2009 R-1 Lecture

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Regulation 1
Regulation 1
1. Individual taxation—filing status ...................................................................................... 7
2. Individual taxation—exemptions .................................................................................... 10
3. Individual taxation—gross income .................................................................................. 16
4. Individual taxation—capital gains and losses.................................................................... 41
5. Appendix A ................................................................................................................ 57
6. Appendix B ................................................................................................................ 58
7. Appendix C ................................................................................................................ 60
8. Appendix D ................................................................................................................ 61
9. Class questions ........................................................................................................... 63

R1-2
Becker CPA Review Regulation 1
INDIVIDUAL TAXATION
GROSS INCOME
< ADJUSTMENTS >

ADJUSTED GROSS INCOME
STANDARD DEDUCTION
OR
ITEMIZED DEDUCTIONS
< EXEMPTIONS >
TAXABLE INCOME
FEDERAL INCOME TAX
< TAX CREDITS >
OTHER TAXES
< PAYMENTS >
TAX DUE OR REFUND
© 2009 DeVry/Becker Educational Development Corp. All rights reserved. R1-3

Regulation 1 Becker CPA Review
INDIVIDUAL TAXATION
Wages
Interest
Dividends
State Tax Refunds
Alimony Received
Business Income
Capital Gain/Loss
GROSS INCOME IRA Income
Pension and Annuity
Rental Income/Loss
K-1 Income/Loss
Unemployment Compensation
Social Security Benefits
Other Income
Educator Expenses
IRA
Student Loan Interest Expenses
Tuition & Fee Deduction
Health Savings Account
< ADJUSTMENTS > Moving Expenses
One-Half Self-Employment FICA
Self-Employed Health Insurance
Self-Employed Retirement
Interest Withdrawal Penalty
Alimony Paid
ADJUSTED GROSS INCOME
Medical (in excess of 7½% of AGI)

Taxes – State/Local (Income/Sales & Property)
Interest Expense – (Home & Investment)
< ITEMIZED DEDUCTIONS > Charity (up to 50% of AGI)
Casualty/Theft (in excess of 10% of AGI)
Miscellaneous (in excess of 2% of AGI)
Other Miscellaneous
Yourself
< EXEMPTIONS > 2008 $3,500 x Spouse
Dependents
TAXABLE INCOME
R1-4 © 2009 DeVry/Becker Educational Development Corp. All rights reserved.



INDIVIDUAL TAXATION—FILING STATUS
I. FILING
A. REQUIREMENT FOR FILING (WHO MUST FILE?)
1. General Rule
Generally, a taxpayer must file a return if his or her income is equal to or greater than
the sum of:
a. The personal exemption plus
b. The regular standard deduction (except for married filing separately) plus
c. The additional standard deduction amount for taxpayers age 65 or over or blind
(except for married persons filing separately).
2. Exceptions
Certain individuals must file income tax returns even if their income is lower than the
"general rule" requirement.
a. Individuals whose net earnings from self-employment are $400 or more must file.
b. Individuals who can be claimed as dependents on another taxpayer's return,
have unearned income, and gross income of $900 (2008) or more must file.
c. Individuals who receive advance payments of earned income credit must file.
B. WHEN TO FILE
1. Due Date: April 15
Individual taxpayers must file on or before the fifteenth day of the fourth month following
the close of the taxpayer's taxable year, which is April 15.
2. Extension
a. Automatic Six-Month Extension
An automatic six-month extension (until October 15) is available for those
taxpayers who are unable to file on the April 15 due date. The automatic six-
month extension is not an extension for the payment of any taxes owed.
Although granted automatically, the six-month extension must be requested by
the taxpayer by filing Form 4868 by April 15th.
b. Payment of Tax
With either extension, the due date for payment of taxes remains April 15.
3. Taxpayers Who are Out of the Country
Taxpayers who are outside of the United States on the filing date and have their
principal place of business outside the United States or are stationed outside the United
States have an automatic two-month extension to file, but not to pay. Such persons
need not file for the extension, but must include documentation if the extension is taken.
They can also request the other extensions under the same rules as for other
taxpayers.

II. FILING STATUS
FILING STATUS
A. SINGLE/END OF YEAR TEST

Any taxpayer who does not qualify for one of the other filing classes must use single status by
default.
1. Single at year end
OR
2. Legally separated
B. JOINT RETURNS/END-OF-YEAR TEST
In order to file a joint return, the parties must be married at the end of the year, living together
in a recognized common law marriage, or married and living apart but not legally separated or
divorced.
1. If married during the year, they may file a joint return provided they are married at year
end.
2. If divorced during the year, they may not file a joint return.
3. If one spouse dies during the year, a joint return may be filed.
C. MARRIED FILING SEPARATELY
A married taxpayer may file a separate return even if only one spouse had income. In a
separate property state, a husband and wife who elect to file married filing separately must
report their own income, exemptions, credits, and deductions on their individual tax returns.
In a community property state, most of the income, deductions, credits, etc., are split 50/50.
D. QUALIFYING WIDOW(ER) (SURVIVING SPOUSE)
1. For Two Years After Spouse's Death
A qualifying widow(er) is a taxpayer who may use the joint tax return standard
deduction and rates (but not the exemption for the deceased spouse) for each of two
taxable years following the year of death of his or her spouse, unless he or she
remarries. In the event of a remarriage, the surviving spouse will file a tax return (joint
or separate) with the new spouse.
2 Principal Residence for Dependent Child
The surviving spouse must maintain a household that, for the whole entire taxable year,
was the principal place of abode of a son, stepson, daughter, or stepdaughter (whether
by blood or adoption). The surviving spouse must also be entitled to a dependency
exemption for such individual.

E. HEAD OF HOUSEHOLD
Head of household status entitles certain taxpayers to pay lower taxes. The lower tax results
from a larger standard deduction and "wider" tax brackets. To qualify, the following
conditions must be met:
1. The individual is not married, is legally separated, or is married and has lived apart from
his/her spouse for the last six months of the year at the close of the taxable year.
2. The individual is not a "qualifying widow(er)."
3. The individual is not a nonresident alien.
4. The individual maintains as his or her home a household that, for more than half the
taxable year, is the principal residence of:
a. A Son or Daughter
(1) Legally adopted children, stepchildren, and grandchildren qualify as sons
and daughters.
(2) Working Families Act: The definition of head-of-household conforms with
the uniform definition of a child. To qualify for head-of-household status,
the child must either be a qualifying child or qualify as the taxpayer's
dependent (qualifying relative).
b. Father or Mother (Not Required to Live With)
A dependent parent is not required to live with the taxpayer, provided the
taxpayer maintains a home that was the principal residence of the parent for the
entire year. Maintaining a home means contributing over half the cost of upkeep.
This means rent, mortgage interest, property taxes, insurance, utility charges,
repairs, and food consumed in the home.
c. Dependent Relatives (Must Live With)
Parents, grandparents, brothers, sisters, aunts, uncles, nephews, and nieces (as
well as stepparents, parents-in-law, etc.) qualify as relatives. A dependent
relative (other than a father or mother) must live with the taxpayer. Note that
cousins, foster parents, and unrelated dependents do not qualify.
5. Summary
Dependent Lives With

Child Yes Yes
Parent Yes No
Relative Yes Yes
PASS KEY
In order to avoid confusing the required time period for different filing statuses, just remember:
W Widow/widower = Whole year
H Head of household = Half a year (more than)

