?
13
Here, it's interesting, because a trade or business is actually not defined by the IRS, but
various regulations suggests that a trader business is such if the objective of the activity
is to make a profit. If expenses are incurred in pursuit of profit, then it is more likely a
business than not. That is, the expenses must not be incurred for personal motives in
the sense that the taxpayer is spending money on his or her food or clothing, but rather
seeking to make a profit out of the activity. If the activity fails to meet the for-profit
motive, then the activity is considered a hobby. We'll discuss Hobbes later in the course,
but this business versus hobby distinction will be very important. For sole proprietors
that run a business, these trader business expenses are deductible for AGI, meaning
they reduce gross income before getting to adjust the gross income. For business
owners these expenses are not from AGI deductions. That is, it doesn't matter if the
business owner itemizes on his or her personal tax return. These expenses are
deductible against both business income and other personal types of income like wages
or interest.
14
Another definition from Section 162(a) we need to examine is ordinary and necessary.
That is, business expenses are deductible if they're ordinary and necessary, and they
must be both. First of all, what's an ordinary expense. Here an ordinary expenses is a
normal or appropriate expense for the business under the circumstances. For example,
an ordinary expense would be to pay for heat and utilities in your office building, so that
your workers can be comfortable and productive. However, the expense does not
necessarily have to be repetitive in order to be ordinary. For example, legal fees might
not be repetitive. Maybe a business owner might hire a lawyer to drop a specialized
contract for a specific customer. The expense in hiring a lawyer is fully deductible
against business income, since the legal fees are business related, even though they
might not be a repetitive.
15
The other term is necessary. What does this mean? Here, a necessary expense is
deductible if it's helpful or conducive to the business activity, but it need not be as
essential or indispensable. Again back to our utilities example, you're a business owner
who pays for heat and utilities so that your employees can be comfortable and
productive. In a very strict sense, is heating your office building really necessary? Well,
you could argue that humans can survive in very harsh conditions, so heating an office
building really isn't a necessary expense. However, heating an office building is certainly
helpful or conducive to conducting your business activity. The business owner certainly
doesn't want his or her employees being freezing cold, uncomfortable or wearing three
blankets, and miserable, and getting sick all the time. So heating and utilities are
completely deductible because they're both ordinary and necessary using the IRS
definitions.
16
Of course, notice that these definitions are qualitative, that is, they're potentially
subjective. Another subjective test here about whether or how much of a business
expense is deductible, is that the expense must be reasonable in amount. So what does
this mean? Well, the courts have interpreted "reasonableness" by examining whether in
expenditure is extravagant or exorbitant. Well, does that really help? Maybe not too
much. These are all relative terms. For example, let's say you're a business owner and
you take out a potential client to dinner, that you want to really impress. So you buy a
$1,000 bottle of wine, is this reasonable? Well, I suppose it could depend. If you're
taking out a billionaire who drinks a $1,000 bottle of wine, like drinks water, then maybe
it's entirely reasonable. But if you're taking out a potential client who has far more
modest like you, then the $1,000 bottle of wine might not be reasonable in amounts. In
the end, these terms are applied on a case-by-case basis to determine whether
business expenses are deductible.
17
There's some statutory limits on trade and business expenses. First, there are capital
expenditures. These are purchases made by business owners of capital or equipment
and machines. When a business owner purchases a machine, is the entire cost of the
machine immediately deductible? Similar to when you pay your heating bill, that the
entire heating bill is fully deductible? So generally speaking, no. Amounts spent to buy
capital are not immediately deductible. So the business owner has to capitalize the
equipment, that is, record the purchase as an asset and then depreciate the cost of the
asset over time. So the expenses that relate to the cost of the asset are spread out over
time. A very simple example is a business owner buying a $1,000 machine to use in
manufacturing a product. When the machine is purchased, the $1,000 shows up on the
business owners balance sheet as an asset. Then each year, say over the next four
years, the deduction could be $250 so that by the end of the useful life of the machine,
that is over time, the original cost has been deducted.
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Next, personal expenses are generally not deductible. Think about putting gas in your
car or buying food, clothing, paying your phone bill, buying a personal car, heating your
home, paying for car and home insurance, rental payments, fixing a leaky faucet, buy
new furniture, these are all personal expenses that are not deductible. The tax code will
not subsidize these personal expenses by providing tax benefits for them.
19
Another limit is that expenses related to generating tax-exempt income are not
deductible. For example, if you're paying an investment adviser to manage your portfolio
of municipal bonds, and we learned from a previous video that municipal bond interest
income is tax-exempt, then the investment advisory fees are also not deductible.
Because you're already generating one tax benefit in the form of tax-exempt income,
the tax code will not allow you to reap a second tax benefit by then also deducting the
cost associated with generating that tax-exempt income. However, if you're generating
income that is includable in gross income, then the expenses may be deductible.
20
The last limit is that expenses related to activities that are against public policy are not
deductible. These include expenses related to paying fines, bribes, penalties, or
lobbying or making political contributions. For example, if you received a speeding ticket
while you're driving, whether it's driving for personal reasons or related to work, then
paying the penalty is not a deductible expense. Again, the IRS will not subsidize or
incentivize bad behavior by allowing fines, penalties, and bribes to reduce gross
income, so that the taxpayer will then pay less tax. An interesting side note here though,
is that there is a case in 1958, Commissioner versus Sullivan, that allows taxpayers
conducting illegal activities to deduct the cost of goods sold and business expenses
against their gross income. Again, remember that the philosophy is that all income must
be reported from whatever source derived, even if it's illegal. Similarly, if there are costs
associated with generating the illegal income, then they're deductible against that
income. The idea here is that the IRS is not the morality police, just report all of your
income, legal or illegal, for tax purposes.
21
Interestingly, this is how the famous Chicago gangster, Al Capone, was finally
apprehended,
not because of his illegal activities per se, but because he never reported the income
from those activities on his tax return.
22
So let's do a few examples here, to reinforce the concepts of business-related

