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 Chapter 14
Tax Consequences of Home Ownership

Discussion Questions

1. [LO 1] How does a taxpayer determine whether a dwelling unit is treated as a residence or
nonresidence for tax purposes?

Whether a dwelling unit is treated as a residence or not depends on the number of days the
dwelling unit is used for personal purposes compared to the number of days it is used for
rental purposes. A dwelling unit is considered to be a residence if the number of personal use
days of the home exceeds the greater of (1) 14 days or (2) 10% of the number of rental days
during the year.

2. [LO 1] For tax purposes, does a residence need to be situated at a fixed location? Explain.

No. A residence is a dwelling unit that provides a place suitable for people to occupy (live
and sleep). For tax purposes, a dwelling unit includes a house, condominium, mobile home,
and boat. As long as the taxpayer lives in the property (uses it for personal purposes) for the
requisite number of days, the property qualifies as a residence even if it is mobile.

3. [LO 1] When determining whether a dwelling unit is treated as a residence or a nonresidence

for tax purposes, what constitutes a day of personal use and what constitutes a day of rental
use?

Personal use by a taxpayer includes days when (1) the taxpayer or other owner stays in the
home, (2) a relative of an owner stays in the home, even if the relative pays full fair market
value rent, except if the relative is renting the home as his or her principal residence, (3) a
nonowner stays in the home under a vacation home exchange or swap arrangement, and (4)
the taxpayer rents out the property for less than fair market value. Rental use includes days
when the property is rented out at fair market value. Days spent repairing or maintaining the
vacation home for rental use count as rental days, and days when the home is available for
rent, but not actually rented out, do not count as personal days or as rental days.

4. [LO 1] A taxpayer owns a home in Salt Lake City, Utah and a second home in St. George,
Utah. How does the taxpayer determine which home her principal residence is for tax
purposes?
When a taxpayer lives in more than one residence during the year, the determination of
which residence is the principal residence depends on the facts and circumstances. Factors
to consider in making this determination include the amount of time the taxpayer spends at
each residence during the year, the proximity of each residence to the taxpayer’s
 employment, the principal place of abode of the taxpayer’s family, and the taxpayer’s
mailing address for bills and correspondence among other things.

5. [LO 2] What are the ownership and use requirements a taxpayer must meet to qualify for the
exclusion of gain on the sale of a residence?

Ownership test: The taxpayer must have owned the property for a total of two or more years
during the five-year period ending on the date of the sale.
Use test: The taxpayer must have used the property as the taxpayer’s principal residence for
a total of two or more years during the five-year period ending on the date of the sale.
Married couples are eligible for the married filing jointly exclusion amount if either spouse
meets the ownership test and both spouses meet the principal use test.

6. [LO 2] Under what circumstances, if any, can a taxpayer fail to meet the ownership and use
requirements but still be able to exclude all of the gain on the sale of a principal residence?

The taxpayer may be able to exclude the gain on the sale of a principal residence when she
sells the home due to unforeseen circumstances such as a change in employment, significant
health issues, or other unforeseen financial difficulties. The maximum exclusion available to
a taxpayer selling under these circumstances is the product of (1) the maximum exclusion
had the taxpayer fully qualified for the exclusion (i.e., $250,000 for a single taxpayer or
$500,000 for a taxpayer filing a joint return) and (2) the ratio of (a) the number of days or
number of months the taxpayer met the ownership and use requirements to (b) 730 days or
24 months, respectively. The taxpayer may use either days or months in the computation.
Note that under this unforeseen circumstances provision, the maximum limitation is reduced,
not necessarily the excludable gain. Consequently, if the taxpayer has a gain on the sale of
the residence that is less than the reduced maximum exclusion, the full amount of the gain
may be excluded.

7. [LO 2] Under what circumstances can a taxpayer meet the ownership and use requirements
for a residence but still not be allowed to exclude all realized gain on the sale of the
residence?

A taxpayer is limited to one exclusion on a sale of a principal residence every two years.
That is, once the taxpayer sells a residence and uses the exclusion on the sale, she will not be
allowed a second exclusion until at least two years passes from the time of the first sale.
Consequently, although a taxpayer may meet the use and ownership tests on two residences,
she can’t exclude gain from the sale of her second residence if she has sold the first
residence within the two preceding years.

Also, if a taxpayer sells a home after December 31, 2008, and the taxpayer had nonqualified
use of the property after December 31, 2008 (that is, the taxpayer used the property for a
purpose other than as a principal residence such as vacation home or rental property) the
 taxpayer is not allowed to deduct a certain percentage of the otherwise excludable gain.
Note, however, that nonqualified use does not include use during any portion of the five-year
period that is after the last date the property was used as the principal residence of the
taxpayer or the taxpayer’s spouse. That is this exception allows the taxpayer a five-year
period to sell the principal residence after moving out of it without having to count the time
the house is available for sale as nonqualified use. The percentage of the gain that is not
excludable is the period of nonqualified use after December 31, 2008, divided by the period
of time the taxpayer owned the home before selling.

8. [LO 2] A taxpayer purchases and lives in a home for a year. The home appreciates in value
by $50,000. The taxpayer sells the home and purchases a new home. What information do
you need to obtain to determine whether the taxpayer is allowed to exclude the gain on the
sale of the first home?

Because the taxpayer lived in the home for only a year, the taxpayer would not be able to
meet the ownership and use tests. However, the taxpayer could potentially exclude all or a
portion of the gain if the taxpayer were able to show that he or she sold the home due to
unforeseen circumstances such as a change in employment, medical reasons, or other
unusual/unforeseen circumstances. Here would need to determine the reason for the move
and whether that reason qualified as an unforeseen circumstance.

9. [LO 3] Juanita owns a principal residence in New Jersey, a cabin in Montana, and a
houseboat in Hawaii. All of these properties have mortgages on which Juanita pays interest.
What limits, if any, apply to Juanita’s mortgage interest deductions? Explain whether
deductible interest is deductible for AGI or from AGI?

Taxpayers are allowed to deduct “qualified residence interest” as an itemized deduction.

Qualified residence interest includes interest paid on loans secured by the taxpayer’s
principal residence and one other residence. The second qualified residence is an annual
election for a taxpayer with more than two residences. If the taxpayer rents the second
residence for part of the year, it still qualifies as a residence for interest deduction purposes
as long as the taxpayer’s personal use of the property exceeds the greater of (1) 14 days or
(2) 10% of the number of rental days during the year. This use limitation is designed to
ensure that taxpayers are using the property as a residence for a significant part of the year
relative to the rental use of the property. A taxpayer’s residence need not be a typical home
attached to the ground; rather, it could include a houseboat or mobile home. Hence,
Juanita’s principal residence in New Jersey as well as either the cabin in Montana or the
houseboat in Hawaii will qualify as qualified residences. The deduction for mortgage interest
on these two properties is subject to additional limits: acquisition indebtedness and home
equity indebtedness. Interest expense on up to $1,000,000 of acquisition indebtedness is
deductible as qualified residence interest. Once acquisition indebtedness is established for a
qualifying residence (or qualifying residences), it is reduced by principal payments on the
loan(s) and can only be increased by additional indebtedness, secured by the residence,
 incurred to substantially improve the residence. Interest on home-equity indebtedness is
deductible as qualified residence interest. However, the amount of home-equity indebtedness
is limited to the lesser of (1) the fair market value of the qualified residence in excess of the
acquisition debt related to that residence and (2) $100,000 ($50,000 for married filing
separately). This means that a taxpayer is able to deduct interest on up to $100,000 of debt
above and beyond acquisition debt as long as the debt is secured by the equity in the home.
This is true no matter what the taxpayer does with the proceeds from the home-equity debt.

10. [ LO 3] Barbi really wants to acquire an expensive automobile (perhaps more expensive than
she can really afford). She has two options. Option 1: Finance the purchase with an
automobile loan from her local bank at a 5 percent interest rate; or Option 2: Finance the
purchase with a home-equity loan at a rate of 5 percent. Compare and contrast the tax and
nontax factors Barbi should consider before deciding which loan to use to pay for the
automobile. Barbi typically has more itemized deductions than the standard deduction
amount.

For tax purposes, Barbi would be better off using the home-equity loan to acquire the
automobile because she would be allowed to deduct the interest payments on the loan. Thus,
her after-tax interest rate for the home-equity loan would be 5% × (1 – marginal tax rate). In
contrast, her after-tax interest rate on the automobile loan from the bank would be 5%.
However, nontax considerations are also important. If Barbi is unable to make her payments
on the automobile loan, she may lose the automobile. However, if she is unable to make the
payments on the home-equity loan, she could lose her home because the home-equity loan is
secured by the home. This is an important consideration for Barbi because she apparently
would like to borrow more than she can afford to pay back.

11. [LO 3] Lars and Leigha saved up for years before they purchased their dream home. They
were considering (1) using all of their savings to make a large down payment on the home
(90 percent of the value of the home) and barely scraping by without backup savings or (2)
making a more modest down payment (50 percent of the value of the loan) and holding some
of the savings in reserve as needed if funds got tight. They decided to make a large down
payment because they figured they could always refinance the home to pull some equity out
of it if they needed cash. What advice would you give them about the tax consequences of
their decision?

If the couple is forced to refinance their loan sometime in the future, the refinanced loan is
treated as acquisition debt only to the extent that the principal amount of the refinancing
does not exceed the amount of the acquisition debt immediately before the refinancing. That
is, the refinancing cannot increase their acquisition indebtedness. Consequently, any amount
borrowed in excess of the remaining principal on the original loan does not qualify as
acquisition indebtedness (unless it is used to substantially improve the home). However,
interest on the excess part of this loan can be deducted to the extent that it qualifies as home-
equity indebtedness. Home equity indebtedness is limited to the lesser of (1) the fair market
 value of the qualified residence(s) in excess of the acquisition debt related to the residence(s)
and (2) $100,000. Thus, the couple will be able to increase their mortgage interest deduction
only to the extent that the refinanced loan qualifies as home-equity indebtedness.

12. [LO 3] How are acquisition indebtedness and home-equity indebtedness similar? How are
they dissimilar?

Both acquisition and home-equity indebtedness are loans that are secured by the residence.
That is, if the owner does not make the payments on the loan, the bank or lender may take
possession of the home to satisfy the owner’s responsibility for the loan. However,
acquisition indebtedness is debt that is incurred in acquiring, constructing, or substantially
improving the residence and the interest on this type of debt is deductible on up to
$1,000,000 of principal. On the other hand, home-equity indebtedness may be used for any
purpose, and the interest is deductible on the lesser of (1) the fair market value of the home
over the acquisition indebtedness or (2) $100,000.

13. [LO 3] Why might it be good advice from a tax perspective to think hard before deciding to
quickly pay down mortgage debt?

If the taxpayer has a cash crunch in the future due to quickly paying down the mortgage debt,
he may be forced to refinance the loan to get the necessary cash. However, when a taxpayer
refinances his home, and the amount of the refinancing exceeds the amount of the acquisition
indebtedness immediately before the refinancing (and the taxpayer doesn’t use the proceeds
to substantially improve the home), the excess cannot be classified as acquisition
indebtedness, it can be treated only as home-equity indebtedness (to the lesser of the fair
market value of the home in excess of the acquisition indebtedness or $100,000). Thus, the
taxpayer may be in a situation where he will not be able to deduct as much interest due to the
refinance as he would have been able to deduct if he had not quickly paid down the mortgage
debt. That is, by decreasing the acquisition indebtedness by paying down the debt, the
taxpayer may be unable to deduct a portion of his interest payments due to refinancing.

14. [LO 3] Can portions of one loan secured by a residence consist of both acquisition
indebtedness and home-equity indebtedness? Explain.

Yes; even though there are separate limits on acquisition indebtedness and home-equity
indebtedness, both limits can apply to the same loan. When a taxpayer refinances his home
and the amount of the refinancing exceeds the amount of the acquisition indebtedness
immediately before the refinancing, the excess cannot be classified as acquisition
indebtedness. However, the excess can be treated as home-equity indebtedness. Thus, the
refinancing includes both acquisition indebtedness and home-equity indebtedness. Likewise,
a taxpayer with a home valued at $1.1 million or greater can borrow and deduct interest on
$1.1 million dollars. In this situation, the first $1 million is considered to be acquisition
indebtedness and the remaining $100K would be considered home-equity indebtedness, even
 though the taxpayer holds only one loan. Also, if a taxpayer takes out a loan and uses part of
the proceeds to substantially improve the home and part for other purposes, the part to
improve the home would be acquisition indebtedness and the remainder would be home
equity debt.

15. [LO 3] When a taxpayer has multiple loans secured by her residence that in total exceed the
limits for deductibility, how does the taxpayer determine the amount of the deductible
interest expense?

When a taxpayer’s home-related debt exceeds the limitations, the amount of deductible
interest can be determined in one of two ways. First, the deductible interest can be computed
by the product of the ratio of qualified debt to total debt outstanding on the home and total
interest expense on debt secured by the home as follows (this method is called the simplified
method):

Qualified debt/Total debt × total interest expense = deductible interest

The second method is based on the order in which the loan was taken out (this method is
called the exact method). Interest on the first loan taken out (up to the limit) is deductible
first and then interest on the next loan is deductible, etc. Interest on loans in excess of the
limits does not generate deductible interest. A taxpayer may opt for the exact method when
the loans taken out first have a higher interest rate than loans taken out later.

16. [LO 3] Compare and contrast the characteristics of a deductible point from a nondeductible
point on a first home mortgage.

Deductible points include points paid to lenders in exchange for a reduced interest rate on
the loan or for loan origination fees. These points are immediately deductible as qualified
residence interest if certain requirements are met. In contrast, nondeductible points are
points paid to compensate lenders for specific services such as appraisal fees, document fees,
or notary fees.

Points paid for a reduced interest rate or for a loan origination fee in refinancing a home
loan are not immediately deductible by the homeowner. These points must be amortized and
deducted on a straight-line basis over the life of the loan.

17. [LO 3] Is the break-even period generally longer or shorter for points paid to reduce the
interest rate on initial home loans or points paid for the same purpose on a refinance?
Explain.

The break-even period is generally shorter for points paid to reduce the interest rate on
initial home loans than for points paid for a refinance. The reason for the extended break-
even period in a refinance situation is that the refinance points are not immediately
 deductible, and hence, they effectively cost more (on a present value basis) than points on
initial home loans. Thus, it takes longer to recoup these greater costs. Note, however, that
this is true only if the taxpayer itemizes deductions. If the taxpayer does not itemize, neither
points paid on an initial home loan or points paid on a refinance generate any tax savings.

18. [LO 3] {Planning} Under what circumstances is it likely economically beneficial to pay
points to reduce the interest rate on a home loan?

Generally speaking, the longer the taxpayer plans on staying in the home and maintaining
the loan (i.e., not refinancing the loan), the more likely it is financially beneficial to pay
points to obtain a lower interest rate. However, paying points can be costly if after a short
time the taxpayer sells the home or refinances the home loan. In these situations, the
taxpayer may not reach the break-even point.