INDIVIDUAL TAXATION—EXEMPTIONS
EXEMPTIONS
I. PERSONAL EXEMPTIONS
Generally, an individual is entitled to a personal exemption that is indexed annually for inflation. For
2008, this amount is $3,500.
A. PERSONS CLAIMED AS DEPENDENTS
Persons eligible to be claimed as dependents on another's tax return will not be allowed a
personal exemption on their own returns.
B. MARRIED TAXPAYERS
1. Each Spouse Receives Personal Exemption
Each married taxpayer claims his or her own personal exemption on the joint or
separate return, as the case may be. The exemption for a spouse is always considered
to be a personal exemption (not a dependency exemption) even if the spouse does not
work.
2. Spouse as Personal Exemption on a Separate Return
Usually, a married taxpayer filing separately is entitled to claim only his or her own
personal and dependency exemption. However, a married taxpayer, who files
separately, may claim his or her spouse's personal exemption if both of the following
tests are met:
a. The taxpayer's spouse has no gross income; and
b. The taxpayer's spouse was not claimed as a dependent of another taxpayer.
C. BIRTH OR DEATH DURING YEAR
If a person is born or dies during the year, he or she is entitled to a personal exemption for
the entire year. Exemptions are not prorated.
PASS KEY
The CPA Examination will intentionally test on the qualifications for exemptions (both personal and dependency). The actual
dollar amounts (which change each year due to indexing) are rarely tested.

II. DEPENDENCY EXEMPTIONS

A taxpayer is entitled to an exemption for each qualifying child and qualifying relative. Each
category has requirements:
QUALIFYING CHILD OR QUALIFYING RELATIVE
Close Relative Support (over 50%) test
Age Limit Under a specific amount of (taxable) gross income test
Residency Requirements Precludes dependent filing a joint tax return test
Eliminate Gross Income Test Only citizens (residents of U.S./Canada or Mexico) test
Support Test Changes Relative test
OR
Taxpayer lives with individual for whole year test
The amount of this exemption is the same as the personal exemption and is $3,500 for 2008.
Taxpayers must obtain a Social Security number for any dependent who has attained the age of
one as of the close of the tax year.
PASS KEY
A taxpayer will be entitled to a full dependency exemption for anyone that a taxpayer "CARES" for, or that they "SUPORT,"
even if the dependent:
• Was born during the year
OR
• Died during the year.
A. QUALIFYING CHILD OR
In general, a child is a qualifying child of the taxpayer if the child satisfies the following:
CARES 1. Close Relative
Under the close relationship test, to be a qualifying child of a taxpayer, the child must
be the taxpayer's son, daughter, stepson, stepdaughter, brother, sister, stepbrother,
stepsister, or a descendant of any of these. An individual legally adopted by the
taxpayer, or an individual who is lawfully placed with the taxpayer for legal adoption by
the taxpayer, is treated as a child of the taxpayer by blood. A foster child who is placed
with the taxpayer by an authorized placement agency or by judgment, decree, or other
order of any court of competent jurisdiction also is treated as the taxpayer's child.
CARES 2. Age Limit
The age limit test varies depending on the benefit. In general, a child must be under
age 19 (or age 24 in the case of a full-time student) to be a qualifying child (although no
age limit applies with respect to individuals who are totally and permanently disabled at
any time during the tax year). A "full time" student is a student who attends an
educational institution for at least part of each of five months during the taxable year.
An "educational institution" is one that maintains full-time faculty and a daytime
program. School attendance only at night does not qualify.
CARES 3. Residency Requirement

Under the residency requirement test, a child must have the same principal place of
abode as the taxpayer for more than one half of the tax year.
CARES
4. Eliminate Gross Income Test
The gross income test (see SUPORT) does not apply to a qualifying child.
CARES 5. Support Test Changes

The support test has been modified to determine if the child did not contribute more
than one-half of his or her own support. The requirement that the taxpayer (parent)
provides over one-half of the child's support is eliminated.
B. QUALIFYING RELATIVE
Taxpayers can apply the "SUPORT" dependency exemption rules to claim a dependency
exemption for a qualifying relative who does not satisfy the qualifying child requirements.
SUPORT 1. Support Test
The taxpayer must have supplied more than one-half (greater than 50%) of the support
of a person in order to claim him or her as a dependent. Support means the actual
expenses incurred by or on behalf of the dependent. Scholarships received by a
dependent student child or stepchild are not included in determining the student's total
support. However, Social Security and state welfare payments are included in the
dependent's total support, but only to the extent that such amounts are actually
expended for support purposes.
a. Multiple Support Agreements
Where two or more taxpayers together contribute more than 50% to the support
of a person but none of them individually contributes more than 50%, the
contributing taxpayers, all of whom must be qualifying relatives of (or lived the
entire year with) the individual, may agree among themselves which contributor
may claim the dependency exemption.
(1) A contributor must have contributed more than 10% of the person's support
in addition to meeting the other dependency tests in order to be able to
claim him or her as a dependent.
(2) The joint contributors are required to file a multiple support declaration,
Form 2120.
b. Child of Divorced Parent
(1) General Rule: Custodial Parents
Generally, the parent who has custody of the child for the greater part of the
year takes the exemption (determined by a "time" test, not the divorce
decree). It does not matter whether that parent actually provided more than
one-half of the child's support. If the parents have equal custody during the
year, the parent with the higher adjusted gross income will claim the
exemption.
(2) Exception: Custodial Parent Waives Right
A noncustodial parent is not allowed a dependency exemption based solely
upon language written in a divorce agreement. A noncustodial divorced or
separated parent may claim the exemption for his or her child if the
custodial parent waives the right to the exemption. This is done by the
custodial parent's signing of a written declaration that is attached to the
noncustodial parent's return. Form 8332 is used as the required written
declaration.
SUPORT 2. Under Exemption Amount of (Taxable) Gross Income

A person may not be claimed as a dependent unless the dependent's gross income is
less than the exemption amount ($3,500 during the taxable year 2008).
a. Definition of Taxable Income
Only income that is taxable is included for the purpose of determining whether
the dependent has earned less than the exemption amount.
b. Non-Taxable Income
(1) Social Security (at low income levels)
(2) Tax exempt interest income (state and muni interest income)
(3) Tax exempt scholarships
SUPORT 3. Precludes Dependent Filing a Joint Return
A taxpayer will lose the exemption for a married dependent who files a joint return,
unless the joint return is filed solely for a refund of all taxes paid or withheld for the
taxable year (i.e., the tax is zero).
Married children may be claimed as dependents provided they do not file joint returns
with their spouses (except to claim a refund of all taxes paid) and provided they satisfy
all other requirements for dependency.
SUPORT 4. Only U.S. Citizens or Residents of U.S., Mexico, or Canada
The dependent must be either a U.S. citizen or a resident of the U.S., Mexico, or
Canada.
SUPORT 5. Relative
Children, grandchildren, parents, grandparents, brothers, sisters, aunts and uncles,
nieces and nephews (as well as stepchildren, in-laws, etc.) can be claimed as
dependents. Children include legally adopted children, foster children, and
stepchildren. Foster parents and cousins must live with the taxpayer the entire year.
A child born at any time during the year may be claimed as a dependent (i.e., the
deduction is not prorated).
OR
SUPORT 6. Taxpayer Lives with Individual (if Non-relative) for Whole Year
A nonrelative member of a household (a person living in the taxpayer's home the entire
year) may be claimed as a dependent.