deductions. The overarching question here is: what amounts can be deducted as
ordinary and necessary business expenses? First, Sam rents a dump truck for his
business While hauling trash to a job site, he was stopped for speeding. He paid a fine
of a $100 for speeding, $50 for caring an offensively smelly load, and $300 for not
having the proper permits to dump trash. So what's happening here? So Sam's
engaging in behavior against public policy. He's speeding, violating the local pollution
laws by having a smelly load, and for not having the right permits. So here, none of the
costs are deductible since they are fines and penalties. Next, Sam paid a part-time
employee $500 to drive his rented dump truck. Sam reimbursed the employee $50 for
gas for the truck. So here, Sam hired an employee to drive his truck and also paid for
the gas. Well, if Sam is in the trash hauling business, then hiring employees to haul
trash is ordinary and necessary. Similarly, paying for gas to use the trucks are also
ordinary and necessary. Therefore, the cost of hiring the employee and paying for the
gas are deductible to Sam. Finally, Sam gave a member of the City Council a new
watch, which cost $500. He hopes that the council member will vote favorably on some
contracts and what Sam is bidding. So here, what's Sam doing? He's paying an official
to make a decision based on a watch, rather than on the merits of the contract bid. This
is a bribe, which is against public policy and would therefore not be deductible to Sam.
In all, it's important to note that trade or business expenses are deductible, if they are
ordinary and necessary, and reasonable in amount, but not against public policy.
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Lesson 5-3: Timing of Deductions
Lesson 5-3.1 Timing of Deductions
Welcome back. After having discussed the concepts behind what trade and business
expenses are deductible, in this video, we'll examine when an expense is deductible.
Generally speaking, the timing of deductions is determined by the taxpayers accounting

