Text Solutions - CH8

Solutions Manual
CHAPTER 8 – SOLUTIONS
END OF CHAPTER MATERIAL
Discussion Questions
1. Can an owner of rental property be treated as conducting a trade or business with

respect to the rental property? If so, what must the taxpayer do for it to be considered a
trade or business?
Answer:
The taxpayer must differentiate between rental property and a trade or
business involving rental property. Generally, if the taxpayer materially
participates in the rental activity and provides significant services to the
renter such as maid services, and is considered a real estate professional,
then the rental activity should be reported on Schedule C as a trade or
business. A taxpayer materially participates in the rental activity if he or she
works on a regular, continuous, and substantial basis in the operation of the
rental.
Learning Objective: 08-01
Topic: Rental Property Income and Expenses
Difficulty: 1 Easy
EA: No
2. For rental expenses to be deductible, what criteria must be met? For this question,
assume no personal use of the rental property.
Answer:
Generally, the same rules apply for rental property as for business expenses
– ordinary, necessary, and reasonable. Deductible expenses include
advertising, depreciation, repair and maintenance, interest, taxes,
management fees, and travel expenses. General repairs and maintenance are
deductible from gross rental income. However, no deduction is allowed for
amounts that are “capital improvements.”
Difficulty: 1 Easy
EA: Yes
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Solutions Manual
3. What is the difference between a deductible repair expense and a capital improvement
of rental property?
Answer:
Allowable repairs are expenditures that neither materially add to the value
of the property nor appreciably prolong the property’s life. Any repairs in
the nature of a replacement are capitalized and depreciated over the
appropriate depreciable life. Repairs are allowed as an immediate expense
deduction, but capital improvements are added to the value of the property
and are depreciated over 27 ½ years (residential) or 39 years (non-
residential).
Difficulty: 1 Easy
EA: Yes
4. When depreciation is deducted on a rental property, why is it beneficial for the