19. [LO 3] Harry decides to finance his new home with a 30-year fixed mortgage. Because he
figures he will be in this home for a long time, he decides to pay a fully deductible discount
point on his mortgage to reduce the interest rate. Assume that Harry itemizes deductions and
has a constant marginal tax rate over time. Will the time required to recover the cost of the
discount point be shorter or longer if Harry makes extra principal payments starting in the
first year (as opposed to not making any extra principal payments)? Explain.

The time required to recoup the cost of the discount point will be longer if Harry makes extra
principal payments. If Harry makes extra principal payments on his mortgage during the first
year, the balance of the loan is reduced and, as a result, Harry will pay less interest than he
would have paid had he not made the extra loan payments (a smaller loan principal times the
same interest rate equals a smaller amount of interest). Consequently, his after-tax savings
from having the lower interest rate is reduced relative to what it would have been had he not
made the extra payments. Because the interest expense is deductible for tax purposes, the
after tax savings from having the lower interest rate is calculated as follows:

Interest saved = principal amount of loan × (original interest rate – lower interest rate)

After-tax interest savings = interest saved – (interest saved × MTR)

Because, the after-tax cost of paying points remains constant, the reduction in after-tax
savings from the lower interest rate increases the break-even point. Recall that the break-
even point is calculated as follows:

Break-even point = after-tax cost of paying points/after-tax savings of lower interest rate.

20. [LO 3, LO 4] Consider the settlement statement in Appendix A to this chapter. What
amounts on the statement are the Jeffersons allowed to deduct on their 2017 tax return?
Indicate the settlement statement line number for each deductible amount (discuss any issues
 that must be addressed to determine deductibility) and label each deduction as a for AGI
deduction or a from AGI deduction.

Line 801 Loan origination fees $3,000 for AGI deduction as qualified residence interest.
Line 802 Loan discount $6,000 for AGI deduction as qualified residence interest.

Note: Rev. Proc. 94-27 1994-1 C.B. 613 indicates that as a matter of administrative
convenience points paid are deductible qualified residence interest if the following
requirements are met:

1. The settlement statement clearly designate the amounts as points payable in connection
with the loan (includes loan origination fees and discount points)
2. The amounts must be computed as a percentage of the stated principal amount of the loan.
3. The amounts paid must conform to an established business general practice of charging
points for loans in the area in which the residence is located, and the amount of the points
paid must not exceed the amount generally charged in that area.
4. The amounts must be paid in connection with the acquisition of the taxpayer’s principal
residence and the loan must be secured by that residence (the deduction for points is not
available for points paid in connection with a loan for a second home).
5. The buyer must provide enough funds in the down payment on the home to at least equal
the cost of the points (the buyer is not allowed to borrow from the lender to pay the points).

Here it appears that the Jeffersons meet the requirements and should be able to deduct the
amounts on both Line 801 and Line 802.

Line 901: Interest from 1/31/2017 through 2/10/2017 of $411 as qualified residence interest.
Note that as of the settlement date, this is prepaid interest. But once the time passes and the
interest accrues, the Jeffersons will be allowed to deduct this amount as a for AGI deduction.

Line 1004: County property taxes of $11,000. This is a reserve the taxpayer has paid to cover
property taxes for the rest of 2017. It will be deductible by the Jeffersons as a from AGI
deduction (real property tax) when the actual property taxes are paid. As of the settlement
date, this amount reflects an estimate of the real property taxes the Jeffersons will have to
pay for 2017.

21. [LO 4] A taxpayer sells a piece of real property in year 1. The amount of year 1 real property
taxes is estimated at the closing of the sale and the amounts are allocated between the buyer
and the taxpayer. At the end of year 1, the buyer receives a property tax bill that is higher
than the estimate. After paying the tax bill, the buyer contacts the taxpayer at the beginning
of year 2 and asks the taxpayer to pay the taxpayer’s share of the shortfall. The taxpayer
sends a check to the buyer. Should the taxpayer be concerned that she won’t get to deduct the
extra tax payment because it was paid to the buyer and not to the taxing jurisdiction?
Explain.
 The taxpayer will be allowed to deduct her share of the real property taxes even though she
didn’t pay the taxing jurisdiction. In most situations, the buyer and seller will agree to divide
the responsibility for the tax payments based on the portion of the property tax year that each
party held the property. This allocation of taxes between buyer and seller is generally spelled
out on the settlement statement when the sale becomes final. However, the amount specified
at settlement is generally just an estimate, so the actual taxes may differ from amounts for
taxes on the settlement statement. For tax purposes, however, it doesn’t matter who actually
pays the tax to the taxing jurisdiction. Assuming the taxes are actually paid by someone, the
tax deduction is based on the relative amount of time each party held the property during the
year. Thus, the taxpayer will get to deduct the total share of the tax bill allocated to her
which is dependent on how long she held the property during the year. The buyer will get to
deduct the remaining portion. This is true even if the taxpayer does not send the extra
payment to the seller.

22. [LO 4] Is a homeowner allowed a property tax deduction for amounts included in the
monthly mortgage payment that are earmarked for property taxes? Explain.

Frequently homeowners pay their real estate taxes through an escrow (holding) account with
their mortgage lender. Each monthly payment to the lender includes an amount that
represents roughly 1/12th of the anticipated real property taxes for the year. The actual
annual tax payment is made by the mortgage company with funds accumulated in the escrow
account. The homeowner gets a deduction when the actual taxes are paid to the taxing
jurisdiction and not when the homeowner makes payments for taxes to the escrow account.

23. [LO 5] {Planning} Is it possible for a taxpayer to receive rental income that is not subject to
taxation? Explain.

Yes. A taxpayer (owner) who lives in a home for at least 15 days and rents it out for 14 days
or less (residence with minimal rental use) is not required to include the gross receipts in
rental income but is not allowed to deduct any expenses related to the rental.

24. [LO 5] Halle just acquired a vacation home. She plans on spending several months each year
vacationing in the home, and renting out the property for the rest of the year. She is
projecting tax losses on the rental portion of the property for the year. She is not too
concerned about the losses because she is confident she will be able to use the losses to offset
her income from other sources. Is her confidence misplaced? Explain.

Because Halle will be living in the home for several months, the home will be considered a
residence with significant rental use. Consequently, she may deduct expenses to obtain
tenants (direct rental expenses such as advertising and realtor commissions) and mortgage
interest and real property taxes allocated to the rental use of the home. To the extent that
these expenses exceed gross rental income she may deduct the loss (the passive loss rules do
 not apply). However, the remaining expenses allocated to the rental use of the home may
only be deducted to the extent of the net rental income after deducting the direct rental
expenses and rental mortgage interest and real property taxes allocated to the property. This
limitation reduces her ability to deduct a rental loss from the home.

25. [LO 5] {Planning} A taxpayer stays in a second home for the entire month of September. He
would like the home to fall into the residence-with-significant-rental-use category for tax
purposes. What is the maximum number of days he can rent out the home and have it
qualify?

To qualify for the residence with significant rental use category, the taxpayer must have used
the home for personal purposes more than the greater of (1) 14 days or (2) 10% of the total
days it is rented out during the tax year and rented the house for more than 14 days. In this
situation, the taxpayer used the second home for personal purposes for 30 days (the entire
month of September). To qualify, the 30 days of personal use must be greater than 10% of the
number of days the property is rented out. If the taxpayer rents the property out for 300 days,
the number of personal use days will be exactly 10% of the number of rental days, and the
property would not qualify as residence. However, if the taxpayer rents out the property for
299 days, the 30 days of personal use will be greater than 10% of the number of rental days,
so the property would qualify as a residence with significant rental use. So, the maximum
number of days the taxpayer can rent out the home and have it qualify as a residence with
significant rental use is 299 days. Anything more than that and the property would be
considered a nonresidence with rental use.

26. [LO 5] Compare and contrast the IRS method and the Tax Court method for allocating
expenses between personal use and rental use for vacation homes. Include the Tax Court’s
justification for departing from the IRS method in your answer.

The IRS method of allocating deductions between personal and rental use allocates the
deductions based on a fraction with the number of days the property was used for rental
property in the numerator and the number of days the property was used for any reason
during the year in the denominator. Each expense relating to the home is multiplied by this
fraction to determine the amount allocable to rental use. Subject to the gross rental income
limitation, tier 1 expenses are deducted first, followed by tier 2 expenses, and then tier 3
expenses.

The Tax Court and the IRS method of allocating deductions are identical except for the
allocation of the tier 1 expenses of interest and real property taxes. Under the Tax Court
approach, interest and taxes are allocated to rental use based on the fraction of days that the
property was rented over the number of days in the year (not the number of days the property
was used for any purpose during the year). The Tax Court justifies this approach by pointing
out that interest expense and property taxes accrue over the entire year regardless of the
level of personal or rental use. The Tax Court method is generally taxpayer favorable
 because it tends to allocate less interest and real property taxes to the rental use which
allows more tier 2 and tier 3 expenses to be deducted when the gross income limitation
applies. The taxpayer does not lose deductions for the interest and property taxes allocated
to personal use and not to the rental activity because these expenses are deductible anyway
as itemized deductions.

27. [LO 5] In what circumstances is the IRS method for allocating expenses between personal
use and rental use for vacation homes more beneficial to a taxpayer than the Tax Court
method?

The IRS method is generally more beneficial than the Tax Court method when the property is
considered to be a nonresidence with rental use. When the property is not a residence, the
interest allocated to personal use is not deductible. Thus, under these circumstances, the
taxpayer is better off by allocating as little interest as possible to personal use. The IRS
method accomplishes this by allocating interest (a tier 1 expense) to rental use by dividing
the total rental days by the total days used and allocating the remainder to personal use. The
Tax Court method would allocate less interest to rental use because the denominator is 365
(366 in a leap year), rather than total days used.

28. [LO 5] Under what circumstances would a taxpayer who generates a loss from renting a
home that is not a residence be able to fully deduct the loss? What potential limitations
apply?

By definition, a rental activity is considered to be a passive activity. Because they are passive
losses, losses from rental property are generally not allowed to offset other ordinary or
investment type income.

However, the loss from a rental activity may be deductible under two circumstances. First, a
taxpayer who is an active participant in the rental activity may be allowed to deduct up to
$25,000 of the rental loss against other types of income (subject to phase-out beginning at
$100,000 AGI). Second, the taxpayer may offset the passive loss from the rental activity
against other sources of passive income.

29. [LO 5] Describe the circumstances in which a taxpayer acquires a home and rents it out and
is not allowed to deduct a portion of the interest expense on the loan the taxpayer used to
acquire the home.

When a rental home is not a residence, the interest allocable to any personal-use days is
nondeductible.

30. [LO 5] Is it possible for a rental property to generate a positive annual cash flow and at the
same time produce a loss for tax purposes? Explain.
 Yes. A taxpayer is able to have a positive cash flow and at the same time produce a loss for
tax purposes. This outcome is possible due to depreciation expense that is deductible for tax
purposes but does not require an annual cash outflow. A rental property could provide a
positive cash flow (gross receipts greater than cash expense for the year) but generate a tax
loss when depreciation expense is deducted.

31. [LO 5, LO 6] How are the tax issues associated with home offices and vacation homes used
as rentals similar? How are the tax issues or requirements dissimilar?

The tax issues facing renters of second homes are similar in a lot of ways with tax issues
facing taxpayers qualifying for home office deductions. Both taxpayers with home offices and
taxpayers with vacation homes are allowed to deduct business or rental expenses not
associated with the use of the home as for AGI deductions without income limitations.
Taxpayers with home offices allocate expenses of the entire home between personal use of
the home and business use of the home. In a similar way, renters of second homes generally
allocate expenses of the second home between personal use of the home and rental use of the
home. Taxpayers with home offices and vacation homes may deduct mortgage interest and
real property taxes allocated to the business or rental use of the home as for AGI deductions
without income limitations. Further, the non mortgage interest and non real property tax
expenses allocated to business use of the home and rental use of a residence with significant
rental use may be limited by the income generated by the property (after deducting business
and rental expenses unrelated to the home and after deducting mortgage interest and real
property taxes allocated to the business or rental use of the home). Disallowed expenses are
carried over and treated as incurred in the next year.

The treatment of home offices and vacation homes are also dissimilar. By definition, a home
office is located in the taxpayer’s “home” and the home office must be used exclusively for
business purposes. In contrast, the tax consequences of owning a second home depend on the
extent to which the property is used for personal and for rental purposes. Personal use of a
rental property is allowed. This is not the case for home offices.

32. [LO 6] Are employees or self-employed taxpayers more likely to qualify for the home office
deduction? Explain.

Self-employed taxpayers are more likely to qualify for the home office deduction. Both must
meet the requirement of using the home office as either (1) the principal place of business for
any of the taxpayer’s trade or businesses or (2) as a place to meet with patients, clients, or
customers in the normal course of business. However, an employee must meet the additional
requirement of using the home office for the convenience of the employer. Thus, self-
employed taxpayers are more likely to qualify for the home office deduction.
33. [LO 6] Compare and contrast the manner in which employees and employers report home
office deductions on their tax returns.

Both employees and employers will determine the amount of their eligible home office
expenses in the same manner. However, each is subject to different limitations and reports
the deduction in different places on the tax return. An employer reports his home office
deduction on Schedule C of his 1040 and is limited to his Schedule C net income before
deducting the home office expense. Thus, an employer’s home office deduction is a for AGI
deduction.
An employee will report his home office expenses as unreimbursed employee business
expenses that are itemized deductions subject to the 2% of AGI floor. Thus, an employee’s
home office deduction is a from AGI deduction.

34. [LO 6] For taxpayers qualifying for home office deductions, what are considered to be
indirect expenses of maintaining the home? How are these expenses allocated to personal and
home office use? Can taxpayers choose to calculate home office expenses without regard to
actual expenses allocated to the home office? Explain.

Indirect expenses are expenses incurred in maintaining and using the home. Indirect
expenses include insurance, utilities, interest, real property taxes, general repairs, and
depreciation on the home as if it were used entirely for business purposes. Under the actual
expense method for determining home office expenses, indirect expenses allocated to the
home office space are deductible. If the rooms in the home are roughly of equal size, the
taxpayer may allocate the indirect expenses to the business portion of the home based on the
number of rooms. Alternatively, the taxpayer may allocate indirect expenses based on the
amount of the space or square footage of the business-use room relative to the total square
footage in the home. Each year, taxpayers can elect to use the simplified method of
determining home office expenses or the actual method. Under the simplified method,
taxpayers do not consider actual home office expenses. Rather, they multiply the square
footage of the home office space (limited to 300 square feet) by a $5.00 application rate.
Under this method, taxpayers deduct all property taxes and mortgage interest as itemized
deductions on Schedule A (taxes and interest are not deductible as home office expenses).
Further, under the simplified method, taxpayers do not claim depreciation expense.

35. [LO 6] What limitations exist for self-employed taxpayers in deducting home office
expenses, and how does the taxpayer determine which expenses are deductible and which are
not in situations when the overall amount of the home office deduction is limited?

The total home office deductions other than mortgage interest and real property taxes
allocated to business use of the home allowable for the taxpayer in any given year is limited
to a taxpayer’s Schedule C net income (without any home office expense deductions) minus
mortgage interest and real property taxes allocated to business use of the home. Thus, home
office deductions other than mortgage interest and real property taxes cannot either create
 or increase a loss on the taxpayer’s Schedule C. Amounts that are not deducted in the
current year are carried over and deducted in the next year subject to the same Schedule C
limitation.