method. Recall that four accounting methods are acceptable to the IRS: cash, accrual,
special, and hybrid. Here, we'll discuss cash and accrual since they are the dominant
accounting methods used by business taxpayers. First, the cash method. When is an
expense deductible under the cash method? Here an expense is deducted when it's
paid with either cash or property or services. Also, even under the cash method, a
current deduction for a capital expenditure is not allowed, that is generally, a business
taxpayer cannot immediately deduct the entire value of business equipment or
machinery in the first year of use. Instead, the taxpayer must capitalize the equipment
as an asset then depreciate it, therefore, over time, the entire cost of the asset will be
deducted. There are some exceptions that do allow for immediate deduction of capital
expenditures, but we'll look at those issues later in the course when we discuss property
transactions and appreciation.
24
Under the cash method, it is also important to note that prepaid expenses that relate to
a future tax year are generally not immediately deductible. For example, prepaying rent
for future tax years would not be a deductible payment for a cash basis taxpayer until
that benefit is actually consumed.
For example, assume you are a calendar year cash basis taxpayer who prepays two
years of rent for your business in July of year 1, the prepayment covers your rent
25
through June of year 3. Here, even though you are a cash basis taxpayer and made the
payment in year 1, only a portion of the prepayment that relates to year 1 would be
deductible in year 1. That's six months out of 24 months, so 25 percent of the payment
deductible in year 1. In year 2, 12 months of the 24 month prepayment will be utilized,
so in year 2, 50 percent of that year 1 prepayment would be deductible. Finally, in year
3, the remaining six months of the prepaid rent would be utilized and thus the remaining
25 percent of the prepayment would be deductible in year 3. Again, that's the
prepayment you made all the way back in year 1.
However, there is an important exception to this general rule, which is known as the 12-
month Rule. Under the 12-month Rule, cash-basis taxpayers can deduct prepaid
expenses related to future years if two conditions are met. First, the contract period of
the prepayment cannot exceed 12 months, in other words, the prepayment cannot
create a right or benefit lasting longer than 12 months. The two-year prepayment
example we just did for the general rule would not qualify for this exception since a two
year benefit period is greater than 12 months. Second, the contract period cannot
extend beyond the end of the tax year following the tax year of the payment is made. In
other words, a prepayment in year 1 cannot extend beyond year 2, it cannot create a
benefit or right in year 3. The example we did above for the general rule would also fail
this test since a year 1 prepayment created a year 3 benefit in that example.
26
Now, let's do an example that qualifies for the 12-month rule. Again, let's say we have a
calendar year cash basis taxpayer, and they prepay 12 months of rent for year 2 on July
15th, year 1. Here, we have to ask two questions. First, is the right or benefit created 12
months or less? Here, the answer is yes, we have a 12 month prepaid rental period,
which is 12 months or less. Second, we have to ask whether the benefit extends
beyond the end of the taxable year following the year of prepayment. Here, we have a
year 1 prepayment, but the entire benefit is utilized by the end a year 2, so no problem
on that prong. Thus, we have a qualifying prepaid expense that can be entirely
deducted by the cash basis taxpayer in the year of prepayment, year 1. But remember
that any prepaid items that don't meet the 12 month tests exception must be prorated
and deducted when that benefit is utilized or when they apply. That is when the product
or service is consumed.
27
Another general exception is that the tax law restricts the use of the cash method to
small businesses, farms, personal service corporations, and certain partnerships.
The second widely used accounting method is the accrual method. Here the general
rule is that expenses are deducted when they're incurred, not necessarily when cash is
paid or property is delivered or services are rendered.
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What does this mean to incur an expense for it to be deducted? Well, there are two
tests, the all events test and the economic performance test. Both tests must be met for
the expense to be deductible under the accrual method.
First, the all events test states that a deduction is allowed when all events have
occurred to create the taxpayers liability and the amount of the liability can be
determined with reasonable accuracy. For example, let's say a machine breaks and I
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call a service repair person to fix it. The person fixes my machine and bills me $500 and
I pay the bill in three months. What does the all events test say as to when the business
taxpayer gets the deduction? Well, under the accrual method, once the repair person
fixes the machine and bills for $500, it means that all the events have occurred to create
a liability to the business owner and the liability can be determined with reasonable
accuracy. Here, the bill is $500. In this case, the business owner can claim a deduction
for $500 on the day the service person bills the business owner and not when the actual
cash payment is made. Note that under the cash method, the $500 deduction will only
occur once the bill is paid. That is, the deduction can only be claimed in three months.
The second test here is the economic performance test. This says that the accrued
services, property or use of property giving rise to the liability can only be deducted
when a service property or use of property has actually been performed, provided, or
used. Back to our service repair example. Because a service repair person fixed the
machine, the service they gave rise to the $500 bill has actually been performed.
Therefore, under the economic performance test, the $500 bill is deductible to the
accrual business owner when the repair person bills the owner. Importantly, note here
that both the all events test and the economic performance tests must be met in order
for the accrual basis taxpayer to deduct an expense. For example, if the repair person
begins working on the machine, but does not yet know the final cost, the all events test
has not been met. If the service repair person must come back later to actually fix the
machine, the economic performance test has also not been met. Both of these tests
must be met in order for the expense to be deductible to the accrual basis taxpayer.
30
There's an exception here for accrual basis taxpayers. If there is a recurring expense, a
deduction can be allowed even if there's no economic performance, at least no
economic performance yet. If an item is recurring and treated consistently year over
year, the item is immaterial or accruing results in a better reflection of income, the all
events test is met, and if economic performance occurs within a reasonable period of
time after year end, then the expense can be deducted in year 1 by the accrual basis
taxpayer. Now, what is a reasonable amount of time? Well, that's going to be the sooner
of eight-and-a-half months after the tax year ends or whenever the tax return is actually
filed. Again, whichever of these two events occurs first.
31
A final important item to note with accrual method taxpayers, is regarding reserves for
estimated expenses. Here the tax law does not allow a deduction for reserves or for
estimated amounts because principally, the economic performance test has not been
met. For example, a company that builds washing machines might estimate that one
percent of its washing machines may need repairs and they value the repairs at
$100,000 per year. Can the washing machine company deduct the $100,000 on its
current year tax return? The answer here is no, because the company has not actually
yet repaired the washing machine. That is, economic performance has not occurred. In
fact, the actual expense might only be $75,000 this year, in which case the company
would be over deducting $25,000. The IRS does not want these types of estimates to
creep into the tax return for fear the taxpayers will have the incentive to overestimate
the deductions and thus underreport their income. Therefore, the business has to wait
until they incur the cost of fixing the washing machine before deducting the known exact
amount. In all we discussed when an expense is deductible. Under the cash method an
expense is generally deductible when it's paid in cash, property, or services. While
under the accrual method, an expense is generally deductible when it's incurred. That
is, when the all events test and the economic performance tests are both met.
32
Lesson 5-4: Political Contributions, Lobbying, Executive Compensation
Lesson 5-4.1 Political Contributions, Lobbying, Executive Compensation
Welcome back. Now that we've talked about trade or business expenses in general and
when they are deductible, let's talk about some types of business expenses that even if
ordinarily necessary, may be non-deductible. In this video, we'll look at trade or
business expenses related to political contributions, lobbying expenses, and executive
compensation. First, political contributions are non-deductible. This will be giving money
to a politician's campaign. Whether that is a campaign for president of the United
States, United States Congress, a State Governor's race or just a local City Council
race. Of course, a business is still free to make these contributions, but they will not
receive a tax benefit, via a deduction, because of it. Along similar, but somewhat
different lines are lobbying expenditures. Lobbying is an effort to influence a politician or
public official on a particular issue. So for example, if there was a law that a business
wanted change, they might pay a lobbyist. That is someone who is a professional
lobbyer. A fee to spend time trying to convince congressmen to change the law the way
they wanted changed. Or, they may have an employee conduct the lobbying
themselves. Lobbying can occur on both elected officials, like Congressmen and
Congresswoman, and the President, or you can lobby a non-elected public official. For
example, a business lobbying on tax issues may lobby the Secretary of Treasury, or
other officials in the Department of Treasury and of the IRS. And like political
contributions to a politician's campaign, lobbying expenses are non-deductible. This is
33
true regardless of whether those lobbying expenditures occur at the local, state or
federal level. Interestingly, the non-deductible lobbying expense rule was slightly
changed by the Tax Cuts and Jobs Act at the end of 2017. Prior to 2018, local lobbying
expenditures were actually deductible. Such as trying to influence a mayor or city
council on a particular issue. But this is no longer the case. So now, no matter whether
the lobbying is local, state or federal, it is non-deductible.
Moving on, one type of business expense that is generally deductible is membership
dues paid to a trade association or a professional organization. But trade associations
like the National Association of Manufacturers, and national professional organizations
like the AICPA for accountants, are also generally involved in at least some amount of
lobbying. When this occurs, the portion of your membership dues that supported the
lobbying efforts will not be deductible. But any membership dues related to the other
non-lobbying activities of these organizations, like education, professional development,
positive branding for an industry, those will generally remain deductible. Basically we
have a pro-rata approach to allocate the membership dues between the deductible and
the non-deductible lobbying. But remember, lobbying is an effort to influence decisions.
Just monitoring and following legislation without an effort to influence is not lobbying.
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And there is one exception to lobbying expenses being non-deductible, and it's a pretty
small one. It's the exception for de minimis in-house lobbying. De minimis is a Latin
phrase meaning, too trivial to merit consideration. So here if a business spends $2,000
or less for one of its employees are officers to lobby, then the costs are deductible
because they're considered too small to matter. In other words, they are de minimis.
However, once the lobbying expenditure exceeds $2,000, then non of the expenses
related to lobbying are deductible.
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Next, we're going to talk about some limitations on deductions for compensation. In
general, compensation such as wages paid to officers and employees, is a deductible
business expense. However, there are some limits we need to know about. First,
compensation paid to shareholders employees and their relatives of closely held
corporations, must be reasonable to be deductible. So, if a person both owns a
business and works in the business as an employee, that individual salary for being an
employee must be reasonable. That means not too low, but not too high, think
Goldilocks here. For example, an employee owner may want a low salary, so they pay
less in payroll taxes, and with lower wages, will have more business income, which in
turn could qualify them for a larger qualified business income deduction. That's the 20
percent deduction for certain pass through and sole proprietorship income. Or they may
want to pay themselves a higher salary to get a bigger deduction for the business. Or
they may want to pay a relative that happens to be in a lower tax bracket, an
unreasonably high salary, to shift income. Each taxpayer may have a different motive
depending on their own tax considerations. But ultimately, the compensation must be
reasonable. One way to demonstrate reasonableness is to compare the wages you pay
for a certain job, to what is the going rate in the market outside of your company. So,
you can compare an owner employee's salary to what other non-owners employees
receive at similar firms maybe in the same industry.
36
As it relates to compensation, there is also a disallowance provision that applies only to