Peter, who is single and lives alone in Idaho, has no income of his own and is supported in full by the following people:
Amount Percent
of Support of Total
Tim (an unrelated friend) $2,400 48
Rick (Peter’s brother) 2,150 43
Dennis (Peter’s son) 450 9
$5,000 100%
Under a multiple support agreement, Peter's dependency exemption can be claimed by:
a. No One
EXAMPLE
b. Tim
c. Rick
d. Dennis
Tim Rick Dennis

Support Test Yes Yes No
Under $ Gross Income Yes Yes
Preclude Joint Filing Yes Yes
Only U.S. Citizens… Yes Yes
Relative or No Yes
Taxpayer lived with… No NA
PASS KEY
Don't let the CPA Examination trick you. Remember the following rule:
- No additional exemption for being
• Old (age 65)
• Blind
- It is an increased standard deduction.

III. PHASE-OUT OF PERSONAL AND DEPENDENCY EXEMPTIONS

This phase-out reduces exemptions by 2% of each $2,500 or fraction thereof ($1,250 for married
taxpayers filing separately) by which adjusted gross income (AGI) exceeds the following thresholds:
2008 Thresholds
Joint/Surviving Spouse $239,950
Head of Household 199,950
Single 159,950
Married Filing Separately 119,975
EXAMPLE
A married couple filing jointly has an AGI of $246,600 in 2007. They would only get 90% of the exemptions for which
they would otherwise be entitled. The 90% is calculated as follows: $246,600 – 234,600 = $12,000 ÷ $2,500 = 4.80
(round up always). Therefore, use 5; 5 x 2% = 10%; 100% – 10% = 90%.
Note: In 2008-2009, the phase-out is only 1/3 of the amount calculated under the rules, and the
phase-out is eliminated in 2010.

GROSS INDIVIDUAL TAXATION—GROSS INCOME

INCOME
I. GROSS INCOME IN GENERAL

The first step in determining tax liability is to compute gross income.
A. GROSS INCOME DEFINED
Generally, gross income means all income from whatever source derived, unless specifically
excluded. Thus, if the taxpayer finds $4,000 under a floorboard in his house, cannot find the
owner and keeps the money, the $4,000 is income regardless of the fact that he did not
"earn" it.
B. COMPUTATION OF INCOME: GENERAL RULE
Except in the cases of gain derived from dealings in property (discussed below), income is
determined by the amount of cash, property (FMV), or services obtained. In cases of
noncash income, the amount of the income is the fair market value of the property or services
received.
PASS KEY
EVENT INCOME BASIS
Taxable = FMV FMV
Non-taxable = N -0- N E NBV

EXAMPLE
A taxpayer performs services and receives a car with a fair market value of $3,000 as compensation. The $3,000 is
income to the taxpayer.
C. REALIZATION AND RECOGNITION

In order to be taxable, the gain must be both realized and recognized.
1. Realization
Realization requires the accrual or receipt of cash, property, or services, or a change in
the form or the nature of the investment (a sale or exchange).
2. Recognition
Recognition means that the realized gain must be included on the tax return (i.e., there
is no provision that permits exclusion or deferral under the Internal Revenue Code).
EXAMPLE
A taxpayer owns stock for which he paid $100 and the stock goes up in value to $150. There is no realized gain even
though there has been an increase in the taxpayer's wealth. Gain is realized when the shares are sold for $150 or
exchanged for other property worth $150. If the gain is taxable, it would also be recognized on the tax return.

D. TIMING OF REVENUE RECOGNITION

1. Accrual Method
Under the accrual method, recognition is required following GAAP (with some
exceptions); that is, when earned.
2. Cash Method
Under the cash method, recognition occurs in the period actually or constructively
received in cash or (FMV) property.
II. SPECIFIC ITEMS OF INCOME AND EXCLUSIONS COMPENSATION

OR WAGES
A. SALARIES AND WAGES
Gross income includes many forms of compensation for services.
1. Money
All money received, credited, or available (constructive receipt).
2. Property
The fair market value (FMV) of all property is included as gross income.
3. Cancellation of Debt
All debts cancelled are included in gross income (except for certain cancellations of
mortgage debt on principal residences, which have very detailed guidelines for
excluded amounts and debts cancelled when insolvency exists).
4. Bargain Purchases
If an employer sells property to the employee for less than its fair market value, the
difference is income to the employee.
5. Taxable Fringe Benefits (Non-Statutory)
The fair market value of a fringe benefit not specifically excluded by law is includable in
income. For example, an employee's personal use of a company car is included as
wages in an employee's income. Further, the amount included is subject to
employment taxes and withholding.

6. Partially Taxable Fringe Benefits: Portion of Life Insurance Premiums
FRINGE Premiums paid by an employer on a group-term life insurance policy covering his
BENEFITS employees are not income to the employees up to the cost on the first $50,000 of
coverage per employee (non-discriminatory plans only). Premiums above the first
$50,000 of coverage are taxable income to the recipient and normally included in W-2
wages. (This amount is calculated from an IRS table, and it is not the entire amount of
the premium in excess of the $50,000 coverage.)
7. Non-Taxable Fringe Benefits
a. Life Insurance Proceeds
The proceeds of a life insurance policy paid because of the death of the insured
are excluded from the gross income of the beneficiary.
(1) The interest income element on deferred payout arrangements is fully
taxable.
(2) Accelerated death benefits received by a terminally ill insured (certified that
the insured is expected to die within 24 months) are not taxable, or a
chronically ill insured (or requiring assisted living), if the proceeds are used
to pay for long-term care.
b. Accident, Medical, and Health Insurance (Employer Paid)
Premium payments are excludable from the employee's income when the
employer paid the insurance premiums, but amounts paid to the employee under
the policy are includable in income unless such amounts are:
(1) Reimbursement for medical expenses actually incurred by the employee; or
(2) Compensation for the permanent loss or loss of use of a member or
function of the body.
c. De Minimis Fringe Benefits
Benefits so minimal that they are impractical to account for may be excluded
from income. An example is an employee's personal use of a company
computer.
d. Meals and Lodging
The gross income of an employee does not include the value of meals or lodging
furnished to him or her in kind by the employer for the convenience of the
employer on the employer's premises. Additionally, in order to be nontaxable the
lodging must be required as a condition of employment.
e. Employer Payment of Employee's Educational Expenses
Up to $5,250 may be excluded from gross income of payments made by
employer on behalf of an employee's educational expenses. The exclusion
applies to both undergraduate and graduate level education.
f. Qualified Tuition Reductions
Employees of educational institutions studying at the undergraduate level who
receive tuition reductions may exclude the tuition reduction from income.
Graduate students may exclude tuition reduction only if they are engaged in
teaching or research activities and only if the tuition reduction is in addition to the
pay for the teaching or research. To be excludable, tuition reductions must be
offered on a nondiscriminatory basis.