The sequence of deductions for the home office follows the exact same sequence of
deductions for homes with significant personal use and significant rental use. Tier 1-type
expenses that would be deductible as itemized deductions (interest and taxes) are deducted
first (and deducted in full regardless of income). Tier 2-type expenses are deducted second,
and Tier 3-type expense (depreciation) is deducted last.

Under the simplified method for calculating home office expenses, deductible home office
expenses are limited to gross revenues from the business minus business expenses not
allocated to the home. Expenses in excess of the limit are not deductible and do not carry
over to subsequent years. Note under the simplified method, home office expenses are
computed by multiplying the square footage of the home office (limited to 300 feet) by a $5
application rate. Under this method, taxpayers deduct all mortgage interest and property
taxes as itemized deductions only. Further, they do not deduct any depreciation expense on
the home.

36. [LO 2, LO 6] A self-employed taxpayer deducts home office expenses, including

depreciation expense. The taxpayer then sells the home at a $100,000 gain. Assuming the
taxpayer meets the ownership and use tests, does the full gain qualify for exclusion? Explain.

No. When a taxpayer deducts depreciation as a home office expense, the depreciation
expense reduces the taxpayer’s basis in the home. Consequently, when the taxpayer sells the
home, the gain on the sale will be greater than it would have been had depreciation not been
deducted. Further, the gain on the sale of the home attributable to depreciation is not eligible
to be excluded under the home sale exclusion provisions (except for depreciation attributable
to periods before May 6, 1997). This gain is treated as unrecaptured §1250 gain and is
subject to a maximum 25% tax rate.

Problems

37. [LO 1] Several years ago, Junior acquired a home that he vacationed in part of the time and
rented out part of the time. During the current year Junior:
 Personally stayed in the home for 22 days.
 Rented it to his favorite brother at a discount for 10 days.
 Rented it to his least favorite brother for eight days at the full market rate.
 Rented it to his friend at a discounted rate for four days.
 Rented the home to third parties for 58 days at the market rate.
 Did repair and maintenance work on the home for two days.
  Marketed the property and made it available for rent for 150 days during the year (in
addition to the days mentioned above).
How many days of personal use and how many days of rental use did Junior experience on
the property during the year?

Junior has 44 days of personal use and 60 days of rental use. Personal use days include the
22 days used personally, the combined 18 days rented to relatives, and the 4 days rented out
at a discount. The rental days include the 58 days rented out to third parties at the market
rate and the 2 days for repairs and maintenance.

38. [LO 1] Lauren owns a condominium. In each of the following alternative situations,
determine whether the condominium should be treated as a residence or nonresidence for tax
purposes?
a. Lauren lives in the condo for 19 days and rents it out for 22 days.
b. Lauren lives in the condo for 8 days and rents it out for 9 days
c. Lauren lives in the condo for 80 days and rents it out for 120 days
d. Lauren lives in the condo for 30 days and rents it out for 320 days.

a. Residence: personal use (19 days) exceeds 14 days and 10% of rental days (2.2)
b. Nonresidence: Personal use does not exceed 14 days.
c. Residence: personal use (80 days) exceeds 14 days and 10% of rental days (12)
d. Nonresidence: Personal use (30 days) exceeds 14 days but not 10% of rental days (32).

39. [LO 2] Steve and Stephanie Pratt purchased a home in Spokane, Washington for $400,000.
They moved into the home on February 1 of year 1. They lived in the home as their primary
residence until June 30 of year 5, when they sold the home for $700,000.
a. What amount of gain on the sale of the home are the Pratts required to include in
taxable income?
b. Assume the original facts, except that Steve and Stephanie live in the home until
January 1 of year 3, when they purchase a new home and rent out the original home.
They finally sell the original home on June 30 of year 5 for $700,000. Ignoring any
issues relating to depreciation taken on the home while it is being rented, what
amount of realized gain on the sale of the home are the Pratts required to include in
taxable income?
c. Assume the same facts as in (b), except that the Pratts live in the home until January
of year 4, when they purchase a new home and rent out the first home. What amount
of realized gain on the sale of the home will the Pratts include in taxable income if
they sell the first home on June 30 of year 5 for $700,000?
d. Assume the original facts, except that Stephanie moves in with Steve on March 1 of
year 3 and the couple is married on March 1 of year 4. Under state law, the couple
jointly owns Steve’s home beginning on the date they are married. On December 1 of
 year 3, Stephanie sells her home that she lived in before she moved in with Steve. She
excludes the entire $50,000 gain on the sale on her individual year 3 tax return. What
amount of gain must the couple recognize on the sale in June of year 5?

a. $0. They are allowed to exclude the entire realized gain.

Amount realized from the sale $700,000
Adjusted basis 400,000
Gain realized $300,000

Since the Pratts owned and used the Spokane home for at least 2 years during the 5-year
period ending on the date of the sale, they qualify for the gain exclusion. The maximum
exclusion for married taxpayers filing jointly is $500,000. Because the exclusion is more
than the gain realized on the sale, the entire gain is excluded from taxation. The Pratts
will not be required to pay any taxes on the gain on the sale of their home.

b. $300,000.
Because the Pratts used the home as their principal residence for less than 2 years
(February 1 of year 1 to January 1 of year 3) and their reason for leaving wasn’t due to
unusual circumstances they don’t qualify for the home sale exclusion. Consequently, they
must recognize all $300,000 of gain realized on the sale.

c. $0.
The Pratts owned and used the home for at least two years (February 1 of year 1 to
January of year 4) during the five-year period ending on the date of sale, so they qualify
for the exclusion. Consequently, the Pratts can exclude the entire $300,000 realized gain
from taxable income.

d. $50,000.
Steve meets the ownership and use test but Stephanie does not (even though she meets the
use test) because she sold her own home on December 1, year 3 and excluded the entire
gain on the sale of her home. She is not eligible to claim another exclusion for two years
after December 1, year 3. Consequently, Steve qualifies for the $250,000 exclusion (not
the $500,000 exclusion because Stephanie does not qualify). Steve (and Stephanie) must
recognize $50,000 of the $300,000 gain.

40. [LO 2] Steve and Stephanie Pratt purchased a home in Spokane, Washington for $400,000.
They moved into the home on February 1, of year 1. They lived in the home as their primary
residence until November 1 of year 1 when they sold the home for $500,000. The Pratts’
marginal ordinary tax rate is 35 percent.
a. Assume that the Pratts sold their home and moved because they didn’t like their
neighbors. How much gain will the Pratts recognize on their home sale? At what rate, if
any, will the gain be taxed?
 b. Assume the Pratts sell the home because Stephanie’s employer transfers her to an
office in Utah. How much gain will the Pratts recognize on their home sale?
c. Assume the same facts as in (b), except that the Pratts sell their home for $700,000.
How much gain will the Pratts recognize on the home sale?
d. Assume the same facts as (b), except that on December 1 of year 0 the Pratts sold their
home in Seattle and excluded the $300,000 gain from income on their year 0 tax return.
How much gain will the Pratts recognize on the sale of their Spokane home?

a. $100,000.
Amount realized from the sale $500,000
Adjusted basis 400,000
Gain realized $100,000

The Pratts owned and used the Spokane home for only 9 months (February 1 to
November 1 of year 1), and so they fail the ownership and use tests required to qualify
for the exclusion. They also don’t qualify for the hardship exception because disliking
one’s neighbors does not meet the “unforeseen circumstances” test. Thus the entire
$100,000 gain is recognized. The gain is taxed at the Pratts' ordinary income rate of 35%
because they did not hold the home (a capital asset) for more than one year, so the gain
is a short-term capital gain, subject to ordinary income rates (note that this assumes that
they did not have any capital losses). Note that if the Pratt’s AGI exceeds $250,000 (if
they file jointly), the gain on the sale will be considered investments for purposes of
computing the 3.8% net investment income tax.

b. $0.
A change in employment qualifies as an unforeseen circumstance,” so the Pratts won’t be
disqualified for the exclusion. However, the maximum available exclusion must be
reduced to reflect the amount of time the Pratts owned and used the Spokane home
relative to the two-year ownership and use requirements as follows:

Maximum exclusion × number of months taxpayers met the use and ownership tests
24 months

$500,000 × 9 months = $187,500

24 months

The Pratt’s can exclude up to $187,500 of gain on the sale. They realized a gain of only
$100,000 ($500,000 – 400,000). Consequently, the Pratts are not required to pay any
taxes on the gain on the sale of the home.

c. $112,500.
A change in employment qualifies as an unforeseen circumstance, so the Pratts won’t be
disqualified from the exclusion. However, the maximum available exclusion must be
 reduced to reflect the amount of time the Pratts owned and used the Spokane home
relative to the two-year ownership and use requirements as follows:

Maximum exclusion × number of months taxpayers met the use and ownership tests
24 months

$500,000 × 9 months = $187,500

24 months

The Pratt’s can exclude up to $187,500 of gain on the sale. Because they realized a gain
of only $300,000 ($700,000 – 400,000) they are able to exclude $187,500 of the gain
from income but they must include $112,500 in their income. The gain is taxed at the
Pratts’ ordinary tax rate because they did not own the home (a capital asset) for more
than a year before they sold it.

d. $0.
Same answer as b. The rule that prohibits taxpayers from claiming an exclusion more
than once every two years does not apply to taxpayers who are selling homes under
hardship circumstances.

41. [LO 2] Steve Pratt, who is single, purchased a home in Spokane, Washington for $400,000.
He moved into the home on February 1 of year 1. He lived in the home as his primary
residence until June 30 of year 5, when he sold the home for $700,000.
a. What amount of gain will Steve be required to recognize on the sale of the home?
b. Assume the original facts, except that the home is Steve’s vacation home and he
vacations there four months each year. Steve does not ever rent the home to others. What
gain must Steve recognize on the home sale?
c. Assume the original facts except that Steve married Stephanie on February 1 of year 3
and the couple lived in the home until they sold it in June of year 5. Under state law,
Steve owned the home by himself. How much gain must Steve and Stephanie recognize
on the sale (assume they file a joint return in year 5).

a. $50,000.
Amount realized from the sale $700,000
Adjusted basis 400,000
Gain realized $300,000

Since Steve owned and used the Spokane home for at least 2 years during the 5-year
period ending on the date of the sale, he qualifies for the gain exclusion. The maximum
exclusion for single taxpayers is $250,000. This exclusion will reduce Steve’s recognized
gain to $50,000 ($300,000 gain realized less the $250,000 exclusion).

b. $300,000 gain recognized.

 Amount realized from the sale $700,000
Adjusted basis 400,000
Gain realized $300,000
Exclusion 0
Gain recognized $300,000

Steve must recognize all of the realized gain because he does not meet the use test. That
is, the home was not his principal residence for two years during the five-year period
ending on the date of the sale.

c. $0 gain recognized.
They realized a $300,000 gain on the sale. However, the couple qualifies for the married
filing joint exclusion of $500,000 because Steve meets the ownership test and Steve and
Stephanie meet the principal use test. Consequently, they can exclude the entire gain.

42. [LO 2] Celia has been married to Daryl for 52 years. The couple has lived in their current
home for the last 20 years. On October of year 0, Daryl passed away. Celia sold their home
and moved into a condominium. What is the maximum exclusion Celia is entitled to if she
sells the home on December 15 of year 1?

Celia may exclude up to $500,000 of gain on the sale of her home because she sold it within
two years of the date of the death of her spouse, she meets the ownership and use tests, and
her husband met the ownership and use tests prior to his death.

43. [LO 2] Sarah (single) purchased a home on January 1, 2008 for $600,000. She eventually
sold the home for $800,000. What amount of the $200,000 gain on the sale does Sarah
recognize in each of the following alternative situations? (Assume accumulated depreciation
on the home was $0.)
a. Sarah used the home as her principal residence through December 31, 2015. She used
the home as a vacation home from January 1, 2016 until she sold it on January 1,
2018.
b. Sarah used the property as a vacation home through December 31, 2015. She then
used the home as her principal residence from January 1, 2016 until she sold it on
January 1, 2018.
c. Sarah used the home as a vacation home from January 1, 2008 until January 1, 2017.
She used the home as her principal residence from January 1, 2017 until she sold it on
January 1, 2018.
d. Sarah used the home as a vacation home from January 1, 2008 through December 31,
2011. She used the home as her principal residence from January 1, 2012 until she
sold it on January 1, 2017.
 a. $0 gain recognized (all $200,000 of gain is excluded). Sarah meets the ownership and
use tests because she has owned the property for two or more years and used it as her
principal residence for at least two out of the last five years, so she can exclude her gain
up to $250,000. She does not have any nonqualified use because the nonqualified use
period does not include the five tax years immediately after she stopped using the home
as a principal residence.

b. $140,000 gain is recognized ($60,000 of gain is excluded). If not for the limitation for
nonqualified use after December 31, 2008, Sarah could have excluded the entire
$200,000 gain. However, because Sarah sold the home after December 31, 2008 and she
had nonqualified use after December 31, 2008, she is not allowed to exclude a
percentage of the gain that would otherwise be excluded. The percentage of the gain that
is not excluded is a fraction, the numerator of which is the nonqualified use after
December 31, 2008, and the denominator is the amount of time she owned the property.
In this case, the numerator of the disallowance fraction is 7 years of post-2008
nonqualified use (January 1, 2009 through December 31, 2015) and the denominator is
10 years of ownership (January 1, 2008 through January 1, 2018) (7/10 = 70%). The
gain that is not eligible for exclusion is $140,000 ($200,000 × 70%).

c. $200,000 gain recognized. $0 gain is excluded. While Sarah meets the ownership test,
she does not meet the use test because she used the property as her principal residence
for less than two of the five years preceding the sale.

d. $66,667 of gain is recognized and $133,333 is excluded. If not for the limitation for
nonqualified use after December 31, 2008, Sarah could have excluded the entire
$200,000 gain. However, because Sarah sold the home after December 31, 2008 and she
had nonqualified use after December 31, 2008, she is not allowed to exclude a
percentage of the gain that would otherwise be excluded. The percentage of the gain that
is not excluded is a fraction, the numerator of which is the nonqualified use after
December 31, 2008, and the denominator is the amount of time she owned the property.
In this case, the numerator of the disallowance fraction is three years of post-2008
nonqualified use (2009-2011) and the denominator is nine years of ownership (2008-
2017) (3/9 = 1/3). So the gain not eligible for exclusion is $66,667 ($200,000 × 33.33%).