compensation paid to executives of publicly traded companies. Here, the deduction for
compensation of the Chief Executive Officer, Chief Financial Officer, and the three other
highest pay corporate officers, is limited to one million dollars each year. This is known
as the Section 162(m) limitation. Since that's where it's found in the Internal Revenue
Code. Note, this limitation only limits the ability of that publicly traded company to
deduct the compensation. They can still pay their executives whatever salary they will
like, but they can only deduct the first one million dollar payment per covered executive.
Any salary paid over one million dollars would be non-deductible. Now prior to the tax
cuts and Jobs Act, there's a pretty easy way to get around this limit. That's because
prior to the TCGA, this one million dollar limit did not apply to incentive-based pay. That
is pay which is based on meeting certain performance incentives, as opposed to being
some guaranteed amount. So for example, it was not uncommon for executives to have
a one million dollar base salary which was entirely deductible and then also have
performance incentives to earn many millions more in compensation, all of which would
have been deductible as well. But starting in 2018, that planning opportunity has been
eliminated. So, no matter whether the compensation is base salary or incentive-based,
this one million dollar deduction limitation will apply. But again, it's just for certain key
executives at publicly traded companies. Private companies can still deduct
compensation in excess of one million dollars, subject that reasonableness
requirements we talked about earlier.
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Lesson 5-5: Investigation Costs
Lesson 5-5.1 Investigation Costs
The last trade or business deduction will examine is related to the investigation of a
business. For example, you're someone interested in starting a business. You incur a
variety of expenses. For example, you travel to different potential locations, to shout
them out. You meet with potential suppliers and customers. You drop surveys, or
marketing reports, and you encrypt professional fees perhaps the accountants and
lawyers. All of these are expenses incurred to determine the feasibility of entering a new
business, or for that matter for expanding an existing business. So are these expenses
deductible?
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If so when? First, to determine if the expenses are deductible, we have to check