g. Qualified Employee Discounts

Employee discounts on employer-provided merchandise and service are
excludable as follows:
(1) Merchandise Discounts
The excludable discount is limited to the employer's gross profit
percentage. Any excess must be reported as income.
(2) Service Discounts
The excludable discount on services is limited to 20% of the fair market
value of the services. Any excess discount must be reported as income.
(3) Employer-Provided Parking
The value of employer-provided parking up to $220 (for 2008) per month
may be excluded. The exclusion is available even if the parking benefit is
taken by the employee in place of taxable cash compensation.
(4) Transit Passes
The value of employer-provided transit passes up to $115 (for 2008) per
month may be excluded.
h. Qualified Pension, Profit-Sharing, and Stock Bonus Plans
(1) Payments Made by Employer (Non-Taxable)
Generally, payments made by an employer to a qualified pension, profit-
sharing, or stock bonus plan are not income to the employee at the time of
contribution.
(2) Benefits Received (Taxable)
The amount that is exempt from tax (plus any income earned on such
amount) is taxable to the employee in the year in which the amount is
distributed or made available to the employee.
i. Flexible Spending Arrangements (FSAs)
A flexible spending arrangement stems from a Section 125 employee flexible
benefit plan and is a plan that allows employees to receive a pre-tax
reimbursement of certain (specified) incurred expenses.
(1) Pre-Tax Deposits into Employee's Account
Employees have the ability to elect to have part of their salary (generally up
to $5,000 per year) deposited pre-tax into a flexible spending account
designated for them. These deposits must be done via salary reduction
directly by the employer, and the employee is not taxed on that income.
The employee has the option to use the deposited funds to pay for qualified
healthcare and/or qualified dependent care costs and submits claims to the
plan administrator for reimbursement.
(2) Forfeit Funds Not Used within 2 ½ Months After Year-end
Funds not used within 2 ½ months after the year-end or not claimed within
a period of time (usually 6 months) are forfeited. However, this grace
period only applies if the employer amended the plan accordingly.

B. INTEREST INCOME
INTEREST INCOME

1. Taxable Interest
a. Federal Bonds
b. Industrial Development Bonds
c. Corporate Bonds
d. Premiums received for opening a savings account (e.g., prizes and awards) are
included at FMV.
e. Part of the proceeds from an installment sale is taxable as interest.
f. Interest paid by federal or state government for late payment of tax refund is
taxable.
2. Tax Exempt Interest (Reportable but Not Taxable)
a. State and Local Government Bonds/Obligations
Interest on state and local bonds/obligations is tax exempt. Further, mutual fund
dividends for funds invested in tax-free bonds are also tax exempt.
b. Bonds of a U.S. Possession
Interest on the obligation of a possession of the United States is tax exempt.
c. Series EE (U.S. Savings Bond)
(1) Interest on Series EE Savings Bonds is tax exempt when:
(a) It is used to pay for higher education, reduced by tax-free
scholarships, of the taxpayer, spouse, or dependents;
(b) There is taxpayer or joint ownership (spouse);
(c) Taxpayer is over age 24 when issued; and
(d) They are acquired after 1989.
(2) Phaseout starts when modified AGI exceeds an indexed amount (e.g.,
$100,650 MFJ).
d. Interest on Veterans Administration Insurance
3. Unearned Income of a Child Under 18 ("Kiddie Tax")
Net unearned income of a dependent child under 18 years of age (or, if the child does
not provide over half of his/her own support, under 19 years of age – under 24 if the
child is a full-time student) is taxed at his parent's higher tax rate. Net unearned income
is calculated by taking the child's total unearned income (from dividends, interest, rents,
royalties, etc.) and subtracting the child's standard deduction of $900 (in 2008) (or
investment expense, if greater) and these less an additional $900, that is, $1,800, in
total. Although such income is taxed at the parent's marginal tax rate, it is nonetheless
reported on the child's tax return. Parents may elect to include on their own return the
unearned income of the applicable child provided the income is between $900 and
$9,000 and consists solely of interest and dividends.
2008 Child's
Unearned Tax
Income Rate
0 − $900 0%
$901 − $1,800 Child's
$1,801 and over Parent's
4. Forfeited Interest (Adjustment): Penalty on Withdrawal from Savings

Forfeited interest is deductible as an adjustment in the year incurred. (It was previously
included in income when earned.) Do not net with interest income.
C. DIVIDEND INCOME
1. Source Determines Taxability
DIVIDENDS The source of the distribution dictates the character. The following four sources exist:
a. Earnings & Profits / Current = By Year End
b. Earnings & Profits / Accumulated = Distribution Date
c. Return of Capital = No Earnings and Profits
d. Capital Gain Distributions = No E&P / No Basis
2. Three Categories of Dividends
a. Taxable Dividends
All dividends that represent distributions of a corporation's earnings and profits
(retained earnings) are includible in gross income.
(1) Taxable Amount (To Shareholder Receiving)
(a) Cash = Amount Received
(b) Property = Fair Market Value
(2) Special (Lower) Tax Rate
(a) Qualified dividends holding period: The stock must be held for more
than 60 days during the 120-day period beginning 60 days before the
ex-dividend dates (ex-dividend date is the date on which a purchased
share no longer is entitled to any recently declared dividends).
(b) Disqualified Dividends
(i) Regulated Investment Companies
(ii) REIT (Real Estate Investment Trust)
(iii) Employer stock held by an ESOP
(iv) Amounts taken into account as investment income (for
purposes of the limitation on investment expenses)
(v) Short sale positions
(vi) Certain foreign corporations
(c) Tax Rates (2008)
(i) 15%—Most taxpayers
(ii) 0%—Low income taxpayers (those in the 10% or 15% income
tax bracket)

b. Tax-Free Distributions
The following items are exempt from gross income:
(1) Return of Capital
Return of capital exists when a company distributes funds but has no
earnings and profits. The taxpayer will simply reduce (but not below zero)
his/her basis in common stock held.
(2) Stock Split
When a stock split occurs, the shareholder will allocate the original basis
over the total number of shares held after the split.
(3) Stock Dividend (Unless Cash or Other Property Option/Taxable FMV)
Unless the shareholder has the option to receive cash or other property
(which would then be taxable at the FMV of the dividend), the basis of the
shares after distribution depends on the type of stock received.
(a) Same stock—original basis is divided by total shares
(b) Different stock—original basis is allocated based on their cumulative
FMVs
(4) Life Insurance Dividend—Dividends Caused By Ownership of
Insurance With a Mutual Company (Premium Return)
c. Capital Gain Distribution
Distributions by a corporation that has no earnings and profits, and for which the
shareholder has recovered his or her entire basis, are treated as taxable gross
income.
D. STATE AND LOCAL TAX REFUNDS
The receipt of a state or local income tax refund in a subsequent year is not taxable if the
taxes paid did not result in a tax benefit in the prior year.
STATE AND
1. Prior year itemized = taxable state or local refund. LOCAL TAXES
2. Prior year used standard deduction = nontaxable state or local refund.
DeFilippis, a single individual, took a standard deduction on his 2008 federal personal tax return. In 2009, he received
EXAMPLE
a $150 state income tax refund. The $150 tax refund is not includible in his 2009 income because he did not itemize in
2008 and therefore did not receive a tax benefit from the state income taxes paid. If he had deducted the state taxes
when paid in 2008, a 2009 (or later) refund of those taxes would be taxable income for federal purposes when
received, regardless of whether or not the taxpayer itemized deductions in the year the refund was received.