44. [LO 2] Troy (single) purchased a home in Hopkinton, Massachusetts, on January 1, 2007 for
$300,000. He sold the home on January 1, 2017 for $320,000. How much gain must Troy
recognize on his home sale in each of the following alternative situations?
a. Troy rented the home out from January 1, 2007 through November 30, 2008. He
lived in the home as his principal residence from December 1, 2008 through the date
of sale. Assume accumulated depreciation on the home at the time of sale was $7,000.
b. Troy lived in the home as his principal residence from January 1, 2007 through
December 31, 2012. He rented the home from January 1, 2013 through the date of the
sale. Assume accumulated depreciation on the home at the time of sale was $2,000.
 c. Troy lived in the home as his principal residence from January 1, 2007 through
December 31, 2014. He rented out the home from January 1, 2015 through the date of
the sale. Assume accumulated depreciation on the home at the time of sale was $0.
d. Troy rented the home from January 1, 2007 through December 31, 2012. He lived in
the home as his principal residence from January 1, 2013 through December 31,
2013. He rented out the home from January 1, 2014 through December 31, 2014 and
he lived in the home as his principal residence from January 1, 2015, through the date
of the sale. Assume accumulated depreciation on the home at the time of sale was $0.

a. $7,000 of gain recognized. Troy meets the ownership and use tests but gain created by
the accumulated depreciation is not eligible for exclusion. Troy realized a gain of
$27,000 ($320,000 amount realized minus $293,000 adjusted basis (basis reduced by
$7,000 of accumulated depreciation). Troy does not have any nonqualified use since he
did not rent out the property after 2008.

b. $22,000 gain recognized. Troy meets the ownership test but he fails the use test because
he did not use the home as his principal residence for two years between January 1, 2012
and January 1, 2017 (five-year period ending on the date of sale). During this five-year
period, he lived in the home as his principal residence from January 1, 2012 through
December 31, 2012 which is less than two years. Troy’s gain is $22,000 ($320,000 -
$298,000). Note that the basis of the home was reduced by the $2,000 of accumulated
depreciation.

c. $0 gain recognized. Troy meets the ownership and use tests. Further, the period from
January 1, 2015, through the date of the sale is not nonqualified use because
nonqualified use does not include any period during the five-year period ending on date
of sale that is after the last date the taxpayer used the home as a principal residence.

d. $10,000 of gain recognized. Troy meets the ownership and use requirements. However,
his use from January 1, 2009 through December 31, 2012 (four years) and his use from
January 1, 2014 through December 31, 2014 (one year) is nonqualified use (post 2008
use as other than principal residence and does not extend beyond his last use of the home
as a principal residence). Troy had five years of nonqualified use (4 + 1) of the home that
he owned for ten years (January 1, 2007 through January 1, 2017). Consequently, of the
$20,000 gain realized, Troy must recognize half of the gain or $10,000 ($20,000 × 5/10).

45. [LO 3] Javier and Anita Sanchez purchased a home on January 1, 2017 for, $500,000 by
paying $200,000 down and borrowing the remaining $300,000 with a 7 percent loan secured
by the home. The loan requires interest-only payments for the first five years. The Sanchezes
would itemize deductions even if they did not have any deductible interest. The Sanchezes’
marginal tax rate is 30 percent.
a. What is the after-tax cost of the interest expense to the Sanchezes in 2017?
 b. Assume the original facts, except that the Sanchezes rent a home and pay $21,000 in
rent during the year. What is the after-tax cost of their rental payments in 2017?
c. Assuming the interest expense is their only itemized deduction for the year and that
Javier and Anita file a joint return, have great eyesight, and are under 60 years of age,
what is the after-tax cost of their 2017 interest expense?

a. $14,700.
The $300,000 loan is treated as acquisition indebtedness, since it was to initially acquire
the home. Interest on up to $1,000,000 of acquisition indebtedness is deductible as an
itemized deduction. Since the $300,000 loan principal is less than the limit, all of the
interest associated with the loan is deductible. The after-tax cost of the interest expense is
calculated as follows:

Description Amount Explanation

(1) Before-tax interest expense $21,000 $300,000 × 7%. All deductible.
(2) Marginal tax rate × 30%
(3) Tax savings from interest expense $6,300 (1) × (2)
After-tax cost of interest expense $14,700 (1) – (3)

b. $21,000.
Because rental payments are not deductible, they do not generate any tax savings, so the
before- and after-tax cost of the rental payments is the same.

c. $18,510.
Because the Sanchezes had no other itemized deductions, their interest expense only
produces a benefit to them to the extent that it exceeds the standard deduction, calculated
as follows:

Description Amount Explanation

(1) Before-tax interest expense $21,000 $300,000 × 7%. All deductible.
(2) Standard deduction 12,700 MFJ
(3) Interest in excess of standard $8,300 (1) – (2)
deduction
(4) Marginal tax rate × 30%
(5) Tax savings from interest expense $2,490 (3) × (4)
After-tax cost of interest expense $18,510 (1) – (5)

46. [LO 3] Javier and Anita Sanchez purchased a home on January 1 of year 1 for $500,000 by
paying $50,000 down and borrowing the remaining $450,000 with a 7 percent loan secured
by the home. The loan requires interest-only payments for the first five years. The Sanchezes
would itemize deductions even if they did not have any deductible interest.
 a. Assume the Sanchezes also took out a second loan (on the same day as the first loan)
secured by the home for $80,000 to fund expenses unrelated to the home. The interest
rate on the second loan is 8 percent. The Sanchezes make interest-only payments on the
loan in year 1. What is the maximum amount of their deductible interest expense (on both
loans combined) in year 1?
b. Assume the original facts and that the Sanchezes take out a second loan (on the same
day as the first loan) secured by the home in the amount of $50,000 to fund expenses
unrelated to the home. The interest rate on the second loan is 8 percent. The Sanchezes
make interest-only payments during the year. What is the maximum amount of their
deductible interest expense (on both loans combined) in year 1?

a. The maximum deductible interest expense is $35,755, using the simplified method
of calculating interest expense.
The first loan of $450,000 is classified as acquisition indebtedness. The second loan of
$80,000 is classified as home-equity indebtedness. The amount of home-equity
indebtedness is limited to the lesser of (1) the fair market value of the qualified residence
in excess of the acquisition debt related to that residence and (2) $100,000 ($50,000 for
married filing separately). The Sanchezes’ home is worth $500,000 ($50,000 down
payment plus the $450,000 acquisition indebtedness). Hence the home-equity
indebtedness is limited to $50,000 which is the lesser of

(1) FMV of residence less acquisition debt ($500,000 - $450,000) = $50,000 or

(2) the amount of home-equity indebtedness or $100,000

Because the total debt secured by the home exceeds the total qualifying debt, the
Sanchezes can use the exact method or the simplified method to determine the total
deductible interest.

Under the exact method, the Sanchezes could deduct $4,000 on the second loan ($50,000
× 8%) and $31,500 on the first loan for a total of $35,500 interest expense.

Under the simplified method the Sanchezes may deduct $35,755 of interest in total,
computed as follows:

$37,900 total interest × $500,000/$530,000 = $35,755. Consequently, simplified method

allows them to deduct more interest in total.

b. $35,500 consisting of $4,000 on the second loan and $31,500 on the acquisition
loan.
In this case, the Sanchezes are able to deduct all of the interest on both loans because the
actual home-equity loan ($50,000) does not exceed the home-equity indebtedness limit
calculated above ($50,000).
47. [LO 3] Javier and Anita Sanchez purchased a home on January 1, year 1 for $500,000 by
paying $200,000 down and borrowing the remaining $300,000 with a 7 percent loan secured
by the home. The loan requires interest-only payments for the first five years. The Sanchezes
would itemize deductions even if they did not have any deductible interest. On January 1, the
Sanchezes also borrowed money on a second loan secured by the home for $75,000. The
interest rate on the loan is 8 percent and the Sanchezes make interest-only payments in year 1
on the second loan.
a. Assuming the Sanchezes use the second loan to landscape the yard to their home, what
is the maximum amount of interest expense (on both loans combined) they are allowed to
deduct year 1?
b. Assume the original facts and that the Sanchezes use the $75,000 loan proceeds for an
extended family vacation. What is the maximum amount of interest expense (on both
loans combined) they are allowed to deduct in year 1?
c. Assume the original facts, except that the Sanchezes borrow $120,000 on the second
loan and they use the proceeds for an extended family vacation and other personal
expenses. What is the maximum amount of interest expense (on both loans combined)
they are allowed to deduct in year 1?

a. $27,000 ($21,000 + $6,000), determined as follows:

The first loan of $300,000 is classified as acquisition indebtedness. The second loan of
$75,000 would likely also be classified as acquisition indebtedness because it was used to
substantially improve the home. Because the Sanchezes’ acquisition indebtedness of
$375,000 ($300,000 + $75,000) does not exceed the $1,000,000 acquisition debt limit,
they may deduct all of the $21,000 interest on the first loan ($300,000 × 7%) and the
entire $6,000 of interest on the second loan ($75,000 × 8%).

b. $27,000 ($21,000 + $6,000), determined as follows:

The Sanchezes can deduct the $21,000 interest on the first loan which is acquisition debt
($300,000 × 7%). The second loan qualifies as a home-equity loan because it was not
used to substantially improve the home. The amount of home-equity indebtedness is
limited to the lesser of (1) the fair market value of the qualified residence in excess of the
acquisition debt related to that residence and (2) $100,000 ($50,000 for married filing
separately). The Sanchezes’ home is worth $500,000 ($200,000 down payment plus the
$300,000 acquisition indebtedness). Hence the home-equity indebtedness is limited to
$75,000 which is the lesser of

(1) FMV of residence less acquisition debt ($500,000 - $300,000) = $200,000, or

(2) the amount of home-equity indebtedness or $100,000,

Thus the Sanchezes can deduct interest on up to $100,000 of home-equity indebtedness.

Because their second loan of $75,000 is below this limit, they can deduct the full $6,000
of interest paid on the second loan ($75,000 × 8%).
 c. $29,143 under the simplified method of computing interest expense as follows:
In this case, the Sanchezes have $420,000 of debt but only $400,000 of qualifying debt
($300,000 acquisition debt + $100,000 qualifying home equity debt). The second loan
qualifies as a home-equity loan because it was not used to substantially improve the
home. The amount of home-equity indebtedness is limited to the lesser of (1) the fair
market value of the qualified residence in excess of the acquisition debt related to that
residence and (2) $100,000 ($50,000 for married filing separately). The Sanchezes’ home
is worth $500,000 ($200,000 down payment plus the $300,000 acquisition indebtedness).
Hence the home-equity indebtedness is limited to $100,000 which is the lesser of

(1) FMV of residence less acquisition debt ($500,000 - $300,000) = $200,000 or

(2) the amount of qualifying home-equity indebtedness of $100,000

In total, the Sanchezes paid $30,600 of interest ($21,000 on the acquisition debt
$300,000 × 7% + $9,600 on the second loan $120,000 × 8%). Because the total debt
secured by the home exceeds the total qualifying debt, the Sanchezes can use the
simplified method or the exact method to determine the total deductible interest.

Under the exact method, they would deduct the $21,000 interest on the first mortgage and
$8,000 on the second mortgage ($100,000 qualifying home equity debt × 8%) for a total
of $29,000.

Under the simplified method the Sanchezes may deduct $29,143 of interest, computed as
follows:

$30,600 total interest × $400,000/$420,000 = $29,143. Assuming the $21,000 interest on

the acquisition debt is deductible in full, $8,143 of the interest on the second loan is
deductible.

In total, the Sanchezes would deduct more interest under the simplified method than
under the exact method.

48. [LO 3] Lewis and Laurie are married and jointly own a home valued at $240,000. They
recently paid off the mortgage on their home. In need of cash for personal purposes unrelated
to the home, the couple borrowed money from the local credit union. How much interest may
the couple deduct in each of the following alternative situations (assume they itemize
deductions no matter the amount of interest)?
a. The couple borrows $40,000 and the loan is secured by their home. They use the loan
proceeds for purposes unrelated to the home. The couple pays $1,600 interest on the
loan during the year and the couple files a joint return.
 b. The couple borrows $10,000 unsecured from the credit union. The couple pays $900
interest on the loan during the year and the couple files a joint return.
c. The couple borrows $110,000 and the loan is secured by their home. The couple pays
$5,200 interest on the loan during the year and the couple files a joint return.
d. The couple borrows $110,000 and the loan is secured by their home. The couple pays
$5,200 interest on the loan during the year and the couple files separate tax returns.
Determine the interest deductible by Lewis only.

a. $1,600. The couple would be able to deduct all of the interest as home equity
indebtedness (limited to $100,000 of principal).

b. $0. Because the loan is for personal purposes and is not secured by the home, the interest
is nondeductible personal interest.

c. $4,727. While the loan is secured by the home, interest is deductible on only $100,000 of
principal. Consequently, the deductible interest is computed as follows: $5,200 ×
$100,000/$110,000.

d. $2,364 (rounded). This is exactly half of the full amount of deductible interest if the
couple had filed jointly. The limit on qualifying home equity indebtedness for married
persons filing separately is $50,000. Because Lewis and Laurie jointly own the home
(presumably 50-50), each spouse is treated as having paid $2,600 of interest.
Consequently, Lewis’s deductible interest is $2,600 × $50,000/55,000.

49. [LO 3] On January 1 of year 1, Arthur and Aretha Franklin purchased a home for $1.5
million by paying $200,000 down and borrowing the remaining $1.3 million with a 7 percent
loan secured by the home.
a. What is the amount of the interest expense the Franklins may deduct in year 1?
b. Assume that in year 2, the Franklins pay off the entire loan but at the beginning of year
3, they borrow $300,000 secured by the home at a 7 percent rate. They make interest-only
payments on the loan during the year. What amount of interest expense may the Franklins
deduct in year 3 on this loan? (Assume the Franklins do not use the loan proceeds to
improve the home.)
c. Assume the same facts as in (b), except that the Franklins borrow $80,000 secured by
their home. What amount of interest expense may the Franklins deduct in year 3 on this
loan? (Assume the Franklins do not use the loan proceeds to improve the home.)

a. $77,000.
Because the acquisition indebtedness limit ($1,000,000) and the home-equity
indebtedness limit ($100,000) are two separate limits, the maximum amount of debt on
which a taxpayer may deduct qualified residence interest is $1,100,000 as long as the
value of the taxpayer’s residence (or residences) is at least $1,100,000. Since the
 Franklin’s home is worth $1.5 million, they can deduct interest on up to $1.1 million.
Thus, the amount of deductible interest on the loan is calculated as follows:

Total interest expense = total loan principal × interest rate

= $1.3 million × 7%
= $91,000

Deductible interest expense = Qualified debt/Total debt × total interest expense

= [$1.1 million/1.3 million] × $91,000
= $77,000

b. $7,000.
Once acquisition indebtedness is established, only payments on principal can reduce the
indebtedness and only additional indebtedness secured by the residence and incurred to
substantially improve the residence can increase it. In this case, the Franklins reduced
their original acquisition indebtedness to zero. Because the Franklins do not use the
additional loan in year 3 to substantially improve their home, the loan cannot be
classified as acquisition indebtedness. Thus, the interest on the loan can only be deducted
to the extent that it qualifies as home-equity indebtedness. $100,000 of the loan qualifies
as home-equity indebtedness and the Franklins may deduct $7,000 of interest paid on the
loan ($100,000 × 7%).

c. $5,600
Similar to part b above, the new loan can only be classified as acquisition indebtedness
to the extent that the loan proceeds are used to substantially improve the residence.
However, in this scenario, the Franklins will be able to deduct the full $5,600 ($80,000 ×
7%) paid in interest because even though the loan proceeds are not used to substantially
improve the residence, the full amount of interest is deductible because it qualifies as
home-equity indebtedness and the amount of the loan is less than $100,000. Thus, it does
not matter how the Franklins use the loan proceeds as long as the loan is less than
$100,000.