whether or not the taxpayer is already engaged in the business or not. If the taxpayer is
already engaged in the business, the investigation expenses are deductible whether or
not the business is expanded or another business is acquired. Here the deduction
occurs in the year of payments. If you're a cash basis taxpayer, or the year in which the
expenses were incurred. If you're an accrual basis taxpayer.
39
Second, if the taxpayer is not already engaged in the business, the deductibility of the
investigation expenses depends on whether the business is eventually entered into or
acquired. If the business is not entered into or acquired, then the investigation expenses
are not deductible, and not capitalized. It's however the taxpayer does enter or acquire
the new business, the expenses are capitalized. That is these costs become an asset
on the taxpayer's balance sheet. They cannot be deducted other than on the company's
last year's tax return. For example, when the company is sold.
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However, a taxpayer can elect a little bit better of a tax treatment than just having an
asset sitting on its books. Here the taxpayer can elect to immediately deduct $5,000 of
the investigation costs in the first year with the remaining amount to be amortized
straight line over the next 180 months, or 15 years. However, if the total investigation
costs exceed $50,000, then there is a dollar for dollar reduction of the $5,000 immediate
deduction. Therefore, by the time the total investigation costs reach $55,000, there's no
allowable immediate deduction left. Although the rest of the startup costs can be
amortized over the next 180 months.
41
So let's look at an example here. Bubba is the owner of a successful restaurant chain in
New Orleans, and he's exploring the possibility of expanding to champaign. How much
can he deduct? Well, first lets say incurs $28,000 of expenses are associated with this
investigation, but decides not to expand. Well, here because Bubba is already in the
restaurant business the $28,000 he incurs to investigate a new restaurant location is
deductible to Bubba.
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Next, let's say Bubba also investigates opening a hotel, that will be part of a hotel chain.
His expenses for this investigation or $53,000, and let's say the hotel does begin
operations on July 1st. Here we need to assess whether Bubba entered the hotel
business. He did. Therefore, the investigation costs may be deductible. So how much?
If he makes the election to immediately deduct up to $5,000, and then amortize the rest,
we need to see how much he can deduct. First, if the total investigation expenses or
$50,000 or less, than $5,000 is immediately deducted. However, for every dollar above
$50,000 that is spent on investigation costs that is a dollar less of the $5,000 the Bubba
can immediately deduct. Therefore, $3,000 of that $5,000 eligible for the immediate
deduction is phased out, so that he can only immediately deduct $2,000. What happens
to the rest of the expense? Well, if he's spent $53,000 total, and can immediately deduct
$2,000 of it. That means $51,000 is left. What can he do with it? Well, he can amortize it
straight line over 180 months. Or we take the $51,000 balance divided by a 180 to get
$283.33 per month. He began operations on July 1st. So he gets six months worth of
amortization here, or $1,700. Therefore, his total current your deduction is $3,700, or
$2,000 from the immediate deduction and $1,700 from the amortization. Going forward,
Bubba will be able to claim $283.33 per month for the next 14.5 years. So next year for
the full year, he'll claim $3,400 in amortization deductions related to the investigation
costs.
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Lesson 5-6: Hobby Losses
Lesson 5-6.1 Hobby Losses
Welcome back. In previous videos, we talked about business related expenses. In this
video, we're going to take a look at expenses related to an activity that is not a
business. Instead we'd considering hobbies, and how to tell a trade or business apart
from a hobby. So what's a hobby? For tax, a hobby is an activity that is not entered into
for profit. In other words, there is no profit motive. Instead, the taxpayer has some other
reason for engaging in the activity, usually for personal pleasure or enjoyment. In other
words, they enjoy the activity so much, they're not overly concerned with whether any
money is actually made from the activity. The activity may very well or in a profit, but it's
not the primary motive. Some examples include raising animals, running out your boat
for fishing excursions, collecting baseball cards, horse racing, or auto racing.
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So what's different about hobbies for tax? Well, hobby income is includable in gross
income just like any other type of revenue from a trade or business. But for hobby
expenses, we have a different treatment. Prior to the tax cuts and jobs acts, the hobby
loss rules treated hobby expenses as being limited to the extent of hobby income. And,
they were only deductible as an itemized deduction. Specifically, they were what is
known as a miscellaneous itemized deduction subject to a 2% of AGI floor. So, under
prior law, and starting again in 2026, once this individual provision expires or sunsets,
hobby expenses are limited to the extent of hobby income. And then those expenses
are further limited by 2% of AGI floor. So how did the TCGA change that for 2018
through 2025? How are hobby expenses and losses treated right now? Well, the
answer is bad news for hobbyists. Under current law, hobby income is still gross
income, just like any other type of business income. But, the tax cuts in jobs act
eliminated all miscellaneous itemized deductions, subject to the 2% of AGI floor. So,
most hobby expenses are basically non-deductible. But, if your hobby involves
manufacturing merchandising or mining, then your gross income that you have to report
from your hobby, includes a reduction for your cost of goods sold. Cost of goods sold is
your direct materials and labor cost that go into your product. For example, suppose you
occasionally knit sweaters as a hobby and you occasionally sell those sweaters at a
local street festival. Well, under the current hobby loss rules what you receive for selling
those sweaters will be included in gross income, no changes there. Further, since you
are manufacturing sweaters, you can still deduct your cost of goods sold before you get
to gross income. In this case, cost of goods sold could include things like the wool for
the sweater, but any other expense involved in your hobby would be non-deductible. So
if you rent it out a small studio for knitting that would be non-deductible. If you are a
45
member of various knitting organizations, those membership dues would be non-
deductible. If you attended a knitting conference that would be non-deductible.
We can contrast this hobby treatment to what happens when a person is engaged in a
trade or business with a profit motive. If there is a trade or business then a tax payer
can deduct all their expenses, not just the cost of good sold. As a for AGI deduction,
and they can even deduct their losses if they exceed their gross income. Although,
there are some other limitations on deducting losses, which are little beyond the scope
of this course that may apply. So here, if the activity is business related, the tax
treatment is much more favorable. Note however, that any expenses related to a hobby
that are deductible anyway. For example, if you're knitting studio was in your house and
a portion of your expenses related to home mortgage interest or property taxes on your
home, those would remain deductible. So with such a gap and treatment between
businesses and hobbies, it's crucial to understand when is an activity a hobby and when
is it a trade or business? So how do we make this determination? Well, it depends on
each tax payers individual facts and circumstances. But in general, the IRS and the
courts look to nine different factors to assist in making the determination. You don't have
to pass all nine in order to have an activity count as a trade or business. Likewise, a
numerical advantage and factors that favor a trade or business versus those that favor a
hobby isn't determinative, although it may certainly be helpful. Instead, we look at all
nine factors as part of a qualitative analysis that considers each factor and the relative
weight of each factor. For example, two factors that just slightly point in the direction of
a trade or business may be outweighed by one other single factor, that heavily points in
the direction of a hobby. So, what are these factors?.
46
The first factor is whether the activity is conducted in a businesslike manner. How do
you operate a activity in a businesslike manner? Well, a few things to look for here are
does the taxpayer have separate bank accounts for their business? Do they maintain
adequate accounting records? Do they have a written business plan? Do they have
budgets?
The second factor is what is the expertise of the tax payer and any advisers tax payer
47
may use. This factor can help gauge the seriousness of the activity as a business. For
example, if you start a boat charter service with no knowledge whatsoever about
boating, that's certainly going to look more like a hobby than a trade or business. But, a
lack of experience isn't always fatal to those factor. For example, suppose you hire an
experience expert to operate the boat, or just to advise and train you. Or, suppose you
start reading books about building, or take classes related to building. Well, in that case,
your activity may point in the direction of trade or business. Even if you don't personally
have any prior experience or expertise.
The third factor focuses on the time and effort you expand in the activity. Is the taxpayer
working two hours a week, which points towards a hobby? Or is the taxpayer working at