taxpayer to allocate the cost of the property to other assets (furniture, appliances, etc.)
connected with the property, rather than allocating the entire lump sum to the building
itself?
Answer:
To accelerate the tax deduction, the taxpayer should allocate the purchase
price to the structure and to furniture, appliances, carpet, as well as to
shrubbery or fences. These assets are depreciated over 5 to 15 years.
Without the allocation, the lump sum of the rental property is depreciated
over 27 ½ (or 39 years), thus delaying depreciation.
Difficulty: 2 Medium
EA: Yes
5. Can travel expenses to and from rental property be deducted? If so, what are the rules
concerning the deductibility of travel, and how is the deduction calculated? (Hint: You
may need to review Chapter 6 to help with this answer.)
Answer:
Travel costs from the taxpayer’s home to a rental property are deductible if
the travel is for business purposes, for example, to conduct repairs or attend
a condo association meeting. The standard mileage rate for business travel is
used in calculating any travel expenses concerning rental property.
Topic: Personal Use of Rental Property
Difficulty: 1 Easy
EA: Yes
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6. Les’s personal residence is in uptown New Orleans. Every year during Mardi Gras,
Les rents his house for 10 days to a large corporation that uses it to entertain clients.
How does Les treat the rental income? Explain.
Answer:
If a residence is rented for less than 15 days, the property is considered
“primarily personal” property. When property is rented for less than 15
days, none of the rental income derived is included in gross income, and no
deduction is allowed for rental expenses, other than the mortgage interest
and property taxes that are usually allowed as itemized deductions.
Difficulty: 1 Easy
EA: Yes
7. Two methods are used to allocate expenses between personal and rental uses of
property. Explain the Tax Court method and the IRS method. Which method is more
beneficial to the taxpayer?
Answer:
The two methods used are the IRS method and the Tax Court method. Using
the IRS method, expenses are allocated based on the ratio of total rental days
to total days used. The rest of the expenses are allocated to personal use.
Using the Tax Court method, interest and taxes are allocated by the ratio of
total rental days to the days in the entire year (365 days if held for the full
year). This method yields a smaller percentage of the interest and taxes
allocated to rental income. This allows a larger portion of other rental
expenses to be used to offset rental income. The interest and taxes are
deducted on Schedule A anyway. The Tax Court method is generally more
beneficial to the taxpayer because less interest expense and real property
taxes are allocated to the rental use which allows more of the remaining
expenses to be deducted when the gross income limitation applies.
EA: Yes
8. Discuss the three categories of vacation home rentals. Include in your discussion how
personal use of the property affects the reporting of income and losses of vacation homes.
Answer:
Vacation rental property can be classified as primarily rental use, primarily
personal use, and personal/rental use. The category depends on the number
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of total rental days to total personal use days the rental property is used.
When property is rented for less than 15 days, none of the rental income
derived from the short rental period is included in gross income, and no
deduction is allowed for rental expenses. If the property is used personally
for more than the greater of 14 days or 10 percent of the number of rental
days during the year and rented for 15 days or more, expenses are allowed
only to the extent that there is income, disallowing losses. A property that is
rented for 15 days or more and used personally for no more than the greater
of 14 days or 10 percent of the total days the property is rented is considered
primarily rental, and losses may be allowed subject to passive loss rules.
Passive loss rules, without income limitations, allow losses from rental
properties up to $25,000.
EA: No
9. What is considered personal use of a vacation rental property?
Answer:
Personal use includes use of the property by the taxpayer (unless he is
working on the property) or his family or non-family’s use of the rental
property free of a rental charge. If any family member uses the rental
property, the days are considered personal use days, even if they paid fair
market value for the rental.
Difficulty: 1 Easy
EA: No
10. Jake has a vacation rental house at the beach. During the tax year, he and his
immediate family used the house for 12 days for a personal vacation. Jake and his son
spent two more weekends (4 days) repairing steps from the property to the beach. The
beach house was rented for 100 days. How is the beach house categorized this year?
Explain your answer.
Answer:
The house is categorized as primarily rental since the personal use of the
property was 12 days. If rental property is used for no more than 14 days for
personal purposes, it is considered “primarily rental” property. Days spent
working on the house are not considered personal days.
EA: No
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11. Would your answer to Question 10 change if Jake also rented his house (at fair
market value) to his brother and his family for 7 days?
Answer:
Yes, because then the property would be used for more than 15 days for
personal use – to a total of 19 days. Rental by family members still counts as
personal use even if it is rented for the fair market value.
EA: No
12. What is royalty income, and which forms are used to report it? What factors
determine which forms should be used?
Answer:
A royalty is a payment for the right to use intangible property. Royalties
may be received from books, stories, plays, copyrights, trademarks,
formulas, patents, and from the exploitation of natural resources such as
coal, gas, or timber. When royalties are received, the payer is required to
send the recipient a 1099-MISC. If the royalty is a result of a trade or
business, the taxpayer should report the royalty on Schedule C. If the
royalty income is produced by a non-trade or business activity (such as an
investment) then the income should be reported on Schedule E.
Topic: Royalty Income
EA: Yes
13. Briefly describe the types of income that are reported on Schedule E.
Answer:
Income and expenses associated with rental, royalty, and flow-through
entities are the types of items known as “for the production of income”
property and are reported on Schedule E of Form 1040. Income and
expenses from rentals and royalties are reported in Part I of Schedule E, and
certain items from flow-through entities such as partnerships, LLCs, S
corporations, and estates and trusts, are reported in Part II and Part III of
Schedule E.
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Topic: Royalty Income
Topic: Flow-through Entity
EA: Yes
14. What is meant by the term flow-through entity? Give some examples.
Answer:
Flow-through entities are given this name because they do not pay income
taxes. Instead, the net share of income or loss from the entities flows-through
to the tax returns of its partners/shareholders/owners. These parties then
pay the tax on their share of the flow-through entity’s income. Common
flow-through entities are partnerships, S corporations, LLCs, estates, and
trusts.
Difficulty: 1 Easy
EA: No
15. How are the income and losses from a flow-through entity reported to the taxpayer
(partner, shareholder or owner)? Are all of the items from the flow-through entity
reported on the same form? Explain.
Answer:
The flow-through entity must supply each taxpayer a Schedule K-1,
indicating the taxpayer’s share of income, expenses, or losses. The
taxpayer’s share is then reported on various places on Form 1040. In the
case of a partnership, the K-1 reports the partner’s share of ordinary
income from the partnership and other separately stated items.
Separately stated items are not included in the income or expenses of the
partnership but are, instead, allocated separately to each of the partners.
Difficulty: 1 Easy
EA: Yes
16. Why are the income and losses (or expenses) separately stated to the partner,
shareholder or owner, and on what form(s) are they reported?
Answer:
Separately stated items are reported on the K-1. All items that can have
different tax treatment for different types of partners are separately stated.
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For example, a corporate partner cannot deduct net capital losses, whereas
an individual partner can deduct up to $3,000 of capital losses against
ordinary income.
EA: No
17. Why are charitable contributions stated separately on the K-1 but not deducted on a
partnership return?
Answer:
For most individual taxpayers, charitable deductions are limited to
50%/60% of AGI. The limit occurs at the individual level and could result in
a different outcome depending on the individual taxpayer’s tax situation.
EA: No
Problems
33. Ramone is a tax attorney and he owns an office building that he rents for
$8,500/month. He is responsible for paying all taxes and expenses relating to the
building’s operation and maintenance. Is Ramone engaged in the trade or business of
renting real estate?
Answer:
No, the office building would be treated as rental property and not a trade or
business. The general rule is that Ramone must materially participate in the
rental activity and provide substantial services to the rental property.
Additionally, Ramone must be considered a real estate professional if the
activity is to be treated as a trade or business.
EA: No
34. Kelvin owns and lives in a duplex. He rents the other unit for $750 per month. He
incurs the following expenses during the current year for the entire property:
Mortgage interest $7,500