50. [LO 3] In year 0, Eva took out a $50,000 home-equity loan from her local credit union. At
the time she took out the loan, her home was valued at $350,000. At the time of the loan,
Eva’s original mortgage on the home was $265,000. At the end of year 1, her original
mortgage is $260,000. Unfortunately for Eva, during year 1, the value of her home dropped
to $280,000. Consequently, as of the end of year 1, Eva’s home secured $310,000 of home-
related debt but her home is only valued at $280,000. Assuming Eva paid $15,000 of interest
on the original mortgage and $3,500 of interest on the home-equity loan during the year, how
much qualified residence interest can Eva deduct in year 1?

Eva may deduct the full $15,000 of interest on the original loan and the full $3,500 of
interest on the home-equity loan. The determination of the fair market value of the home (in
 order to determine the amount of home equity) is made on the date that the last debt is
secured by the home. In this case, the determination would be the date that Eva took out the
$50,000 loan. Because the home was valued at $350,000 at that time, the entire $50,000 is
considered to be home-equity indebtedness even though the value of the home subsequently
dropped to the point that she does not have $50,000 of available equity in the home. Thus, in
year 1, Eva would be able to deduct the full $15,000 interest on the original mortgage and
the full $3,500 from the home-equity loan.

51. [LO 3] On January 1 of year 1, Jason and Jill Marsh acquired a home for $500,000 by paying
$400,000 down and borrowing $100,000 with a 7 percent loan secured by the home. On
January 1, of year 2, the Marshes needed cash so they refinanced the original loan by taking
out a new $250,000 7 percent loan. With the $250,000 proceeds from the new loan, the
Marshes paid off the original $100,000 loan and used the remaining $150,000 to fund their
son’s college education.
a. What amount of interest expense on the refinanced loan may the Marshes deduct in
year 2?
b. Assume the original facts except that the Marshes use the $150,000 cash from the
refinancing to add two rooms and a garage to their home. What amount of interest
expense on the refinanced loan may the Marshes deduct in year 2?

a. $14,000, determined as follows:

Because the Marshes paid off all of their original acquisition indebtedness and did not
increase it by making substantial improvements on their home, their acquisition
indebtedness remains at $100,000. Therefore, the Marshes may deduct interest on
$100,000 of the acquisition indebtedness portion of the loan for the year. This amounts to
$7,000 ($100,000 × 7%). They may also deduct interest on $100,000 of home equity
indebtedness. Home-equity indebtedness is limited to the lesser of (1) $100,000 or (2) the
fair market value of the qualified residence in excess of the acquisition debt related to the
residence. Assuming the home is worth at least $250,000, the Marshes may also deduct
interest on $100,000 of home equity loan for the year. This amounts to $7,000 ($100,000
× 7%). In total, the Marshes may deduct $14,000 of interest on the refinanced loan.

b. $17,500.
In this case, because the Marshes used the loan proceeds to add on to their house, the
entire refinanced loan qualifies as acquisition indebtedness. Because the total acquisition
indebtedness is under $1,000,000, the Marshes may deduct all of the interest on the
refinanced loan. The interest on the loan and the Marshes’ deduction is $17,500
($250,000 × 7%).

52. [LO 3] {Planning} On January 1, year 1 Brandon and Alisa Roy purchased a home for $1.5
million by paying $500,000 down and borrowing the remaining $1 million with a 7 percent
loan secured by the home. Later the same day, the Roys took out a second loan, secured by
the home, in the amount of $300,000.
a. Assuming the interest rate on the second loan is 8 percent. What is the maximum
amount of the interest expense the Roys may deduct on these two loans (combined) in
year 1?
b. Assuming the interest rate on the second loan is 6 percent, what is the maximum
amount of interest expense the Roys may deduct on these two loans (combined) in year
1?

a. $79,538.
Because the acquisition indebtedness limit ($1,000,000) and the home-equity
indebtedness limit ($100,000) are two separate limits, the maximum amount of debt on
which a taxpayer may deduct qualified residence interest is $1,100,000 as long as the
value of the taxpayer’s residence (or residences) is at least $1,100,000. Since the Roy’s
home is worth $1.5 million, they can deduct interest on up to $1.1 million. The Roys have
two options for determining the amount of deductible interest. First, they could deduct a
pro-rata portion of the interest expense from each loan (simplified method). Under this
option, their deductible interest expense would be calculated as follows:

Option 1: Total interest expense = [acquisition debt × interest rate] + [home equity debt
× interest rate]
= [$1 million × 7%] + [$300,000 × 8%]
= $94,000
Deductible interest expense= Qualified debt/Total debt × total interest expense
= [$1.1 million/1.3 million] × $94,000
= $79,538

Alternatively, the Roys could deduct the interest based on the order in which the loans
were taken out (exact method). Under this option, the Roy’s deductible interest expense
would be as follows:

Option 2: Deductible interest expense

$1 million × 7% = $70,000
$100,000 × 8% = $8,000
Deductible interest expense = $78,000

The Roys would maximize their interest expense deductions by using option 1 (the
simplified method). This option generates $1,538 more in interest deductions than option
2.

b. $76,000.
Because the acquisition indebtedness limit ($1,000,000) and the home-equity
indebtedness limit ($100,000) are two separate limits, the maximum amount of debt on
 which a taxpayer may deduct qualified residence interest is $1,100,000 as long as the
value of the taxpayer’s residence (or residences) is at least $1,100,000. Since the Roy’s
home is worth $1.5 million, they can deduct interest on up to $1.1 million. The Roys have
two options for determining the amount of deductible interest. First, they could deduct a
pro-rata portion of the interest expense from each loan (simplified method). Under this
option, their deductible interest expense would be calculated as follows:

Option 1: Total interest expense = [acquisition debt × interest rate] + [home equity debt
× interest rate]
= [$1 million × 7%] + [$300,000 × 6%]
= $88,000
Deductible interest expense= Qualified debt/Total debt × total interest expense
= [$1.1 million/1.3 million] × $88,000
= $74,462

Alternatively, the Roys could deduct the interest based on the order in which the loans
were taken out (exact method). Under this option, the Roy’s deductible interest expense
would be as follows:

Option 2: Deductible interest expense

$1 million × 7% = $70,000
$100,000 × 6% = $6,000
Deductible interest expense = $76,000

The Roys would maximize their interest expense deductions by using option 2 (the exact
method). This option generates $1,538 more in interest deductions than option 1 (the
simplified method).

53. [LO 3] {Research} Jennifer has been living in her current principal residence for three years.
Six months ago Jennifer decided that she would like to purchase a second home near a beach
so she can vacation there for part of the year. Despite her best efforts, Jennifer has been
unable to find what she is looking for. Consequently, Jennifer recently decided to change
plans. She purchased a parcel of land for $200,000 with the intention of building her second
home on the property. To acquire the land, she borrowed $200,000 secured by the land.
Jennifer would like to know whether the interest she pays on the loan before construction on
the house is completed is deductible as mortgage interest.
a. How should Jennifer treat the interest if she has begun construction on the home and
plans to live in the home in 12 months from the time construction began?
b. How should Jennifer treat the interest if she hasn’t begun construction on the home,
but plans to live in the home in 15 months?
c. How should Jennifer treat the interest if she has begun construction on the home but
doesn’t plan to live in the home for 37 months from the time construction began?
 See Reg §1.163-10T(p)(5).

a. Unless the taxpayer has begun construction of a home on the land that the taxpayer
can occupy within 24 months, the land would be considered an investment and the
interest paid on the second mortgage would not qualify as deductible mortgage interest.
Because Jennifer will be in the home within 12 months, the interest qualifies as mortgage
interest.

b. Because Jennifer has not begun construction on the home, the interest on the loan is
not eligible for mortgage interest even though Jennifer will live in the home in 15 months.
She would be able to deduct the interest as investment interest expense (subject to
limitations on the expense) if she itemizes her deductions.

c. Even though she has begun construction, because Jennifer will not occupy the home
within 24 months the interest expense does not qualify as mortgage interest. However,
she would be able to deduct it as an itemized deduction for investment interest expense
(subject to limitations on investment interest expenses deductibility).

54. [LO 3] {Planning} Rajiv and Laurie Amin are recent college graduates looking to purchase a
new home. They are purchasing a $200,000 home by paying $20,000 down and borrowing
the other $180,000 with a 30-year loan secured by the home. The Amins have the option of
(1) paying no discount points on the loan and paying interest at 8 percent or (2) paying 1
discount point on the loan and paying interest of 7.5 percent. Both loans require the Amins to
make interest-only payments for the first five years. Unless otherwise stated, the Amins
itemize deductions irrespective of the amount of interest expense. The Amins are in the 25
percent marginal ordinary income tax bracket.
a. Assuming the Amins do not itemize deductions, what is the break-even point for
paying the point to get a lower interest rate?
b. Assuming the Amins do itemize deductions, what is the break-even point for paying
the point to get a lower interest rate?
c. Assume the original facts except that the home costs $325,000 and the amount of the
loan is $300,000. What is the break-even point for the Amins for paying the point to get a
lower interest rate?
d. Assume the original facts except that the $180,000 loan is a refinance instead of an
original loan. What is the break-even point for paying the point to get a lower interest
rate?
e. Assume the original facts except that the amount of the loan is $300,000 and the loan is
a refinance and not an original loan. What is the break-even point for paying the point to
get a lower interest rate?

a. 2 years.

Cost of paying 1 point= loan principal × 1%

 =$180,000 × 1%
=$1,800

Because the Amins do not itemize deductions, they will receive no tax benefit from the
deduction for the points paid. Consequently, the after-tax cost of the point is the same as
the before-tax cost of the point—$1,800. The Amins need to determine how long it will
take them to recoup this cost due to a lower interest rate. To do this, they should divide
the after-tax cost of paying the point by the yearly after-tax interest savings from the
point. The after-tax cost of paying the point is $1,800. The after-tax savings due to a
lower interest rate is $900 calculated as follows:

Before-tax savings due to a lower interest rate = $180,000 loan × (8% - 7.5%)
= $900

Because the Amins are not itemizing deductions, additional interest payments do not
generate any tax savings, therefore the after-tax savings from the lower interest rate is
the same as the before-tax savings of $900.

The break-even period, then, is 2 years ($1,800 after-tax cost of the point/$900 after-tax
annual savings from the lower interest rate).

b. 2 years.

Loan summary: $180,000; 8% rate with no

points. 7.5% rate with 1 point. The Amins pay
only interest for the first five years.
Description Amounts Calculation
(1) Initial cash outflow from paying 1 point ($1,800) $180,000 × 1%
(2) Tax benefit from deducting points + $450 (1) × 25%
(3) After-tax cost of points ($1,350) (1) + (2)
(4) Before-tax savings per year from 7.5% vs. $900 [$180,000 × (8% –
8% interest rate 7.5%)]
(5) Forgone tax benefit per year of higher ($225) (4) × 25%
interest rate
(6) After-tax savings per year of 7.5% vs. 8% $675 (4) + (5)
interest rate
Break-even point in years 2 years (3) / (6)

The break even period is 2 years. This is the same break-even point for the Amins even if
they don’t itemize deductions.

c. 2 years.
 Loan summary: $300,000; 8% rate with no
points. 7.5% rate with 1 point. The Amins pay
only interest for the first five years.
Description Amounts Calculation
(1) Initial cash outflow from paying 1 point ($3,000) $300,000 × 1%
(2) Tax benefit from deducting points + $750 (1) × 25%
(3) After-tax cost of points ($2,250) (1) + (2)
(4) Before-tax savings per year from 7.5% vs. $1,500 [$300,000 × (8% -
8% interest rate 7.5%)]
(5) Forgone tax benefit per year of higher ($375) (4) × 25%
interest rate
(6) After-tax savings per year of 7.5% vs. 8% $1,125 (4) + (5)
interest rate
Break-even point in years 2 years (3) / (6)

d. 2.6 years.

Loan summary: $180,000; 8% rate with no

points. 7.5% rate with 1 point. The Amins pay
interest only for the first 5 years. 30-year loan.

Description
Amounts Calculation
(1) Initial cash outflow from paying points ($1,800) $180,000 × 1%
(2) Tax benefit from deducting points 0
(3) After-tax cost of points ($1,800) (1) + (2)
(4) Before-tax savings per year from 7.5% vs. [$180,000 × (8% -
8% interest rate $900 7.5%)]
(5) Foregone tax benefit per year of higher (4) × 25%
interest payments ($225)
(6) After-tax savings per year of 7.5% vs. 8% $675 (4) + (5)
interest rate
(7) Annual tax savings from amortizing points $15 (1) / 30 years × 25%
(8) Annual after-tax cash flow benefit of paying $690 (6) + (7)
points
Break-even point in years 2.6 years (3) / (8)

Because this is a refinance, the $1,800 paid for the point is not immediately deductible.
Consequently, the after-tax cost of the point is $1,800. The $1,800 is amortized over 30
years, generating a $60 deduction each year. The $60 deduction will save the Amins $15
in taxes each year ($60 × 25%).
 e. 2.6 years.

Loan summary: $300,000; 8% rate with no

points. 7.5% rate with 1 point. The Amins pay
interest only for the first 5 years. 30-year loan.

Description
Amounts Notes
(1) Initial cash outflow from paying points ($3,000) $300,000 × 1%
(2) Tax benefit from deducting points 0
(3) After-tax cost of points ($3,000) (1) + (2)
(4) Before-tax savings per year from 7.5% vs. [$300,000 × (8% -
8% interest rate $1,500 7.5%)]
(5) Foregone tax benefit per year of higher (4) × 25%
interest payments ($375)
(6) After-tax savings per year of 7.5% vs. 8% $1,125 (4) + (5)
interest rate
(7) Annual tax savings from amortizing points $25 (1) / 30 years × 25%
(8) Annual after-tax cash flow benefit of paying $1,150 (6) + (7)
points
Break-even point in years 2.6 years (3) / (8)

Because this is a refinance, the $3,000 paid for the point is not immediately deductible.
Consequently, the after-tax cost of the point is $3,000. The $3,000 is amortized over 30
years, generating a $100 deduction each year. The $100 deduction will save the Amins
$25 in taxes each year ($100 × 25%).

55. [LO 4] In year 1, Peter and Shaline Johnsen moved into a home in a new subdivision. Theirs
was one of the first homes in the subdivision. In year 1, they paid $1,500 in real property
taxes on the home to the state government, $500 to the developer of the subdivision for an
assessment to pay for the sidewalks, and $900 for real property taxes on land they hold as an
investment. What amount of property taxes are the Johnsens allowed to deduct assuming
their itemized deductions exceed the standard deduction amount before considering any
property tax deductions?