this activity full time, which points to this factor towards a trader business?
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The fourth factor asks, is there an expectation that the assets will appreciate in value?
That is, will the activity be worth more after the taxpayer has engaged in it? An example
here would be purchasing land with the expectation that it will increase in value. And
while you hold the land, you use it for farming. Well, the fact that you're holding the land
with an expectation that it will appreciate in value may point that farming activity towards
being a trade or business, even if the farming by itself isn't that profitable.
49
The fifth factor is the taxpayers previous success in similar activities. If a taxpayer has
previously operated the same type of business and it was successful, that will point
towards a trade or business. You can see that this factor may overlap with an earlier
factor we talked about, which is the taxpayer's expertise. And this just goes to show that
a lot of these factors may have some overlapping facts and circumstances. Moving on
to the sixth factor.
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What is the history of income or losses from the activity? If there is a long string of
losses and usually not any income it looks more like a hobby and not a real viable
business. Of course, most businesses lose money in their first few years of operations.
So a string of losses in the first few years isn't going to carry much weight. But if the
activity has been around for a while. Well, a string of losses is going to make it look
much more like a hobby. Conversely, a prior history of profits points towards a trade or
business. And as we'll see a little bit later, a profit history may by itself even create a
presumption that the activity is a trade or business.
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Seventh, what is the relation of profits earned two losses incurred? So for this factor
we're looking at, do you have many years of very small profits coupled with a couple of
year's where you had very large losses. So here, the large losses are going to outweigh
those many years of small profits and may take this factor towards a hobby. Even if in
most years business had a small profit.
For the eighth factor, we asked what is the financial status of the taxpayer. So if a
52
taxpayer has substantial other sources of income, it may be less likely that they have
engaged in this activity for profits. But, if the tax payer has few or no other sources of
income and is in fact relying on this activity to support themselves, then a profit motive
and thus a trade or business classification is going to be much more likely.
And finally, the ninth factor asks, what are the elements of personal pleasure or
recreation from this activity? If an activity is done for recreational purposes or
amusement, it's going to look more like a hobby. Of course, this doesn't mean that you
can't enjoy your job but if you're engaged in an activity that you really dislike, well, you
must be doing it for profit reasons.
53
And again, these factors are very sensitive to a taxpayer's individual facts and
circumstances. So they are qualitative and they are subjective. But to provide a little bit
more structure around the determination of whether an activity is a hobby or a business.
Internal Revenue Code Section 183D creates a rebuttable presumption that if an activity
has generated a profit for three of the last five years, or two of the last seven years, if
your activity involves horses. Then the activity is presumed to be a trade or business
rather than a hobby. Now, this presumption is rebuttable, which means that the IRS can
challenge the presumption by looking to the factors. But instead of the burden being on
the taxpayer to prove that the activity is a trade or business. The burden has shifted to
the IRS to prove the activity as a hobby. So in summary, an activity can be classified as
a trade or business, in which case, income from the trade or business is reported as
gross income and expenses related to the business are deducted as a for AGI
deduction. For a sole proprietor, this usually all occurs on Schedule C of form 1040.
However, if the activity is treated as a hobby, then the income from the hobby, that's
going to be gross received less the cost of goods sold, is still included in gross income.
But all other expenses of the hobby are going to be non-deductible at least for the next
few years. How do you tell whether an activity is a trade or business or a hobby? Well, it
depends on the facts and circumstances of each individual activity. But to help us make
this determination the IRS encores up to nine different factors. But remember, no one
factor is determinative, and a mere numerical advantage of factors pointing to one
direction, isn't always enough. It really is a qualitative judgment based on the individual
facts and circumstances of each situation. But, if you have sufficient profits in the last
few years, you can usually avoid this nine factor test by creating a rebuttable
presumption that the activity is a trade or business.
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Lesson 5-7: Vacation Home Rental Deductions
Lesson 5-7.1 Vacation Home Rental Deductions
Welcome back as we continue discussing deductions. In this video, we'll examine how
to handle deductions related to vacation home rentals. In general, recall that deductions
are not allowed for personal expenditures. In particular, personal expenses related to
the home are also not deductible, such as buying furniture or paying for maintenance or
insurance on your house. That is, if you use a property for personal purposes, the only
personal types of expenses that are deductible are limited to what's available on
Schedule A, related to deducting a mortgage interest and real estate taxes. Recall also
that if you owned a property and rented it out, we would report the income and
expenses on Schedule E. In this case, the expenses related to maintaining the property
would be deductible. However, what if you run into the situation where it's a little bit of
both? What if, for example, you own a vacation home on the beach? Perhaps you use it
for two months during the summer, but also rent it out for two months. There are, of
course, costs associated with maintaining the beach home. You might pay for it to be
professionally cleaned. You might pay for lawn maintenance, insurance, and utilities.
How much of these costs are deductible for tax purposes? And how much of the costs
are not deductible?
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Well, generally speaking there are three possible tax treatments for expenses related to
properties. First, is if the property is primarily personal use. A property is primarily
personal use if it's rented out 14 days or less during the year. Here, any rental income
earned from the property is actually entirely excluded from gross income. But that also
means that no rental expenses are deductible. Here are the only expenses that are
deductible are the typical Schedule A expenses of home mortgage interest and property
taxes. For example, let's say the Olympics comes to your town and you rent out your
house for ten days during the Olympics and charge $10,000. That $10,000 rental
income is entirely excluded from your gross income. But if you incurred any expenses in
renting out your home, such as advertising expenses or you paid a lawyer to drop a
rental contract, those expenses are not deductible. The only deductible expenses relate
to your regular deductible expenses if you itemize.
56
So on the one side we had primarily personal property, at the other extreme, we have
primarily rental property. What does this mean if a property is primarily rental use?
Here, it means that the property has been rented out for more than 14 days during the
year, and it's not used for personal purposes more than the greater of 14 days or 10%
of the total days rented. What happens here is the owner can deduct all expenses
allocated to the rental use of the property, even if there is a loss. As an aside, there may
be some limits here, known as passive loss limitations, but that's beyond the scope of
this course. But generally, the expenses associated with maintaining the property
including cleaning, maintenance, supplies, utilities, and depreciation are deductible
against the rental income. And may even generate a net rental loss and be deductible
against the property owner's other income.
57
Now what if it's a little bit of both? There's some personal use to the property. There's
also some rental use. Here, it's considered mixed personal and rental use property. If
the property is rented more than 14 days and personal use days exceed the greater of
14 days or 10% of days rented, then the property owner has to allocate the rental
expenses against rental income and only deduct rental expenses to the extent of rental
income.
58
Specifically, all expenses must first be classified into three tiers. The first tier relates the
expenses that would otherwise be deductible, regardless of whether the activity was
rental related. This relates to items, for example, like home mortgage interest or
property taxes that are deductible on Schedule A, regardless of how much the person's
property is being used for rental activity. The second tier relates to expenses incurred
for the rental activity that does not affect bases. That is, expenses that don't relate to
depreciation of the property or equipment in the property, like refrigerators, washing
machines, and the like. These are kind of like non-capital based operating expenses. So
any expenses incurred for property insurance, supplies, advertising, maintenance,
cleaning, or real estate broker fees would all fit into tier two expenses. Finally, we have
tier three expenses. These are expenses that do affect bases, namely depreciation