E. PAYMENTS PURSUANT TO A DIVORCE

1. Alimony/Spousal Support (Income)
ALIMONY Payments for the support of a spouse are income to the spouse receiving the payments
and are deductible to arrive at adjusted gross income (adjustment) by the contributing
spouse. To be deemed alimony under the tax law:
a. Payments must be legally required pursuant to a written divorce (or separation)
agreement;
b. Payments must be in cash (or its equivalent);
c. Payments cannot extend beyond the death of the payee-spouse;
d. Payments cannot be made to members of the same household;
e. Payments must not be designated as anything other than alimony; and
f. The spouses may not file a joint tax return.
2. Child Support
a. Non-Taxable
If any portion of the payments is fixed by the decree or agreement as being for
the support of minor children (or is contingent on the child's status, such as
reaching a certain age), such portion is not deductible by the spouse making
payment and is not includible by the spouse receiving payment.
b. Payment Applies First to Child Support
If the decree or agreement specifies that payments are to be made both for
alimony and for support, but the payments subsequently made fall short of
fulfilling these obligations, the payments will be allocated first to child support
until the entire child support obligation is met and then to alimony.
3. Property Settlements (Non-Taxable)
If the divorce settlement provides for a lump-sum payment or property settlement by a
spouse, that spouse gets no deduction for payments made, and the payments are not
includible in the gross income of the spouse receiving the payment.
F. BUSINESS INCOME OR LOSS, SCHEDULE C OR C-EZ
Net income from self-employment is computed on Schedule C. The net income from the sole
proprietorship is then transferred to Form 1040 as one amount.
SELF- EMPLOYED
INCOME
Gross Business Income
< Business Expenses >
Profit
OR
Loss
PASS KEY
Note: Income from farming activities is reported in a manner very similar to other businesses (those reporting on a Schedule
C), but the related income and expenses are reported on Schedule F. For tax purposes a "farmer" is a person (or entity) who
operates or manages a farm with the intent of earning a profit. See Appendix B for additional information.



1. Gross Income
Those items that would normally be revenue in a trade or business or other self-
employed activity (such as director or consulting fees) are included as part of gross
income on Schedule C.
a. Cash = Amount Received (cash basis)
b. Property = Fair Market Value
c. Cancellation of Debt
2. Expenses
Expenses include those items that one would expect to find in business, such as:
a. Cost of goods (inventory is expensed when sold)
b. Salaries and commissions paid to others
c. State and local business taxes paid
d. Office expenses (including supplies, equipment, and rent)
e. Actual automobile expenses (only that portion used for business auto
depreciation is limited) or a standard mileage rate (50.5¢ through June 2008;
58.5¢ for remainder of 2008).
f. Business meal and entertainment expenses at 50% (Where all proceeds go to
charity, 100% is deductible as an itemized deduction.)
g. Depreciation of business assets
h. Interest expense on business loans (Note that interest expense paid in advance
by a cash basis taxpayer cannot be deducted until the tax year/period to which
the interest relates.)
i. Employee benefits
j. Legal and professional services
k. Bad debts actually written off for accrual basis taxpayer only (Note that the direct
write off method, not the allowance method, is used for tax purposes.)
3. Nondeductible Expenses (on Schedule C)
a. Salaries paid to the sole proprietor (they are considered a "draw")
b. Federal income tax
c. Personal portion of:
(1) Automobile and travel (and vacation) expenses
(2) Personal meals, entertainment expenses (100% of country club dues are
nondeductible)
(3) Interest expense (this is an itemized deduction if for mortgage or
investment)
(4) State and local tax expense (show as an itemized deduction on Schedule A)
(5) Health insurance of a sole proprietor is not a Schedule C expense
(permitted as an adjustment)
d. Bad debt expense of a cash basis taxpayer (who never reported the income)
e. Charitable contributions (use Schedule A)

PASS KEY
The CPA examination often attempts to confuse the candidate by providing personal itemized deductions as expenses of a
sole proprietorship. It is important to only subtract business expenses from business income. Itemized deductions and/or
other adjustments are deducted elsewhere.
4. Net Business Income or Loss is Taxable

a. Net Taxable Business Income
There are two taxes on net taxable income:
(1) Income tax and
(2) Federal self-employed (SE) tax.
(a) An adjustment to income is allowed for one-half (e.g., 7.65% up to
$102,000 in 2008) of S/E tax (Medicare plus Social Security) paid.
(b) This allows the sole proprietor the ability to "deduct" the employer
portion of the S/E tax as an adjustment to gross taxable income (of
which the net Schedule C amount is a part).
(c) All S/E income is subject to the 2.9% Medicare tax, but only up to
$102,000 in 2008 is subject to the 12.4% Social Security tax (e.g., a
total of 15.3% on earnings of less than $102,000 in 2008).
b. Net Taxable Loss
A business with a loss may deduct the loss against other sources of income.
When the loss exceeds these amounts, the excess net operating loss is
permitted as a carryover (at taxpayer's election, it may be used as a carryforward
only):
(1) 2-year carryback
(2) 20-year carryforward



5. Uniform Capitalization Rules

The uniform capitalization rules provide guidelines with respect to capitalizing or
expensing certain costs (i.e., taxes paid in connection with the acquisition of property
are capitalized as part of the property's cost). In the first year of implementation, they
generally cause an increase in the carrying cost of ending inventory and a decrease in
operating expense. This causes an increase in taxable income.
a. Types of Property
Uniform capitalization rules apply to the following:
(1) Produced for Use: Real or tangible personal property produced by the
taxpayer for use in his or her trade or business (e.g., machine tools for use
in the production line of a machine tool manufacturer).
(2) Produced for Sale: Real or tangible personal property produced by the
taxpayer for sale to his or her customers (i.e., manufacturer's inventory).
(3) Acquired for Resale: Real or tangible personal property acquired by the
taxpayer for resale (i.e., retailer's inventory). However, the uniform
capitalization rules do not apply to (inventory) property acquired for resale
if the taxpayer's average gross receipts for the preceding three tax years
do not exceed $10,000,000 annually.
b. Costs Required to be Capitalized
Costs required to be capitalized include direct materials, direct labor (e.g.,
compensation, vacation pay, and payroll taxes), and certain indirect costs (i.e.,
those to which an allocation must be applied). Examples of indirect capitalizable
expenses include utilities, warehousing costs, repairs, maintenance, indirect
labor (e.g., supervisory), rents, storage, depreciation, insurance, pension
contributions, engineering and design, repackaging, spoilage, and administrative
supplies.
c. Costs Not Required to be Capitalized
Costs not required to be capitalized include selling, advertising, and marketing
expenses, certain general and administrative expenses, research, and officer
compensation not attributed to production services.
PASS KEY
For inventory, even a sole proprietor will be required to apply the following rules:
Capitalized as Inventory Period Expense
• Direct materials • Selling
• Direct labor • General
• Factory overhead • Administrative
• Research & development
G. GAINS AND LOSSES ON DISPOSITION OF PROPERTY

Gain or loss on the disposition of property (covered in detail in a later section of this chapter)
is measured by the difference between the amount realized and the adjusted basis. Gains
and losses are given tax effect (recognized) only when the asset is sold or disposed by other
means. The basic formula in determining the gain or loss is as follows:
Amount Realized
< Adjusted Basis of Assets Sold >
Gain or Loss Realized