Property taxes 2,000
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Utilities 1,500
Fixed light fixture in rental unit 100
Fixed dishwasher in personal unit 250
Painted entire exterior 1,300
Insurance 1,800
Depreciation (entire structure) 7,000
How are the above income and expenses reported on Kelvin’s tax return? On
what tax form(s) are these amounts reported?
Answer:
Personal Schedule A Schedule E

Income $9,000
Mortgage 3,750 $3,750 (3,750)
Interest
Property Taxes 1,000 1,000 (1,000)
Utilities 750 N/D (750)
Fix Light (100)
(Rental)
Fix Dishwasher 250 N/D
Paint Exterior 650 N/D (650)
Insurance 900 N/D (900)
Depreciation 3,500 N/D (3,500)
$4,750 ($1,650)

Difficulty: 3 Hard
EA: Yes
The $4,750 of personal expenses for taxes and interest is deductible as

various itemized deductions (see Chapter 5). The other personal expenses
are non-deductible. The rental loss of $1,650 is deductible subject to the
passive loss rules (Chapter 13).
35. In the current year, Sandra rented her vacation home for 75 days, used it for personal
use for 22 days, and left it vacant for the remainder of the year. Her income and expenses
before allocation are as follows:
Rental income $15,000

Real estate taxes 2,000
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Utilities 1,500
Mortgage interest 3,800
Depreciation 7,200
Repairs and Maintenance 1,300
What is Sandra’s net income or loss from the rental of her vacation home? Use the Tax
Court method.
Answer:
Schedule E Schedule A
Rental Income $15,000
Real Estate Taxes $2,000 * (75365) (411) $1, 589
Utilities $1,500 * (7597) (1,160)
Mortgage Interest $3,800 * (75365) (781) 3,019
Repairs and $1,300 * (7597) (1,005)
Maintenance
Depreciation $7,200 * (7597) (5,567)
Net Rental Income $6,076

Difficulty: 3 Hard
EA: Yes
36. Alice rented her personal residence for 13 days to summer vacationers for $4,500.
She has AGI of $105,000, before the rental income. Related expenses for the year
include the following:
Real property taxes $4,500

Utilities 5,000
Insurance 900
Mortgage interest 7,000
Repairs 800
Depreciation 15,000
Calculate the effect of the rental on Alice’s AGI. Explain your rationale, citing
tax authority.
Answer:
Since the rental days are 14 days or less, none of the income and rental
expenses are reported (IRC §280(A)(g)). Alice’s income remains unchanged
at $105,000. The mortgage interest and property taxes are deductible on
Schedule A as itemized deductions.
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Difficulty: 3 Hard
EA: Yes
37. Alicia and Marie own a vacation home at the beach. During the year, they rented the
house for 42 days (6 weeks) at $890 per week and used it for personal use for 58 days.
The total costs of maintaining the home are as follows:

Property taxes 700
Insurance 1,200
Utilities 3,200
Repairs 1,900
Depreciation 5,500
a. What is the proper tax treatment of this information on their tax return using the Tax
Court method?
b. Are there options available for how to allocate the expense between personal and
rental use? Explain.
c. What is the proper tax treatment of the rental income and expenses if Alicia and Marie
rented the house for only 14 days?
Answer:
Schedule E Schedule A
Income 6 weeks * $890 $5,340
Mortgage Interest (42365) * $4,200 483 $3,717
Property Taxes (42365) * $700 81 619
Insurance (42100) * $1,200 504
Utilities (42100) * $3,200 1,344
Repairs (42100) * $1,900 798
Depreciation (limited to Net 2,130
Rental Income)
Net Income $0
a. The proper tax treatment is to allocate the expenses between personal

and rental expenses. Schedule E would show $0 net income for this
property and remaining taxes and interest would be deducted on
Schedule A.
b. The taxpayer can use the Tax Court method or the IRS method to
allocate expenses. The Tax Court method allows for an overall larger
deduction. However, the IRS has maintained it will continue to fight the
Tax Court method.
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c. In this case, the property would be primarily personal; and none of the
income would be included and only the interest and taxes would be
deductible on Schedule A.