expense. So to the extent you have property or equipment that's subject to depreciation,
these expenses would be considered last. The tiers one, two, and three expenses
related to the rental activity are deductible for AGI. The personal portion of tier one
expenses that do not pertain to the rental activity are still deductible, but as from AGI
deductions, if the taxpayer itemizes. Here, the rental related expenses are deductible for
AGI against rental income. Note that you can only deduct expenses for AGI that are
related to the rental portion of the properties' activity. So the big question now is how
does the taxpayer allocate the costs between rental and personal days? Here for tier
one expenses only, that is, think mortgage, interest, and property taxes, two methods
are allowed. The first is the IRS' method, where expenses are allocated on the basis of
total days used. So here, the taxpayer has to take the number of days rented divided by
the number of days used for either rental or personal use to figure out the percentage of
tier one expenses that are deductible for AGI. The second method was approved by the
59
courts in Bolton versus Commissioner in 1982 by the Ninth Circuit Court of Appeals
after the case was heard and decided in the Tax Court. This is referred to as the Bolton
method. Here, the tier one expenses are allocated over the number of days in the year,
rather than the number of days used. So here the tax payer would take the number of
days rented divided by the number of days in the year or 365, to figure out the
percentage of tier one expenses that are deductible for AGI. For tiers two and three
expenses, the taxpayer can only allocate the cost using the IRS method. Again, number
of days rented divided by the number of days the property is used for both rental and
personal use. In terms of process, when a taxpayer goes through this calculation, the
tax payer will start with gross income from the rental activity. Then the tax payer will
subtract tier one expenses. If the net rental income amount remains positive, then the
tax payer can go on and subtract tier two expenses. If the net rental income amount
remains positive after having subtracted tier two expenses, then the tax payer can go on
and subtract tier three expenses. If at any point, the expenses exceed the remaining
income, the most in expenses that can be used in the current year is how much net
rental income is left. Therefore, rental expenses cannot create net rental losses for
mixed personal and rental use properties. Any losses in excess of rental income are
disallowed. That is, they cannot be claimed against other income of the taxpayer. Let's
turn back and look at this Bolton method a little bit more closely. What usually happens
when a tax payer chooses the Bolton method over the IRS method is that the share of
tier one expenses deductible for AGI will be smaller under the Bolton method than
under the IRS method. Yes, smaller deductions for AGI. So a smaller deduction is
allocated to rental income from tier one expenses under the Bolton than IRS method.
So why would a taxpayer want to do that? To choose to minimize their four AGI
deductions for tier one expenses? Well, if a taxpayer knows that he or she will be
itemizing expenses, then in effect, the taxpayer might be indifferent whether the tier one
expenses are allocated for or from AGI. The deduction will reduce gross income one
way or another. Where this does matter is that if the net rental income that is left over
after having deducted tier one expenses is now relatively higher, because the Bolton
method did not allocate very many expenses to tier one, then there's more net rental
income against which to claim tiers two and three expenses against. So here, tiers two
and three expenses can only be allocated in using the IRS method. And recall that
these expenses are greater than the net rental income after having subtracted out tier
one expenses. Then they're disallowed for the current year, although they are carried
forward indefinitely to offset future rental income. So in the end what can happen is that
under the Bolton method, there will be more deductions claimed in total in the current
year. That is expenses in all three tiers, plus the larger personal from AGI deductions
using the Bolton method, compared to the total deductions claimed using the IRS
method for all three tiers, plus the lower personal from AGI deductions. To recap, in this
video, we looked at how to differentiate rental activity between primarily personal,
60
primarily rental, and mixed personal and rental use, and how rental expenses and
losses are treated and allocated for tax purposes.
61
Lesson 5-8: Vacation Home Rental Deductions: Example
Lesson 5-8.1 Vacation Home Rental Deductions: Example
Welcome back. So in the previous video, we discussed how rental income deductions
are calculated and allocated. In this video, let's work through an example together.
During the year, Michelle rented her vacation home for 3 months, so 90 days. And spent
one month there, so 30 days. Gross rental income from the property was $5,000.
Michelle incurred the following expenses. She had mortgage interest expense of
$3,000. Real estate taxes of $1,500. Utilities of $800, Maintenance of $500, and
Depreciation of $4,000.
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So let's consider the following questions. First, is the vacation home subject to limitation
on the amount of the allowed deductions? That is, personal use slash rental use
property. Why or why not? Here, we need to consider two tests. First, was the property
rented for greater than 14 days? Yes, it was rented for 90 days. Second, was the
property used personally for more than the greater of 14 days, or 10% of days rented?
10% of days rented is 9 days. So the greater of 14 or 9, 14. Was it used personally for
more than 14 days? Yes, it was used personally for 30 days.
63
So here, we can see that Michelle meets these two tests to be considered a mixed
personal and rental use property. The implication herefrom the mixed personal and
rental use property is that Michelle can take deductions but only to the extent that his
rental income. This is similar to a hobby or we can only deduct hobby expenses up to
hobby income.
Next, let's calculate the effect of the rental income on Michelle's AGI using the Bolton
64
method. Let's compare that to the IRS method. At issue in the Bolton approach is the
allocation of tier 1 expenses only. So here, interest in taxes only. The calculation of
gross income, as well as the tier 2 out of pocket expenses and tier 3 depreciation
expenses are the same, using either of the two methods. The IRS method looks at
interest in taxes on a usage basis. So time rented divided by time used. Whereas,
Bolton looks at interest and taxes ratably. So time rented divided by the total time in the
year. So we first start with gross rental income and from it, we subtract year one
expenses. But here, we allocate them differently under Bolton vs IRS. Notice that for
Bolton, the 3/12s is the total rental use months, so 3 months, divided by total months in
the year, 12 months. For IRS, the 3/4s is the total number of months rented. So three
months, divided by the total number of months used. So three rental months plus one
personal month. So her, notice that the subtotal, the net rental income after allocating
tier 1 expenses, is 3,875 under the Bolton method. But only 1,625 under the IRS
method. Because these subtotals are positive, we can go on and subtract our tier 2
expenses next.
The tier 2 expenses here are utilities and repairs. So here, we have to actually use the
IRS method. Which is allocated according to total rental time, so three months, divided
by total use time, for four months. And this method is required regardless of which
method was used for tier 1 expense allocation. Under both scenarios, we have positive
net rental income after applying tier 2 expenses. Therefore, we can move on and
subtract tier 3 expenses up to the net rental income subtotal. Here, depreciation would
have been $3,000, or $4,000 total depreciation times 3/4s. But like hobbies, the amount
of deduction is limited to the amount of income. Here, depreciation can only offset
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$2,900 of rental income. Unlike hobbies, however, the unused loss is carried over into
future years indefinitely to offset future rental income. The deductions up to rental
income are for AGI. Again, note that utilities repairs and depreciation under both
methods is the same calculation. Except limited here to $2,900 or $650 because that's
the extent of income remaining under the Bolton or IRS methods when tier 1 expenses
are calculated. So at the end of the day, Michelle had $5,000 of gross rental income,
and now has 0 rental income. That is, she generated $5,000 of for AGI deductions.
You're probably scratching your head and asking, why does the Bolton versus IRS
method matter here? Well, what we'll see next is that it matters when we're figuring out
how much in deductions Michelle can take from AGI.
So finally, does Michelle have any deductions from AGI? And if so, how much? So here,
the balance of the unused interest in taxes that were not deducted above against rental
income are deductible from AGI. So what we have here is that more of the tier one
deductions are pushed into being classified as from AGI under the Bolton method than
under the IRS method. So the punch line here is that total for and from AGI deductions
under Bolton is $8,375 or a $5,000 in for AGI deductions Michelle took against the
rental income above. Plus the $3,375 from AGI deductions here. Meanwhile, the total
for and from AGI deductions under the IRS method is only $6,125 or the same $5,000
for AGI deductions allocated against rental income plus the $1,125 dollars AGI
deductions here. So hopefully this video helps you better understand the expense
calculations and allocations related to mixed personal and rental use properties.
66