The Johnsens may deduct $2,400 of property taxes as itemized deductions. This includes the
$1,500 paid in property taxes on their home and $900 in property taxes paid on land they are
holding as an investment. However, taxpayers are not allowed to deduct fees paid for water
and sewer services, and assessments for local benefits such as streets and sidewalks. Thus,
the Johnsens may not deduct the $500 assessment fee to pay for sidewalks.
56. [LO 4] Jesse Brimhall is single. In 2017, his itemized deductions were $4,000 before
considering any real property taxes he paid during the year. Jesse’s adjusted gross income
was $70,000 (also before considering any property tax deductions). In 2017, he paid real
property taxes of $3,000 on property 1 and $1,200 of real property taxes on property 2.
a. If property 1 is Jesse’s primary residence and property 2 is his vacation home (he
does not rent it out at all), what is his taxable income after taking property taxes into
account?
b. If property 1 is Jesse’s business building (he owns the property) and property 2 is his
primary residence, what is his taxable income after taking property taxes into
account?
c. If property 1 is Jesse’s primary residence and property 2 is a parcel of land he holds
for investment, what is his taxable income after taking property taxes into account?

a. $57,750.
The property tax on both properties are deductible as itemized deductions because
neither property is used for business or rental activities and the sum of Jesse’s itemized
deductions, including property taxes, exceeds his standard deduction.

Description Amount Calculation

(1) AGI $70,000
(2) Standard deduction (6,350)
(3) Itemized deductions (8,200) $4,000+ $3,000 + $1,200
(4) Personal exemption (4,050)
Taxable income after property taxes $57,750 (1) + (3) + (4)

b. $56,600.
The property tax on the business building is deductible for AGI, and the tax on the
personal residence is deductible as an itemized deduction

Description Amount Calculation

(1) AGI before property taxes $70,000
(2) Business property taxes (3,000) For AGI deduction
(3) AGI 67,000 (1) + (2)
(4) Standard deduction (6,350)

(5) Itemized deductions (including property (5,200) $4,000 + $1,200

taxes)
(6) Greater of standard deduction or (6,350) (5) > (4)
itemized deductions
(7) Personal exemption (4,050)
 Taxable income after property taxes $56,600 (3) + (6) + (7)

c. $57,750.
The answer is the same as part (a). The property taxes on both properties (residence and
investment property) are deductible as itemized deductions because neither property is
used for business or rental activities.

57. [LO 4] Craig and Karen Conder purchased a new home on May 1 of year 1 for $200,000. At
the time of the purchase, it was estimated that the real property tax rate for the year would be
one percent of the property’s value. How much in property taxes on the new home are the
Conders allowed to deduct under each of the following circumstances (the Conders’ itemized
deductions exceed the standard deduction before considering property taxes)?
a. The property tax estimate proves to be accurate. The seller and the Conders paid their
share of the tax. The full property tax bill is paid to the taxing jurisdiction by the end of
the year.
b. The actual property tax bill was 1.05 percent of the property’s value. The Conders paid
their share of the estimated tax bill and the entire difference between the one percent
estimate and the 1.05 percent actual tax bill and the seller paid the rest. The full property
tax bill is paid to the taxing jurisdiction by the end of the year.
c. The actual property tax bill was .95 percent of the property’s value. The seller paid
taxes based on their share of the one percent estimate and the Conders paid the difference
between what the seller paid and the amount of the final tax bill. The full property tax bill
is paid to the taxing jurisdiction by the end of the year.

a. $1,333 ($200,000 × .01 × 8/12). Because the Conders owned the property for 8 of 12
months in year 1, they are allowed to deduct two-thirds (8/12) of the actual property taxes
paid to the taxing jurisdiction for the year.

b. $1,400 ($200,000 × .0105 × 8/12). Because the Conders owned the property for 8 of 12
months in year 1, they are allowed to deduct two-thirds (8/12) of the actual property taxes
paid to the taxing jurisdiction for the year. This is true even though the Conders ended up
paying more than $1,400 to the taxing jurisdiction for the year.

c. $1,267 ($200,000 × .0095 × 8/12). Because the Conders owned the property for 8 of 12
months in year 1, they are allowed to deduct two-thirds (8/12) of the actual property taxes
paid to the taxing jurisdiction for the year. This is true even though the Conders ended up
paying less than $1,267 to the taxing jurisdiction for the year.

58. [LO 4] Kirk and Lorna Newbold purchased a new home on August 1 of year 1 for $300,000.
At the time of the purchase, it was estimated that the real property tax rate for the year would
be .5 percent of the property’s value. Because the taxing jurisdiction collects taxes on a July
1 year-end, it was estimated that the Newbolds would be required to pay $1,375 in property
taxes for the property tax year relating to August through June of year 2 ($300,000 × .005 ×
11/12). The seller would be required to pay the $125 for July of year 1. Along with their
monthly payment of principal and interest, the Newbolds paid $125 to the mortgage company
to cover the property taxes. The mortgage company placed the money in escrow and used the
funds in the escrow account to pay the property tax bill in July of year 2. The Newbolds’
itemized deductions exceed the standard deduction before considering property taxes.
a. How much in property taxes can the Newbolds deduct for year 1?
b. How much in property taxes can the Newbolds deduct for year 2?
c. Assume the original facts except that the Newbolds were not able to collect $125 from
the Seller for the property taxes for July of year 1. How much in property taxes can the
Newbolds deduct for year 1 and year 2?
d. Assume the original facts except that the tax bill for July 1 of year 1 through June 30 of
year 2 turned out to be $1,200 instead of $1,500. How much in property taxes can the
Newbolds deduct in year 1 and year 2?]

a. $0. Homeowners are allowed to deduct property taxes when the actual taxes are paid
to the taxing jurisdiction and not when they make payments for taxes to the escrow
account. Consequently, the Newbolds will deduct their share of the property taxes when
the taxes are actually paid in year 2. They are not allowed to deduct any property taxes
in year 1 because they did not pay any taxes to the taxing jurisdiction during year 1.

b. For tax purposes, it doesn’t matter who actually pays the tax. Assuming the taxes are
paid, the tax deduction is based on the relative amount of time each party held the
property during the year. Thus, the Newbold’s tax deduction is $1,375, calculated as
follows:

Tax deduction = $300,000 × 0.005 × 11/12 (since they held the property for 11 months
of the property tax year)
= $1,375

c. For tax purposes, it doesn’t matter who actually pays the tax. Thus, it doesn’t matter
that the Newbolds were unable to collect $125 from the seller for property taxes.
Assuming the taxes are paid, the tax deduction is based on the relative amount of time
each party held the property during the year. Since no taxes were paid during year 1, no
deduction is allowed for year one. The Newbold’s tax deduction for year 2 is still $1,375,
calculated as follows:

Tax deduction = $300,000 × 0.005 × 11/12 (since they held the property for 11 months
of the property tax year)
= $1,375

d. Since no taxes were paid during year 1, the Newbolds don’t deduct any property
taxes for year one. However, the Newbold’s tax deduction for year 2 is $1,100 calculated
as follows:
 Tax deduction = $1,200 (total tax liability) × 11/12 (number of months property was
held by the Newbolds)
= $1,100

59. [LO 4] {Research} Jenae and Terry Hutchings own a parcel of land as tenants by entirety.
That is, they both own the property but when one of them dies the other becomes the sole
owner of the property. For nontax reasons, Jenae and Terry decide to file separate tax returns
for the current year. Jenae paid the entire $3,000 property tax bill for the land. How much of
the $3,000 property tax payment is each spouse entitled to deduct in the current year?

According to Rev. Rul. 72-79, 1972-1 CB 51, if a husband and wife are co-owners of
property and they are jointly and severally liable for the property tax and they file separate
tax returns for the year, each spouse is allowed to deduct on his or her separate return the
amount of the property taxes he or she paid for the year. In this case, because Jenae paid the
entire $3,000 property tax bill, she is allowed to deduct the entire $3,000 on her separate tax
return.

60. [LO 5] Dillon rented his personal residence at Lake Tahoe for 14 days while he was
vacationing in Ireland. He resided in the home for the remainder of the year. Rental income
from the property was $6,500. Expenses associated with use of the home for the entire year
were as follows:
Real property taxes $3,100
Mortgage interest 12,000
Repairs 1,500
Insurance 1,500
Utilities 3,900
Depreciation 13,000

a. What effect does the rental have on Dillon’s AGI?

b. What effect does the rental have on Dillon’s itemized deductions?

a. Since Dillon resided in his home for at least 15 days during the year and rented the
home for fewer than 15 days, he excludes the rental income from taxable income and
does not deduct the associated rental expenses. So, the rental has no effect on Dillon’s
AGI.

b. He will be allowed to deduct the real property taxes of $3,100 and mortgage interest
of $12,000 as itemized deductions.

Use the following facts to answer problems 61 and 62.

Natalie owns a condominium near Cocoa Beach in Florida. This year, she incurs the
following expenses in connection with her condo:
 Insurance $1,000
Advertising expense 500
Mortgage interest 3,500
Property taxes 900
Repairs & maintenance 650
Utilities 950
Depreciation 8,500

During the year, Natalie rented out the condo for 75 days, receiving $10,000 of gross income.
She personally used the condo for 35 days during her vacation.

61. [LO 5] {Tax Forms} Assume Natalie uses the IRS method of allocating expenses to rental
use of the property.
a. What is the total amount of for AGI (rental) deductions Natalie may deduct in the
current year related to the condo?
b. What is the total amount of itemized deductions Natalie may deduct in the current year
related to the condo?
c. If Natalie’s basis in the condo at the beginning of the year was $150,000, what is her
basis in the condo at the end of the year?
d. Assume that gross rental revenue was $2,000 (rather than $10,000), what amount of for
AGI deductions may Natalie deduct in the current year related to the condo?
e. Using the original facts, complete Natalie’s Form 1040, Schedule E for this property.
Also, partially complete Natalie’s 1040, Schedule A to include her from AGI deductions
related to the condo.

Note that the home falls into the residence with significant rental use category.

a. $10,000, calculated as follows:

Gross rental income $10,000

Tier 1 expenses:
Advertising expense = $500
Mortgage interest = (75/110) × $3,500=$2,386
Property taxes= (75/110) × $900=$614
Less: total Tier 1 expenses (3,500)
Balance $6,500
Tier 2 expenses:
Insurance = (75/110) × $1,000=$682
Repairs & Maintenance = (75/110) × $650=$443
Utilities= (75/110) × $950=$648
Less: total Tier 2 expenses (1,773)
Balance $4,727
 Tier 3 expenses:
Depreciation (75/110) × $8,500= $5,795, but the
deduction is limited to the remaining income of (4,727)
$4,727. The nondeductible portion of $1,068
carries over to the next year.
Balance $0
Total “For AGI” deductions ($3,500 + $1,773 + $4,727) $10,000

b. Natalie may deduct the personal-use portion of the mortgage interest and property taxes
since they are deductible without regard to rental income. Her deductions for these items
are computed as follows:

Mortgage interest [(35/110) × $3,500] $1,114

Real property taxes [(35/110) × $900] 286
Total “from AGI” deductions $1,400

c. $145,273, calculated as follows:

Beginning basis $150,000

Less: depreciation actually deducted (4,727)
Adjusted basis $145,273

d. $3,500. Even though it creates a loss ($2,000 - $3,500), Natalie is allowed to deduct all
of the advertising expense and the portion of the mortgage interest expense and real
property taxes allocated to the rental use of the home as for AGI deductions (these
deductions are not limited to rental revenue). The loss is not subject to the passive loss
rule limitations.
e.
62. [LO 5] Assume Natalie uses the Tax Court method of allocating expenses to rental use of the
property.
a. What is the total amount of for AGI (rental) deductions Natalie may deduct in the
current year related to the condo?
b. What is the total amount of itemized deductions Natalie may deduct in the current year
related to the condo?
c. If Natalie’s basis in the condo at the beginning of the year was $150,000, what is her
basis in the condo at the end of the year?
d. Assume that gross rental revenue was $2,000 (rather than $10,000), what amount of for
AGI deductions may Natalie deduct in the current year related to the condo?

Note that the home falls into the residence with significant rental use category

a. $8,969, calculated as follows:

Gross rental income $10,000

Tier 1 expenses:
Advertising expense = $500
Mortgage interest = (75/365) × $3,500 = $719
Property taxes= (75/365) × $900 = $185
Less: total Tier 1 expenses
 (1,404)
Balance $8,596
Tier 2 expenses:
Insurance = (75/110) × $1,000=$682
Repairs & Maintenance = (75/110) × $650=$443
Utilities= (75/110) × $950=$648
Less: total Tier 2 expenses (1,773)
Balance $6,823
Tier 3 expenses:
Depreciation (75/110) × $8,500= $5,795 (5,795)
Balance—net income from rental of condo $1,028
Total “For AGI” deductions ($1,404 + $1,773 + $5,795) $8,972

b. Natalie may deduct the personal-use portion of the mortgage interest and property
taxes since they are deductible without regard to rental income. Her deductions for these
items are computed as follows:

Mortgage interest [(290/365) × $3,500] $2,781

Real property taxes [(290/365) × $900] $715
Total "from AGI" deductions $3,496

c. $144,205, calculated as follows:

Beginning basis $150,000

Less: depreciation actually deducted (5,795)
Adjusted basis $144,205

d. $2,000. Natalie is allowed to deduct all $1,404 of the tier 1 expenses (advertising
expense and the portion of the mortgage interest expense and real property taxes
allocated to the rental use of the home) as for AGI deductions (these deductions would
not be limited to rental revenue even if it created a loss). Natalie is also able to deduct
$596 of the tier two expenses. In total, she will deduct $2,000 of rental related expenses—
leaving her with $0 net income from the property.

Use the following facts to answer problems 63, 64, and 65.
Alexa owns a condominium near Cocoa Beach in Florida. This year, she incurs the following
expenses in connection with her condo:
Insurance $2,000
Mortgage interest 6,500
Property taxes 2,000
 Repairs & maintenance 1,400
Utilities 2,500
Depreciation 14,500

During the year, Alexa rented out the condo for 100 days. She did not use the condo at all
for personal purposes during the year. Alexa’s AGI from all sources other than the rental
property is $200,000. Unless otherwise specified, Alexa has no sources of passive
income.

63. [LO 5] Assume Alexa receives $30,000 in gross rental receipts.

a. What effect do the expenses associated with the property have on her AGI?
b. What effect do the expenses associated with the property have on her itemized
deductions?

a. Expenses reduce AGI by $28,900. Alexa’s property is treated as a nonresidence with

rental use property because she rented it for 100 days and did not use it all for personal
purposes. The rental deductions are fully deductible for AGI. Thus, the expenses reduce
Alexa’s AGI by $28,900 and the gross rental income increases the AGI by $30,000.
Overall, Alexa’s AGI will be increased by the rental net income of $1,100, calculated as
follows:

Gross rental income $30,000

Expenses:
Insurance (2,000)
Mortgage interest (6,500)
Property taxes (2,000)
Repairs & maintenance (1,400)
Utilities (2,500)
Depreciation (14,500)
Less: total expenses (28,900)
Balance—net rental income $1,100

b. Because Alexa did not use the rental property for personal purposes, all expenses
associated with the property were allocated to rental use and were deducted for AGI.
Thus, the expenses associated with the property have no effect on her itemized
deductions.