H. IRA INCOME
1. General Rules (Taxable when Withdrawn)
INDIVIDUAL Generally, retirement money cannot be withdrawn until the individual reaches the age of
RETIREMENT 59½ (except in certain situations, covered later) or the individual elects to receive equal
ACCOUNTS periodic distributions over his life expectancy. A taxpayer is required to start
withdrawals by the age of 70½.
2. Taxation of Distributions (Benefits)
a. Regular Tax
(1) Ordinary Income (Traditional Deductible IRA Distributions)
When a person retires, the funds will be taxed as ordinary income when
received (regardless of what type of income was earned while the funds
were invested, such as capital gains, etc.)
(2) Distributions/Benefits from Non-deductible IRAs
(a) Roth IRA
All qualified benefits received from a Roth IRA are non-taxable.
(b) Traditional Non-deductible IRA
Benefits received from a traditional non-deductible IRA are partially
taxable.
(1) Principal—nontaxable
(2) Accumulated earnings—taxable (when withdrawn)
b. Penalty Tax (10%)
Generally, a premature distribution is subject to a 10% penalty tax (on top of any
increase in regular income tax) if the individual has not met an exception.
c. Exception (to Penalty Tax)
There is no penalty if the premature distribution was used to pay:
(1) Home buyer (1st time): $10,000 max if used toward first home (within 120
days)
(2) Insurance (Medical)
(a) Unemployed with twelve consecutive weeks of unemployment
compensation
(b) Self-employed (who are otherwise eligible for unemployment
compensation)
(3) Medical expenses in excess of 7.5% of AGI
(4) Disability (permanent of indefinite disability, but not temporary disability)
(5) Education: College tuition, books, fees, etc.
(6) and
(7) Death

I. ANNUITIES
The investment amount is divided by a factor representing the number of months over which
the investment will be recovered. This factor is based on the age of the annuitant at the start
of the payout period. Factors range from 360 for starting ages under 56 to 160 for starting
ages over 70.
General Rules
If the investment in the contract is $60,000 and the annuitant is 64 years old (factor is 260 months) at the start of the
payout period, then:
$60,000
= $230.77 excludible from each of the first 260 payments
260
EXAMPLE
In this example, the first $230.77 of the first 260 payments received is not taxable. Amounts of each payment in
excess of $230.77 are taxable.
Live Longer Than Actuarial Payout Period

If the annuitant lives longer than 260 months, then further payments are fully taxable.
Death Before Full Recovery

If the annuitant dies before the 260 payments are collected, the unrecovered portion of the $60,000 is a
miscellaneous itemized deduction on the annuitant's final income tax return not subject to the 2% of AGI floor.
J. RENTAL INCOME (PASSIVE ACTIVITY)

Schedule E is used to compute supplemental income and/or loss from:
(i) Rental Real Estate
(ii) Royalties
(iii) Partnerships & LLCs (from Schedule K-1)
(iv) S-Corporations (from Schedule K-1)
(v) Estates (from Schedule K-1)
(vi) Trusts (from Schedule K-1)



1. General
The basic formula for the determination of net rental income or loss is as follows:
Gross Rental Income

Prepaid Rental Income
Rent Cancellation Payment
Improvement In-Lieu-of Rent
< Rental Expenses >
Net Rental Income
OR
Net Rental Loss
2. Rental of Vacation Home

a. Rented Less Than 15 Days
If the residence is rented for less than 15 days per year, it is treated as a
personal residence. The rental income is excluded from income, and mortgage
interest (first or second home) and real estate taxes are allowed as itemized
deductions. Depreciation, utilities, and repairs are not deductible.
b. Rented 15 or More Days
If the residence is rented for 15 or more days, and is used for personal purposes
for the greater of (i) more than 14 days or (ii) more than 10% of the rental days, it
is treated as a personal/rental residence. Expenses must be pro-rated between
personal and rental use (see example below). However, a different pro-ration
method is used for mortgage interest and property taxes (see * in the example
below), than for other property-related expenses (e.g., utilities, insurance,
depreciation, etc.). Rental use expenses are deductible only to the extent of
rental income.
Julie rents her vacation home for two months and lives there for one month (during the other 11 months, Julie lives in
the city). Thus, of the three-month period the vacation home is used, one-third is personal and two-thirds is rental.
Assume that Julie's gross rental income is $6,000, her real estate taxes are $2,400, interest is $3,600, utilities are
$4,800, and related depreciation is $7,200.
These amounts are deductible in the following order:
Rental Personal
Gross rental income $ 6,000 –
Deduct: Taxes $2,400
Interest 3,600
EXAMPLE
$6,000 x 2/12* (1,000) $5,000 – Schedule A

Balance $ 5,000
Deduct: Utilities $4,800 x 2/3** (3,200) $1,600 – Not Deductible
$ 1,800
Deduct: Depreciation $7,200 x 2/3**
$4,800 but limited to*** (1,800) $2,400 – Not Deductible
Net income $ 0
* Allocated based on rental period/total annual period.
** Allocated based on rental period/total annual usage.
*** The additional $3,000 (4,800 - 1,800) is not deductible, but is carried over to next year
and applied against future income from this property.

3. Passive Activity Losses (PALs) PASSIVE

ACTIVITY
A passive activity is any activity in which the taxpayer does not materially LOSSES
participate. Such activities include rental activities, interests in limited
partnerships, S corporations, and most tax shelters.
a. Deductibility
A net passive activity loss may not be deducted against wages, salaries, other
active income or against portfolio (interest and dividends) or capital gains
income. Expenses related to passive activities can be deducted only to the
extent of income from all passive activities.
b. Nondeductible PALs
Carry forward without any time limit unused passive activity losses held in
suspension.
(1) Suspended losses are used to offset passive income in future years.
(2) If still unused, suspended losses become fully tax deductible in the year the
property is disposed of (sold).
(3) If the taxpayer becomes a material participant in the passive activity
(therefore changing from "passive" to "active"), unused passive losses from
the activity can be used to offset the taxpayer's active income in the same
activity.
c. Taxpayers Subject to PAL Rules
Individuals, estates, trusts, personal service corporations, and closely held C
corporations are subject to the passive activity rules.
d. PAL (Disallowed Net Loss) Exceptions
An individual may deduct rental activity losses (although deduction may be
limited) if either of the following two conditions are met:
(1) Mom and Pop Exception
(a) $25,000 and "Active"
Taxpayers may deduct up to $25,000 (per year) of net passive losses
attributable to rental real estate annually if the individuals are actively
participating/managing (although not participating to the extent
needed to avoid passive activity classification as described below)
and own more than 10% of the rental activity.
(b) Carryforward
Any excess would be carried forward indefinitely as an unused
passive activity loss. An estate can qualify for the two years following
the decedent's death if the decedent actively participated in the
operation.
(c) Phaseout
The $25,000 allowance is reduced by 50% of the excess of the
taxpayer's AGI (without consideration of this loss deduction) over
$100,000. The allowance is eliminated completely when AGI
exceeds $150,000.