Difficulty: 3 Hard
EA: Yes
38. Janet owns a home at the lake. She incurs the following expenses:

Property taxes 800
Insurance 1,500
Utilities 1,800
Repairs 300
Depreciation 4,000
What is the proper treatment of these rental income and expenses in each of the following
cases? Use the Tax Court allocation method, if applicable.
Case Rental Income Days Rented Personal Use

Days
A $9,000 45 10
B 12,000 55 25
C 6,000 10 30
D 22,000 365 0
Answer:
Case A B C D
Schedule Sch. A/No Schedule Sch. A/No *(see Schedule
E Deduction E Deduction below) E
Income $9,000 $12,000 $22,000
Mortgage (45365): 1,140 – (55365): $1,104- (1,300)
Interest (160) Sch. A (196) Sch. A
Property (45365): 701 – (55365): 679 – (800)
Tax (99) Sch.A (121) Sch. A
Insurance (4555): 273 N/D (5580): 469 N/D (1,500)
(1,227) (1,031)
Utilities (4555): 327 N/D (5580): 562 N/D (1,800)
(1,473) (1,238)
Repair (4555): 55 N/D (5580): 94 N/D (300)
(245) (206)
Depreciatio (4555): 727 N/D (5580): 1,250 N/D (4,000)
n
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(3,273) (2,750)
Rental $2,523 $6,458 $0 $12,300
Income
*For less than 15 days rental, there is no income or rental expense reported.
Interest and taxes are deducted on Schedule A.

Difficulty: 3 Hard
EA: Yes
39. Randolph and Tammy own a second home. They spent 45 days there and rented it
for 88 days at $150 per day during the year. The total costs relating to the home include
the following:

Property taxes 1,200
Insurance 1,800
Utilities 2,300
Repairs 1,500
Depreciation 6,500
What is the proper treatment of these items relating to the second home? Would you use
the Tax Court allocation or the IRS allocation? Explain.
Answer:
Tax Court – Schedule E Personal

Income $13,200
Mortgage (88365) * ($1,085) $3,415 To Schedule A
Interest 4,500 = 1,085
Property Tax (88365) * ($289) 911 To Schedule A
1,200 = 289
Insurance (88133) * ($1,191) 609 Non-deductible
1,800 = 1,191
Utilities (88133) * ($1,522) 778 Non-deductible
2,300 = 1,522
Repairs (88133) * ($992) 508 Non-deductible
1,500 = 992
Depreciation (88133) * ($4,301) 2,199 Non-deductible
6,500 = 4,301
Net Rental $3,820
Income
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IRS Method – Schedule E Personal

Income $13,200
Mortgage (88133) * (2,977) $1,523 To Schedule A
Interest 4,500 = 2,977
Property Tax (88133) * (794) 406 To Schedule A
1,200 = 794
Insurance (88133) * (1,191) 609 Non-deductible
1,800 = 1,191
Utilities (88133) * (1,522) 778 Non-deductible
2,300 = 1,522
Repairs (88133) * (992) 508 Non-deductible
1,500 = 992
Depreciation (88133) * (4,301) 2,199 Non-deductible
6,500 = 4,301
Net Rental $1,423
Income
The IRS method produces the least amount of net rental income for
Randolph and Tammy and would be the preferable allocation of expenses for
them. Net rental income reported using the Tax Court method is $2,397
greater than they are under the IRS method. Itemized deductions however,
are $2,397 greater under the Tax Court method.