QekZVqmARlmpGVapgIZZmQ Module 5 Transcript Federal Taxation I Individuals Employees and Sole Proprietors

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QekZVqmARlmpGVapgIZZmQ Module 5 Transcript Federal Taxation I Individuals Employees and Sole Proprietors

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Federal Taxation I: Individuals, Employees, and Sole Proprietors

Professor Matthew Hutchens

Module 5: Deductions and Losses: In General

Lesson 5-2: Trade or Business Deductions: Concepts ...................................................................... 13

Lesson 5-3: Timing of Deductions ................................................................................................... 24

Lesson 5-4: Political Contributions, Lobbying, Executive Compensation .......................................... 33

Lesson 5-5: Investigation Costs ....................................................................................................... 38

Lesson 5-6: Hobby Losses ............................................................................................................... 44

Lesson 5-7: Vacation Home Rental Deductions ............................................................................... 55

Lesson 5-8: Vacation Home Rental Deductions: Example ................................................................ 62

Lesson 5-1: Deductions: For vs. From AGI

Lesson 5-1.1 Deductions: For vs. From AGI

Lesson 5-2: Trade or Business Deductions: Concepts

Lesson 5-2.1 Trade or Business Deductions: Concepts

So let's do a few examples here, to reinforce the concepts of business-related

Lesson 5-3: Timing of Deductions

Lesson 5-3.1 Timing of Deductions

Generally speaking, the timing of deductions is determined by the taxpayers accounting

Lesson 5-4: Political Contributions, Lobbying, Executive Compensation

Lesson 5-4.1 Political Contributions, Lobbying, Executive Compensation

As it relates to compensation, there is also a disallowance provision that applies only to

Lesson 5-5: Investigation Costs

Lesson 5-5.1 Investigation Costs

If so when? First, to determine if the expenses are deductible, we have to check

Lesson 5-6: Hobby Losses

Lesson 5-6.1 Hobby Losses

Lesson 5-7: Vacation Home Rental Deductions

Lesson 5-7.1 Vacation Home Rental Deductions

Lesson 5-8: Vacation Home Rental Deductions: Example

Lesson 5-8.1 Vacation Home Rental Deductions: Example

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