(2) Real Estate Professional (Not Passive Activity)

If the following two conditions are met and the taxpayer is deemed to have
material participation in the activity, the rental activities are not considered
passive and the taxpayer (sometimes referred to on the CPA Exam as a
real estate person) can deduct fully losses from the rental activities against
other income:
(a) More than 50% of the taxpayer's personal services during the year
are performed in real property businesses, and
(b) The taxpayer performs more than 750 hours of services in real
property businesses during the year.
K. UNEMPLOYMENT COMPENSATION
A taxpayer must include in gross income the full amount received.
L. SOCIAL SECURITY INCOME
SOCIAL Social Security benefits received might be included in income. Taxpayers are classified into
SECURITY five categories depending on the level of provisional income (see boxed information on page
BENEFITS R1-40), which is defined as AGI plus tax-exempt interest plus 50% of Social Security benefits.
Taxpayers must include in income the lesser of 50% (or 85%, depending on income) of social
security received or 50% (or 85%, depending on income) of the excess provisional income
over the threshold.
1. Low Income = No Social Security benefits are taxable (income below: single
$25,000/MFJ $32,000)
2. Lower Middle Income = Less than 50% of Social Security benefits are taxable
3. Middle Income = 50% of SS benefits are taxable (income up to: single $25,000/MFJ
$32,000)
4. Upper Middle Income = Between 50% and 85% of Social Security benefits are taxable.
5. Upper Income = 85% of Social Security benefits are taxable (income over: single
$34,000/MFJ $44,000)
M. TAXABLE MISCELLANEOUS INCOME
1. Prizes and Awards
The fair market value of prizes and awards is taxable income. An exclusion from
income for certain prizes and awards applies where the winner assigns the award
directly to a governmental unit or charitable organization.
2. Gambling Winnings and Losses
a. Winnings
Gambling winnings are included in gross income.
b. Losses
Unless the taxpayer is in the trade or business of gambling (which follows other
specific reporting rules), gambling losses may only be deducted to the extent of
gambling winnings. The allowable amount of these gambling losses are
deductible on Schedule A as an itemized deduction but are not subject to the 2%
of AGI limitation on miscellaneous itemized deductions.

3. Business Recoveries
To decide whether a business recovery is excludible, one must determine "in lieu of
what the damages paid were." Thus, if a damage award is compensation for lost profit,
the award is income.
4. Punitive Damages
Punitive damages are fully taxable as ordinary income if received in a business context
or for loss of personal reputation. Punitive damages received by an individual in a
personal injury case are also taxable except in wrongful death cases where state law
has limited wrongful death awards to punitive damages only.
N. PARTIALLY TAXABLE MISCELLANEOUS ITEMS: SCHOLARSHIPS AND FELLOWSHIPS
1. Degree-Seeking Student SCHOLARSHIPS
Scholarships and fellowship grants are excludible only up to amounts actually spent on
tuition, fees, books, and supplies, (not room and board) provided:
a. The grant is made to a degree-seeking student;
b. No services are to be performed as a condition to receiving the grant; and
c. The grant is not made in consideration for past, present, or future services of the
grantee.
2. Nondegree-Seeking Student
Scholarships and fellowships awarded to nondegree-seeking students are fully taxable
at FMV.
3. Tuition Reductions
Graduate teaching assistants and research assistants who receive tuition reductions
are taxed on the reduction if it is their only compensation, but not if the reduction is in
addition to other taxable compensation.
O. NONTAXABLE MISCELLANEOUS ITEMS
1. Life Insurance Proceeds (Nontaxable) LIFE
The proceeds of a life insurance policy paid because of the death of the INSURANCE
PROCEEDS
insured are excluded from the gross income of the beneficiary.
a. Interest income element on deferred payout arrangements is fully taxable.
b. Accelerated death benefits received by a terminally ill insured (certified that the
insured is expected to die within 24 months), or a chronically ill insured (or
requiring assisted living), if the proceeds are used to pay for long-term care, are
not taxable.
2. Gifts and Inheritances (Nontaxable)
Gross income does not include property received as a gift or inheritance; however, any
income received from such property is taxable.
3. Medicare Benefits (Nontaxable)
Exclude from gross income basic Medicare benefits received under the Social Security
Act.
4. Workers' Compensation (Nontaxable)
Exclude from gross income compensation received under a workers' compensation act
for personal injury or sickness.

5. Personal (Physical) Injury Award (Nontaxable)

Exclude from gross income damages received as compensation for personal (physical)
injury.
6. Accident Insurance—Premiums Paid by Taxpayer (Nontaxable)
Exclude from gross income all payments received (even with multiple recoveries) if the
individual paid all premiums for the insurance.
7. Foreign-Earned Income Exclusion
Taxpayers working abroad may exclude from gross income up to $87,600 (2008) of
their foreign-earned income. In order to qualify for the exclusion, the taxpayer must
satisfy one of the following two tests:
a. Bona Fide Residence Test
The taxpayer must have been a bona fide resident of a foreign country for an
entire taxable year.
b. Physical Presence Test
The physical presence test requires that the taxpayer must have been present in
the foreign country for 330 full days out of any 12-consecutive-month period
(which may begin on any day).
Note: The exclusion cannot exceed the taxpayer's foreign earned income reduced by
the taxpayer's foreign housing exclusion (maximum $26,280 in 2008). Further, the
amount of excluded income and housing is used to determine the income tax rate (and
alternative minimum tax rate) for the taxpayer for the year (i.e., although it is not taxed,
the excluded income could cause other income to be taxed at higher rates, as if the
excluded income were taxable).
Modified Adjusted Gross Income (MAGI), also known as provisional income, includes the following items:
• Any income you excluded because of the foreign earned income exclusion.
• Any exclusion or deduction you claimed for foreign housing.
• Any interest income from series EE bonds that you were able to exclude because you paid qualified higher
education expenses.
• Any deduction you claim for student loan interest or qualified tuition and related expenses.
• Any employer-paid adoption expense you excluded.
• Any deduction you claimed for an annual (non-rollover) contribution to a regular IRA.
In other words, the above items are not taken into account in determining AGI vs. MAGI.

INDIVIDUAL TAXATION—CAPITAL GAINS AND LOSSES
I. DEFINITIONS
A. REAL PROPERTY (LAND AND BUILDING)
Real property's land and all items permanently affixed to the land (e.g., buildings, paving,
etc.).
B. PERSONAL PROPERTY (MACHINERY AND EQUIPMENT)
Personal property is all property not classified as real property.
C. CAPITAL ASSETS
Capital assets include property (real and personal) held by the taxpayer, such as:
1. Personal automobile of taxpayer CAPITAL
GAINS
2. Furniture and fixtures in the home of the taxpayer & LOSSES
3. Stocks and securities of all types (except those held by dealers)

4. Personal property of a taxpayer not used in a trade or business
5. Real property not used in a trade or business
6. Interest in a partnership
7. Goodwill of a corporation
8. Copyrights, literary, musical, or artistic compositions purchased
9. Other assets held for investment
D. NON-CAPITAL ASSETS
1. Property normally included in inventory or held for sale to customers in the ordinary
course of business
2. Depreciable personal property and real estate used in a trade or business (for example,
Section 1231, Section 1245, and Section 1250 property)
3. Accounts and notes receivable arising from sales or services in the taxpayer's business
4. Copyrights, literary, musical, or artistic compositions held by the original artist
(Exception: Sales of musical compositions held by the original artist receive capital gain
treatment.)
5. Treasury stock (not an ordinary asset and not subject to capital gains treatment)