64. [LO 5] Assuming Alexa receives $20,000 in gross rental receipts, answer the following
questions:
a. What effect does the rental activity have on her AGI for the year?
b. Assuming that Alexa’s AGI from other sources is $90,000, what effect does the rental
activity have on Alexa’s AGI? Alexa makes all decisions with respect to the property.
 c. Assuming that Alexa’s AGI from other sources is $120,000 what effect does the rental
activity have on Alexa’s AGI? Alexa makes all decisions with respect to the property.
d. Assume that Alexa’s AGI from other sources is $200,000. This consists of $150,000
salary, $10,000 of dividends, $25,000 of long-term capital gain, and net rental income
from another rental property in the amount of $15,000. What effect does the Cocoa Beach
Condo rental activity have on Alexa’s AGI?

Note that the property is a nonresidence with rental use property.

a. Alexa’s AGI will be reduced by $0, calculated as follows:

Gross rental income $20,000

Expenses:
Insurance (2,000)
Mortgage interest (6,500)
Property taxes (2,000)
Repairs & maintenance (1,400)
Utilities (2,500)
Depreciation (14,500)
Less: total expenses (28,900)
Balance—net rental loss ($8,900)

By definition, a rental activity [unless it is a residence with significant rental use (a

vacation home rental)], is considered to be a passive activity. Consequently, losses from
rental property are not allowed to offset other ordinary or investment type income. As a
result, Alexa will include $20,000 of rental income in gross income. She will also get to
deduct $20,000 of expenses related to the rental property. The remaining $8,900 of
expenses (the rental loss) is not deductible this year because (1) the rental activity is a
passive activity, (2) Alexa has no passive income from other sources, and (3) Alexa’s AGI
is above the phase-out range ($100,000 - $150,000) so she is not allowed to deduct any
of the loss under the rental real estate exception to the passive loss rules. She may,
however, carry the loss forward to future years in which she has passive income to offset.

b. Reduction of $8,900.
Under a rental real estate exception, a taxpayer who is an “active” participant in the
rental activity may be allowed to deduct up to $25,000 of the rental loss against other
types of income. To be considered an active participant, the taxpayer must (1) own at
least 10% of the rental property and (2) participate in the process of making management
decisions such as approving new tenants, deciding on rental terms, and approving
repairs and capital expenditures. Since Alexa owns 100% of the property, and she makes
all decisions with respect to the property, she is an active participant in the rental
activity. Thus, she meets the rental real estate exception, and, because her AGI is below
$100,000 she is eligible to deduct up to $25,000 of the loss against other types of income.
 In this case, she may deduct the entire $8,900 loss as an ordinary deduction in the
current year.

c. Reduction of $8,900.
Under a rental real estate exception, a taxpayer who is an “active” participant in the
rental activity may be allowed to deduct up to $25,000 of the rental loss against other
types of income. To be considered an active participant, the taxpayer must (1) own at
least 10% of the rental property and (2) participate in the process of making management
decisions such as approving new tenants, deciding on rental terms, and approving
repairs and capital expenditures. The $25,000 maximum exception amount is phased out
by 50 cents for every dollar the taxpayer’s adjusted gross income exceeds $100,000.
Consequently, the entire $25,000 is phased-out when the taxpayer’s adjusted gross
income reaches $150,000.

Since, Alexa owns 100% of the property, and she makes all decisions with respect to the
property, she is an active participant in the rental activity. Thus, she meets the rental real
estate exception, and she may potentially deduct the rental loss as an ordinary deduction
in the current year. However, because her AGI exceeds $100,000, part of the exception
amount is phased out as follows:

Phase-out = [AGI - $100,000] × $.50

= [$120,000 - $100,000] × $.50
= $10,000

Exception amount = $25,000 (maximum) - $10,000 (phase-out) = $15,000

Since Alexa’s rental loss of $8,900 is less than the exception amount of $15,000, she can
deduct the entire $8,900 as an ordinary deduction in the current year.

d. The rental activity reduces her AGI by $8,900. (All transactions described in the
problem decrease her AGI to $191,100.)
Since Alexa has passive income (the rental income from another property), she can
deduct the loss against this passive income. Thus, her net passive income is $6,100
($15,000 rental income - $8,900 rental loss). In summary, she will include $150,000
salary, $10,000 dividends, $25,000 LTCG, and $35,000 rental income ($15,000 +
$20,000) in gross income. She will also be able to deduct all of the expenses related to
the rental property ($28,900) from the income in arriving at AGI. The $8,900 loss from
the rental property reduces her AGI by $8,900.

65. [LO 5] {Planning} Assume that in addition to renting the condo for 100 days, Alexa uses the
condo for 8 days of personal use. Also assume that Alexa receives $30,000 of gross rental
receipts. Answer the following questions:
 a. What is the total amount of for AGI deductions relating to the condo that Alexa may
deduct in the current year? Assume she uses the IRS method of allocating expenses
between rental and personal days.
b. What is the total amount of from AGI deductions relating to the condo that Alexa may
deduct in the current year? Assume she uses the IRS method of allocating expenses
between rental and personal days.
c. Would Alexa be better or worse off after taxes in the current year if she uses the Tax
Court method of allocating expenses?

Note that the home is considered to be a nonresidence with rental use

a. $26,760.
Since Alexa used the condo personally for 8 days, she must allocate the expenses between
personal use and rental use days. As illustrated below, the portion attributable to the
rental days are deductible as “for AGI” deductions.

Gross rental income $30,000

Expenses:
Insurance [100/108] × $2,000 (1,852)
Mortgage interest [100/108] × $6,500 (6,019)
Property taxes [100/108] × $2,000 (1,852)
Repairs & maintenance [100/108] × $1,400 (1,296)
Utilities [100/108] × $2,500 (2,315)
Depreciation [100/108] × $14,500 (13,426)
Less: total expenses (26,760)
Balance—net rental income $3,240
Total “for AGI” deductions $26,760

b. Alexa may deduct the personal-use portion of property taxes since they are
deductible without regard to rental income. However, she is not allowed to deduct the
mortgage interest related to personal-use days because the property no longer qualifies
as a personal residence. Her deduction for the property taxes is calculated as follows:

Real property taxes = (8/108) × $2,000 = $148.

c. The Tax Court method is less favorable in this circumstance because it allocates
less interest expense to the rental activity and more to personal use. The interest expense
allocated to personal use, however, does not qualify for an interest deduction because the
taxpayer does not meet the minimum amount of personal use required for the deduction.
By using the Tax Court method, any mortgage interest allocated to the personal-use days
generates no tax benefit. Also, since this is primarily rental property, the taxpayer may
deduct expenses in excess of income from the property. So, the taxpayer may not be as
concerned about allocating more taxes to the rental property because doing so does not
 limit the taxpayer’s ability to deduct other expenses, as it might with mixed-use property.
Note however, that a loss may not be immediately deductible due to the passive activity
rules.

66. [LO 6] {Tax Forms} Brooke owns a sole proprietorship in which she works as a management
consultant. She maintains an office in her home where she meets with clients, prepares bills,
and performs other work-related tasks. The home office is 300 square feet and the entire
house is 4,500 square feet. Brooke incurred the following home-related expenses during the
year. Unless indicated otherwise, assume Brooke uses the actual expense method to compute
home office expenses.

Real property taxes $ 3,600

Interest on home mortgage 14,000
Operating expenses of home 5,000
Depreciation 12,000
Repairs to home theater room 1,000

a. What amount of each of these expenses is allocated to the home office?

The expenses are allocated to the home office as follows:

Expense Amount Type Allocated to home office

6.667% of indirect (300/4,500 sq.
ft)
Real property taxes $3,600 Indirect $240
Interest on home mortgage 14,000 Indirect 933
Operating expenses of home 5,000 Indirect 333
Depreciation 12,000 Indirect 800
Repairs to home theater room 1,000 Unrelated 0
Total expenses $35,600 $2,306

b. What are the total amounts of tier 1, tier 2, and tier 3 expenses allocated to the home
office?

 Tier 1 expenses: $1,173 ($240 real property + $933 interest on home mortgage).

 Tier 2 expenses: $333 (operating expenses of the home)

 Tier 3 expense: $800 depreciation.

c. If Brooke reported $2,000 of Schedule C income before the home office expense
deduction, what is the amount of her home office expense deduction and what home office
expenses, if any, would she carry over to next year?

$2,000 home office expense in total and $306 depreciation expense carryover to next year.
She would subtract all $1,173 of the tier 1 expenses and all $333 of the tier 2 expenses from
her $2,000 of Schedule C income. This leaves $494 ($2,000 - $1,173 – 333) of net income
before depreciation (tier 3 expense). Because the home office expense deduction can reduce
net income to $0 but not below, Brook may deduct $494 of depreciation expense and carry
the remaining $306 over to next year.

d. Assuming Brooke reported $2,000 of Schedule C income before the home office expense
deduction, complete Form 8829 for Brooks home office expense deduction. Also assume the
value of the home is $500,000 and the adjusted basis of the home (exclusive of land) is
$468,019.
e. Assume that Brooke uses the simplified method for computing home office expenses. If
Brooke reported $2,000 of Schedule C net income before the home office expense deduction,
what is the amount of her home office expense deduction and what home office expenses, if any,
would she carry over to next year?

Home office expense deduction is $1,500 (300 square feet × $5.00 per square foot). The gross
income limit does not apply here because the Schedule C net income before the home office
expense deduction ($2,000) exceeds the home office expenses of $1,500. Because this is less than
Schedule C net income before the home office expense of $2,000 exceeds the $1,500 home office
expense amount. Under the simplified method, taxpayers cannot carryforward expenses to the
next year even when the gross income limits the amount of the home office expense deduction.

Use the following facts to answer problems 67 and 68.

Rita owns a sole proprietorship in which she works as a management consultant. She
maintains an office in her home (500 square feet) where she meets with clients, prepares
bills, and performs other work-related tasks. Her business expenses, other than home office
expenses, total $5,600. The following home-related expenses have been allocated to her
home office under the actual expense method for calculating home office expenses.

Real property taxes $1,600

Interest on home mortgage 5,100
Operating expenses of home 800
Depreciation 1,600

Also, assume that not counting the sole proprietorship, Rita’s AGI is $60,000.

67. [LO 6] {Planning} Assume Rita’s consulting business generated $15,000 in gross income.
a. What is Rita’s home office deduction for the current year?
b. What would Rita’s home office deduction for the current year be if her business
generated $10,000 of gross income instead of $15,000? (Answer for both the actual
expense method and the simplified method).
c. Given the original facts, what is Rita’s AGI for the year?
d. Given the original facts, what types and amounts of expenses will she carry over to
next year?

a. $9,100, using the actual expense method calculated as follows:

Gross Income $15,000

Less: business expenses (5,600)
Balance $9,400
Less: Tier 1 expenses (interest $5,100 + $1,600
taxes) (6,700)
 Balance after tier 1 expenses $2,700
Less Tier 2 expenses (operating expenses) (800)
Balance after tier 2 expenses 1,900
Less Tier 3 expenses (depreciation) (1,600)
Net income from business $300

Rita is allowed to deduct all expenses allocated to the home office ($6,700 interest and
taxes + 800 home operating expenses + depreciation 1,600).

Under the simplified method, Rita’s home office deduction would have been limited to
$1,500 (300 square feet × $5 application rate). However, she also would have been able
to deduct all of the $6,700 for interest and taxes as itemized deductions. This would have
provided her with $1,500 + $6,700 = $8,200 of deductions but this is still less than the
$9,100 in deductions under the actual method

b. Under the actual expense method, she would report a net loss from the business
of $2,300.

Gross Income $10,000

Less: business expenses (5,600)
Balance $4,400
Less: Tier 1 expenses (interest $5,100 + $1,600
taxes) (6,700)
Loss after tier 1 expenses ($2,300)
Less Tier 2 expenses (operating expenses) 0
Loss after tier 2 expenses ($2,300)
Less Tier 3 expenses (depreciation) 0
Net loss from business ($2,300)

Rita is allowed to deduct only the mortgage interest and real property taxes allocated to
the business use of the home. The remaining expenses (tier 2 and tier 3) are suspended
and carried over to next year.

Under the simplified method, Rita would report $2,900 ($4,400 less home office expense
of $1,500) of Schedule C net income but she would have $6,700 more for itemized
deductions for mortgage interest and taxes.

c. Rita’s AGI is $60,300 for the year. This is her AGI without the sole
proprietorship plus the net income from the business ($60,000 + $300).

d. None. Because Rita is allowed to deduct all of the expenses this year, she does
not carry any over to next year.
68. [LO 6] Assume Rita’s consulting business generated $13,000 in gross income for the current
year. Further, assume Rita uses the actual expense method for computing her home office
expense deduction.
a. What is Rita’s home office deduction for the current year?
b. What is Rita’s AGI for the year?
c. Assume the original facts, except that Rita is an employee and not self-employed. (She
uses the home office for the convenience of her employer.) Consequently, she does not
receive any gross income from the (sole proprietorship) business and she does not incur
any business expenses unrelated to the home office. Finally, her AGI is $60,000
consisting of salary from her work as an employee. What effect do her home office
expenses have on her itemized deductions?
d. Assuming the original facts, what types and amounts of expenses will she carry over to
next year?

a. $7,400, calculated as follows:

Gross Income $13,000

Less: business expenses (5,600)
Balance $7,400
Less: Tier 1 expenses (interest $5,100 + $1,600
taxes) (6,700)
Balance after tier 1 expenses $700
Less: Tier 2 expenses (operating expenses $800
before limit) (700)
Balance after tier 2 expenses 0
Less Tier 3 expenses (depreciation $1,600 before
limit) (0)
Net income from business $0

Rita is allowed to deduct a total of $7,400 in home office expenses ($6,700 in interest and
taxes and $700 of home operating expenses).

b. $60,000. This is the $60,000 of AGI without the sole proprietorship plus $0 net
income from the home business.
c. $0. Because Rita is an employee, and is not self-employed, all home-office
deductions are treated as unreimbursed employee business expenses subject to the
2% of AGI floor. Further, because Rita does not have any income from the
business (she does not operate a sole proprietorship), the only deductions she
would be able to claim are Tier 1 expenses for property tax and mortgage
interest. However, because these deductions would be subject to the 2% of AGI
floor, Rita would do best to not claim the home office deduction at all but rather
 deduct the full amount of the interest and property taxes as itemized deductions
on her schedule A as interest and taxes, respectively. This would provide her with
an increase in her itemized deductions of $6,700 ($5,100 interest + $1,600 taxes)
rather than $5,500 ($6,700 minus 2% × $60,000 AGI) if she were to deduct the
home office expense. Note that Rita would not benefit from the simplified method
deduction because she does not have income from the business.
d. Rita will carry over $100 of tier 2 expenses (operating expenses) and $1,600 of tier
3 expenses (depreciation expense) to next year.

69. [LO 2, LO 6] Alisha, who is single, owns a sole proprietorship in which she works as a
management consultant. She maintains an office in her home where she meets with clients,
prepares bills, and performs other work-related tasks. She purchased the home at the
beginning of year 1 for $400,000. Since she purchased the home and moved into it she has
been able to deduct $10,000 of depreciation expenses to offset her consulting income. At the
end of year 3, Alisha sold the home for $500,000. What is the amount of taxes Alisha will be
required to pay on the gain from the sale of the home? Alisha’s ordinary marginal tax rate is
30 percent.