Difficulty: 3 Hard
EA: Yes
40. Mabel, Loretta, and Margaret are equal partners in a local restaurant. The restaurant
reports the following items for the current year:
Revenue $600,000
Business expenses 310,000
Investment expenses 150,000
Short-term capital gains 157,000
Short-term capital losses (213,000)
Each partner receives a Schedule K-1 with one-third of the preceding items reported to
her. How must each individual report these results on her Form 1040?
Answer:
Revenues $600,000
Expenses 310,000
Ordinary Income $290,000
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x 1/3
Page 2 of Schedule E $ 96,666
Investment Expense $150,000

x 1/3
Schedule A $ 50,000
(limited to investment income)
Net short-term capital loss ($56,000)

($157,000 - $213,000)
x 1/3
Schedule D ($18,666)
The loss is netted against other short-term and long-term capital gains. The
partners would also be allowed a QBI of 20% of their share of the $96,666
(depending on the other income on their individual tax returns - not given in
the problem).

Difficulty: 3 Hard
EA: Yes
41. Nicole and Mohammad (married taxpayers filing jointly) are equal owners in an S
corporation. The company reported sales revenue of $450,000 and expenses of $310,000.
The corporation also earned $20,000 in taxable interest and dividend income and had
$15,000 investment interest expense. How are these amounts treated for tax purposes?
Answer:
Revenue $450,000
Expenses 310,000
Ordinary Income, reported on Schedule E, Page 2 $140,000
Interest and dividends of $20,000 are reported as interest and dividends

separately on Schedule B, Form 1040. The investment interest expense is an
itemized deduction on Schedule A. The shareholders would also be allowed a
QBI of 20% on their share of the $140,000 (depending on the other income
on their individual tax returns - not given in the problem).

EA: Yes
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42. Dominique and Terrell are joint owners of a bookstore. The business operates as an
S corporation. Dominique owns 65%, and Terrell owns 35%. The business has the
following results in the current year:
Revenue $1,500,000
Charitable contributions 50,000
Short-term capital losses 4,500
Long-term capital gains 6,000
How do Dominique and Terrell report these items for tax purposes?
Answer:
Total Dominique Terrell

(65%) (35%)
Revenues $1,500,000
Expenses 750,000
Ordinary 750,000 $487,500 $262,500 To Sch. E, pg.
Income 2
Charitable 50,000 32,500 17,500 To Sch. A
Contributions
S/T Capital (4,500) (2,925) (1,575) To Sch. D
Losses
L/T Capital 6,000 3,900 2,100 To Sch. D
Gains
The shareholder would also be allowed a QBI of 20% on their share of the $750,000
(depending on the other income on their individual tax returns and the income
limitations- not given in the problem).

Difficulty: 3 Hard
EA: Yes
43. Shirelle and Newman are each 50% partners of a business that operates as a
partnership. The business reports the following results:
Revenue $95,000
Investment expenses 8,000
Short-term capital gains 15,000
Short-term capital losses (22,000)
How do Shirelle and Newman report these items for tax purposes?
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Answer:
Revenue $95,000
Expenses (48,000)
Ordinary Income $47,000
x 50%
Page 2 of Schedule E $23,500
Investment Expense $8,000

x 50%
Schedule A (limited to investment income) $4,000
Net Short-term capital loss $7,000

($15,000 - $22,000)
x 50%
Schedule D ($3,500)
The loss is netted against other short-term and long-term capital gains. The
partners would also be allowed a QBI of 20% of their share of the $47,000
(depending on the other income on their individual tax returns - not given in
the problem).

Difficulty: 3 Hard
EA: Yes

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Solutions Manual

1. Can an owner of rental property be treated as conducting a trade or business with

4. When depreciation is deducted on a rental property, why is it beneficial for the

9. What is considered personal use of a vacation rental property?

Topic: Rental Property Income and Expenses

Mortgage interest $7,500

Personal Schedule A Schedule E

Learning Objective: 08-01

The $4,750 of personal expenses for taxes and interest is deductible as

Rental income $15,000

Learning Objective: 08-02

Real property taxes $4,500

Learning Objective: 08-02

Mortgage interest $4,200

a. The proper tax treatment is to allocate the expenses between personal

Learning Objective: 08-02

Mortgage interest $1,300

Case Rental Income Days Rented Personal Use

Learning Objective: 08-02

Mortgage interest $4,500

Tax Court – Schedule E Personal

IRS Method – Schedule E Personal

Learning Objective: 08-02

Investment Expense $150,000

Net short-term capital loss ($56,000)

Learning Objective: 08-04

Interest and dividends of $20,000 are reported as interest and dividends

Learning Objective: 08-04

Total Dominique Terrell

Learning Objective: 08-04

Investment Expense $8,000

Net Short-term capital loss $7,000

Learning Objective: 08-04

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