$2,500, calculated as follows:

Amount realized $500,000

Beginning basis $400,000
Less depreciation (10,000)
Adjusted basis $390,000
Gain realized $110,000
Gain eligible for exclusion (gain $100,000
realized minus depreciation
expense)
Less: exclusion amount
(lesser of gain eligible for
exclusion or $250,000) (100,000)

Total gain recognized

(Gain realized minus exclusion) $10,000

When a taxpayer deducts depreciation as a home office expense, the depreciation expense
reduces the taxpayer’s basis in the home. Consequently, when the taxpayer sells the home,
the gain on the sale will be greater than it would have been had depreciation not been
deducted. Further, the gain on the sale of the home attributable to depreciation is not eligible
to be excluded under the home sale exclusion provisions. This gain is treated as
unrecaptured §1250 gain and is subject to a maximum 25% tax rate. Thus, Alisha will owe
$2,500 ($10,000 × 25%) in taxes on the sale. Further, if Alisha’s AGI exceeds $200,000, the
 $10,000 gain recognized on the sale will be considered investment income for purposes of
determining the 3.8% net investment income tax.

Comprehensive Problems

70. {Planning} Derek and Meagan Jacoby recently graduated from State University and Derek
accepted a job in business consulting while Meagan accepted a job in computer
programming. Meagan inherited $75,000 from her grandfather who recently passed away.
The couple is debating whether they should buy or rent a home. They located a rental home
that meets their needs. The monthly rent is $2,250. They also found a three-bedroom home
that would cost $475,000 to purchase. The Jacobys could use Meagan’s inheritance for a
down-payment on the home. Thus they would need to borrow $400,000 to acquire the home.
They have the option of paying 2 discount points to receive a fixed interest rate of 4.5 percent
on the loan or paying no points and receiving a fixed interest rate of 5.75 percent for a 30-
year fixed loan.

Though anything could happen, the couple expects to live in the home for no more than five
years before relocating to a different region of the country. Derek and Meagan don’t have
any school-related debt, so they will save the $75,000 if they don’t purchase a home.
Also, consider the following information:
 The couple’s marginal tax rate is 25 percent.
 Regardless of whether they buy or rent, the couple will itemize their deductions.
 If they buy, the Jacobys would purchase and move into the home on January 1, 2017.
 If they buy the home, the property taxes for the year are $3,600.
 Disregard loan-related fees not mentioned above.
 If the couple does not buy a home, they will put their money into their savings
account where they earn 5 percent annual interest.
 Assume all unstated costs are equal between the buy and rent option.

Required: Help the Jacobys with their decisions by answering the following questions:
a. If the Jacobys decide to rent the home, what is their after-tax cost of the rental for the
first year (include income from the savings account in your analysis)?
b. What is the approximate break-even point in years (or months) for paying the points
to receive a reduced interest rate (to simplify this computation, assume the Jacobys
will make interest-only payments and ignore the time value of money)?
c. What is the after-tax cost of the interest expense and property taxes of living in the
home for 2017? Assume that the Jacoby’s interest rate is 5.75 percent, they do not
pay discount points, they make interest-only payments for the first year, and the
value of the home does not change during the year.
d. Assume that on March 1, 2017, the Jacobys sold their home for $525,000, so that
Derek and Meagan could accept job opportunities in a different state. The Jacobys
used the sale proceeds to (1) pay off the $400,000 principal of the mortgage, (2) pay
a $10,000 commission to their real estate broker, and (3) make a down payment on a
 new home in the different state. However, the new home cost only $300,000. What
gain or loss do the Jacobys realize and recognize on the sale of their home and what
amount of taxes must they pay on the gain, if any (assume they make interest only
payments on the loan)?
e. Assume the same facts as in (d), except that the Jacobys sell their home for $450,000
and they pay a $7,500 commission. What effect does the sale have on their 2017
income tax liability? Recall that the Jacobys are subject to an ordinary marginal tax
rate of 25 percent and assume that they do not have any other transactions involving
capital assets in 2017.

a. $24,188, computed as follows:

Rent the Home

Description Amount Calculation
(1) Monthly rent ($2,250)
(2) Total rent payments for the year (27,000) (1) × 12 months
(3) Interest earned on inheritance 3,750 $75,000 × 5%
(4) Taxes on earnings (938) (3) × 25%
(5) After-tax interest earnings 2,812 (3) + (4)
Total after-tax cost of renting for first year ($24,188) (2) + (5)

b. 1.6 years (19.2 months), computed as follows:

Loan summary: $400,000; 5.75% rate with no

points. 4.5% rate with 2 points ($8,000). Assume the
Jacobys pay interest only for first three years.
Description Amounts Calculation
(1) Initial cash outflow from paying points ($8,000) $400,000 × 2%
(2) Tax benefit from deducting points + 2,000 (1) × 25%
(3) After-tax cost of points ($6,000) (1) + (2)
(4) Before-tax savings per year from 4.5% vs. 5.75% $5,000 [$400,000 × (5.75%
interest rate - 4.5%)]
(5) Forgone tax benefit per year of higher interest ($1,250) (4) × 25%
rate
(6) After-tax savings per year of 4.5% vs. 5.75% $3,750 (4) + (5)
interest rate
Break-even point in years (months) 1.6 years (3) / (6)
(19.2
months)

c. $19,950, computed as follows:

 Description Amount Explanation
(1) Marginal tax rate 25%
(2) Mortgage principal $400,000
(3) Mortgage interest rate 5.75%
(4) First year interest payment (23,000) (2) × (3)
(5) Tax savings from interest payments 5,750 (1) × (4)
(6) After-tax cost of interest payments (17,250) (4) + (5)
(7) Deductible property taxes for year (3,600)
(8) Tax savings from property tax deduction 900 (1) × (7)
(9) After-tax cost of real property taxes (2,700) (7) + (8)
After-tax cost of buying home for 2017 ($19,950) (6) + (9)

d. $40,000 gain realized; $0 recognized gain; $0 taxes payable on gain, computed as

follows:

Description Amount Explanation

(1) Sales proceeds $525,000
(2) Sales commission (10,000)
(3) Amount realized $515,000 (1) + (2)
(4) Basis in home (475,000) Initial purchase price. Assumes interest
only payments on mortgage
(5) Gain realized $40,000 (3) + (4)
(6) Exclusion for sale of home (40,000) Because after 2 months the Jacobys moved
for work reasons, they qualify for a
maximum exclusion on their home of
$41,667 ($500,000 × 2/24)
(7) Gain recognized and taxes $0 (5) + (6), no gain, no taxes on the gain.
payable on gain

e. $32,500 loss realized; $0 recognized loss; $0 tax benefit from loss, computed as
follows:

Description Amount Explanation

(1) Sales proceeds $450,000
(2) Sales commission (7,500)
(3) Amount realized $442,500 (1) + (2)
(4) Basis in home (475,000) Initial purchase price. Assumes interest
only payments on mortgage
(5) Loss realized (32,500) (3) + (4)
Effect of loss on Jacoby’s tax $0 Loss not deductible because it is a personal
 liability loss so no effect on tax liability.

71. James and Kate Sawyer were married on New Year’s Eve of 2016. Before their marriage,
Kate lived in New York and worked as a hair stylist for one of the city’s top salons. James
lives in Atlanta where he works for a public accounting firm earning an annual salary of
$100,000. After their marriage, Kate left her job in New York and moved into the couple’s
newly purchased 3,200-square-foot home in Atlanta. Kate incurred $2,200 of qualified
moving expenses. The couple purchased the home on January 3, 2017 by paying $100,000
down and obtaining a $240,000 mortgage for the remainder. The interest rate on this loan
was 7 percent and the Sawyers made interest-only payments on the loan through June 30,
2017 (assume they paid exactly one-half of a year’s worth of interest expense on the loan by
June 30). On July 1, 2017, because the value of their home had increased to $400,000, the
Sawyers were in need of cash, and interest rates had dropped, the Sawyers refinanced their
home loan. On the refinancing, they borrowed $370,000 at 6 percent interest. They made
interest-only payments on the home loan through the end of the year and they spent $20,000
of the loan proceeds improving their home (assume they paid exactly one-half of a year’s
worth of interest on this loan by year end).
Kate wanted to try her hand at making it on her own in business, and with James’s help, she
started Kate’s Beauty Cuts LLC. She set up shop in a 384-square-foot corner room of the
couple’s home and began to get it ready for business. The room conveniently had a door to
the outside providing customers direct access to the shop. Before she opened the doors to the
business, Kate paid $2,100 to have the carpet replaced with a tile floor. She also paid $1,200
to have the room painted with vibrant colors and $650 to have the room rewired for
appropriate lighting. Kate ran an ad in the local newspaper and officially opened her shop on
January 24, 2017. By the end of the year, Kate’s Beauty Cuts LLC generated $40,000 of net
income before considering the home office deduction. The Sawyers incurred the following
home-related expenditures during 2017:
 $4,200 of real property taxes.
 $2,000 for homeowner’s insurance.
 $2,400 for electricity.
 $1,500 for gas and other utilities.
They determined depreciation expense for their entire house for the year was $8,364.

Also, on March 2, Kate was able to finally sell her one-bedroom Manhattan condominium for
$478,000. She purchased the condo, which she had lived in for six years prior to her
marriage, for $205,000.

Kate owns a vacation home in Myrtle Beach, South Carolina. She purchased the home
several years ago, largely as an investment opportunity. To help cover the expenses of
maintaining the home, James and Kate decided to rent the home out. They rented the home
for a total of 106 days at fair market value (this included eight days that they rented the home
to James’s brother Jack). In addition to the 106 days, Kate allowed a good friend and
customer, Clair, to stay in the home for half-price for two days. James and Kate stayed in the
 home for six days for a romantic getaway and another three days in order to do some repair
and maintenance work on the home. The rental revenues from the home in 2017 were
$18,400. The Sawyers incurred the following expenses associated with the home.
 $9,100 of interest expense.
 $3,400 of real property taxes.
 $1,900 for homeowner’s insurance.
 $1,200 for electricity.
 $1,600 for gas, other utilities, and landscaping.
 $5,200 for depreciation.

Required: Determine the Sawyers’ taxable income for 2017. Disregard self-employment
taxes for Kate. Assume the couple paid $4,400 in state income taxes and files a joint return.
For determining the deductible home office expenses and allocating expenses to the rental,
the Sawyers would like to use the methods that minimize their overall taxable income for the
year.

James and Kate have taxable income of $116,592. See the analysis below.
Description Amount Explanation
Total income
James’s Salary $100,000
Kate’s Schedule C income before 40,000
home office deduction
Home-office deduction (for AGI) (8,470) See Note A below for computation. Not
limited by income limitation
Rent revenue 18,400
Rental expenses (for AGI) (12,005) Tax Court method allows more total
deductions for year ($937 more in
deductions); See Note B below for
computation
Gain on sale of principal residence 23,000 $478,000 – 205,000 = $273,000 gain
after exclusion minus 250,000 exclusion
(1) Total income $160,925
(2) Moving expenses (2,200)
(3) AGI $158,725 (1) + (2)
Itemized deductions:
State income taxes (4,400)
Real property taxes on principal (3,696) $4,200 – 504 (deducted as home office
residence expense) = $3,696
Real property taxes on (2,459) $3,400 – 940(deducted as rental
vacation/rental home expense) =$2,460
Home mortgage interest expense on (16,896) $19,200 – 2,304 (deducted as home
principal residence office expense) = $16,896
 Home mortgage interest expense on (6,582) $9,100 – 2,518 (deducted as rental
vacation/rental home expense) = $6,582
(4) Total itemized deductions (34,033) Standard deduction for MFJ is
$12,700 so James and Kate deduct
itemized deductions.
(5) Personal and dependency (8,100) $4,050 × 2 = $8,100
exemptions
(6) Total from AGI deductions (42,133) (4) + (5)
Taxable income $116,592 (3) + (6)

Note A: Home office deduction computation using the actual expense method:
Home Office Deduction (A) (B) (A) × (B)
Type Amount Office % Home office
(384/3,200 Expense
for indirect)
New flooring Direct $2,100 100% $2,100
New paint for office Direct 1,200 100% 1,200
New office lighting Direct 650 100% 650
Real property taxes Indirect 4,200 12% 504
Home interest expense* Indirect 19,200 12% 2,304
Utilities Indirect 3,900 12% 468
Homeowner’s insurance Indirect 2,000 12% 240
Depreciation Indirect 8,364 12% 1,004
Total expenses $41,614 $8,470

*Total interest expense for the year is computed as follows:

First loan: $240,000 × 7% × ½ of a year = $8,400.
Second loan: $240,000 of initial acquisition debt plus $20,000 of refinanced loan to improve
home (can be considered acquisition indebtedness) plus $100,000 of home equity debt equals
$360,000 of qualifying debt (interest on $10,000 of the $370,000 loan is not deductible).
$360,000 × 6% × ½ = $10,800.
Total interest expense = $19,200 ($8,400 from loan 1 + $10,800 from loan 2).

Note that under the simplified method, the home office expense deduction is $1,500 (300
square feet × $5). Under this method, the Sawyers would be able to deduct an additional
 $2,808 ($504 + $2,304) in itemized deductions for the interest and taxes. Nevertheless, the
deductions allowed under the simplified method are considerably less than those under the
actual expense method.

Note B: Rental expenses: The Sawyers used the rental home as follows: Rental days: 101 (98
rental to unrelated parties at fair market value + 3 maintenance); Personal days: 16 days (6
vacation days + 8 rented to brother + 2 rented at less than fair market value). Because
personal use of 16 is more than the greater of (1) 14 days or (2)10% of the number of rental
days (10.1), their residence qualifies as property with significant personal and significant
rental use (mixed use or vacation home)—this means deductions are limited to gross rental
income. Because the Tax Court method allows them to deduct $937 more deductions overall
(rental + personal taxes and interest), they use the Tax Court method to determine their
deductions from the rental.

Allocation method to
Rental Home Expense Allocation
rental use
IRS method Tax Court
method
(101/365 tier 1
Expense Amount Tier (101/117) 101/117 other)
Interest $9,100 1 $7,856 $2,518
Real estate taxes 3,400 1 2,935 941
Total tier 1 expenses $12,500 1 $10,791 $3,459
Electricity 1,200 2 1,036 1,036
Gas/other utilities and landscaping 1,600 2 1,381 1,381
Insurance 1,900 2 1,640 1,640
Total tier 2 expenses $4,700 2 $4,057 $4,057
Depreciation (tier 3) 5,200 3 4,489 4,489
Total Expenses on property $22,400
Net income from rental IRS Tax Court
method method
Rental receipts $18,400 $18,400
Less tier 1 expenses (10,791) (3,459)
Income after tier 1 expenses 7,609 14,941
Less tier 2 expenses (4,057) (4,057)
Income after tier 2 expenses 3,552 10,884
Less: tier 3 expenses (3,552) (4,489)
Taxable rental income $0 $6,395
Deductible personal use expenses $1,709 $9,041
(interest and property taxes)
Deductible rental expenses (sum of 18,400 12,005
tier 1, 2, and 3 expenses) (for AGI)
Depreciation expense carried over to 937 0
next year
Total deductions associated with $20,109 $21,046
property (for and from)