II. CALCULATION RULES

The basic formula in determining the gain or loss is as follows:
Amount Realized
< Adjusted Basis of Asset Sold >
Gain
OR
Loss
A. AMOUNT REALIZED
Amount
AmountRealized
Realized
The amount realized includes:
<<Adjusted
AdjustedBasis
Basisof
ofAsset
AssetSold
Sold>>
1. Cash received (boot),
Gain
Gain
2. Cancellation of debt (boot),
OR
OR
3. Property received at fair market value, and
Loss
Loss
4. Services received at fair market value.
5. Reduce the amount realized by any selling expenses
(e.g., broker's commissions).
Taxpayer conveys commercial property in which he has a basis of $70,000 and which is subject to a mortgage of
EXAMPLE
$45,000 to X for $60,000 in cash. The taxpayer is treated as if he had received $105,000 in the transaction, whether or
not X expressly assumes the mortgage, and the taxpayer realizes a gain of $35,000 ($105,000 proceeds minus
$70,000 basis.
B. ADJUSTED BASIS OF ASSET SOLD Amount

AmountRealized
Realized
BASIS 1. Purchased Property Basis = Cost <<Adjusted
AdjustedBasis
Basisof
ofAsset
AssetSold
Sold>>
Generally, the basis of property is the cost
Gain
Gain
of such property to the taxpayer. There are a number of
instances in which the taxpayer's basis in property is to OR
OR
be adjusted upward or downward.
Loss
Loss
a. Increase Basis for Capital Improvements
Basis is adjusted upward for expenditures chargeable to the asset account.
EXAMPLE
Taxpayer owns a factory and adds on a new wing for $50,000. The basis of the factory is increased by $50,000.
b. Reduce Basis for Accumulated Depreciation (= NBV)

The basis is adjusted downward in the amount of any depreciation (allowed or
allowable) by the taxpayer with respect to that asset.
EXAMPLE
A taxpayer has a milling machine worth $10,000. In its first year, he deducts $1,000 from gross income for
depreciation of the machine. The basis of the machine is accordingly reduced to $9,000 ($10,000 minus $1,000
depreciation deduction).

c. "Spreading" Adjustments
Although most adjustments require an increase or decrease in the basis, some
spread the basis.
EXAMPLE
Under the IRC, the receipt of a nontaxable stock dividend will require the shareholder to spread the basis of his original
share over both the original shares and the new shares received resulting in the same total basis, but a lower basis per
share of stock held.
2. Gift Property Basis

a. General Rule: Donor's Rollover Cost Basis
Property acquired as a gift generally retains the rollover cost basis as it had in
the hands of the donor at the time of the gift. Basis is increased by any gift tax
paid that is attributable to the net appreciation in the value of the gift. Gains and
losses are calculated using this rollover cost basis (subject to the exception
noted below).
b. Exception: Lower FMV at Date of Gift
If the fair market value at date of gift is lower than the rollover cost basis from the
donor, the basis for the donee depends upon the donee's future selling price of
the asset.
(1) Sale of Gifts at Price Greater than Donor's Rollover Basis (Gain Basis)
When a taxpayer sells a gift for greater than the rollover basis, the gain
shall be the difference between the sale price and that rollover basis.
EXAMPLE
Donor gives nondepreciable property worth $3,000 and having an adjusted basis of $5,000 to taxpayer, who
subsequently sells the property for $6,500. Taxpayer's gain will be $1,500 ($6,500 proceeds minus $5,000 basis).
(2) Sale of Gift at Price Less than Lower Fair Market Value (Loss Basis)
When a taxpayer sells the gift for less than the lower FMV at the date of
gift, the basis of the gift for purposes of determining the loss is the fair
market value of the gift at the time the gift was given.
EXAMPLE
Donor gives property worth $3,000 having an adjusted basis of $5,000 to taxpayer who subsequently sells the property
for $1,000. The taxpayer's loss will be $2,000 ($3,000 FMV at date of gift minus $1,000). (Note that the loss may or
may not be deductible on the taxpayer's income tax return, depending on the situation.)

(3) Sale Less than Rollover Cost Basis but Greater than Lower Fair
Market Value (In the Middle)
When taxpayer sells a gift for a price less than the donor's rollover cost
basis, but more than the lower fair market value at the date of gift, neither
gain nor loss is recognized. The basis to the donee is the "middle" selling
price.
EXAMPLE
Donor gives property worth $3,000 and having an adjusted basis of $5,000 to taxpayer, who subsequently sells the
property for $3,500. Taxpayer will have neither gain nor loss on the transaction. For purposes of determining gain,
taxpayer's basis is $5,000. For purposes of determining loss, his basis is $3,000.
PASS KEY
• Sell higher → Use "donor's basis" to determine gain.
Donor
Basis
• Sell between → No gain or loss
Lower FMV at
Date of Gift
• Sell lower → Use "lower FMV at date of gift" to determine loss.
c. Holding Period
The recipient of the gift normally assumes the donor's holding period. However,
under the exception above, if fair market value at the time of gift is used (loss
basis) as the basis of the gift, the holding period starts as of the date of the gift.
EXERCISE: BASIS OF GIFTED STOCK AND GAIN OR LOSS ON RESALE
General Rule: Exception:

FMV Higher FMV Lower
1 2 3 4
Donor's (Rich Uncle) Basis $20,000 $20,000 $20,000 $20,000

EXERCISE
FMV at Gift Date 40,000 13,000 13,000 13,000
Nephew's Selling Price 30,000 25,000 10,000 15,000
"Basis" to Nephew
Taxable Gain (if any)
Deductible Loss (if any)
See Appendix A for answers to this exercise.

3. Inherited Property Basis

a. General Rule: Date of Death FMV Becomes Basis
Property acquired by bequest or inheritance generally takes as its basis the step-
up (or down) to the fair market value at the date of the decedent's death.
b. Alternate Valuation Date
If validly elected by the executor, the fair market value on the alternate valuation
date (the earlier of 6 months later or the date of distribution/sale) may be used to
value all of the estate property. The alternate valuation date is only available if
its use lowers the entire gross estate and estate tax (although individual assets
may go up or down during the period). [Note: Estate taxation is covered in detail
in lecture R4.]
If the alternate valuation date is validly elected, the asset is valued using FMV at
the earlier of:
(1) Distribution date of asset or
(2) Alternate valuation date (earlier of 6 months after death or date of
distribution/sale).
EXAMPLE
Testator died owning property worth $60,000 and in which he had a basis of $20,000. His son inherited the land and
subsequently sold it for $55,000. The son will recognize a loss of $5,000 ($60,000 basis minus $55,000 proceeds).
The gain inherent in the property at the time of the testator's death goes unrecognized.
c. Holding Period
Property acquired from a decedent is automatically considered to be long-term
property regardless of how long it actually has been held.
EXERCISE: BASIS OF INHERITED PROPERTY
1. Assume a taxpayer inherited property from a decedent. The FMV at date of death was $20,000. The property
was worth $15,000 six months later, and was worth $22,000 when it was distributed to the taxpayer eight
months later. It had a cost basis to the deceased of $5,000.
What is the basis of inherited property to the taxpayer:
EXERCISE
a. If the alternate valuation date was not elected? $________

b. If the alternate valuation date was elected? $________
2. Assuming the beneficiary sold that property for $25,000, compute the capital gain:
a. Assuming the alternate valuation date was not elected. $________
b. Assuming the alternate valuation date was elected. $________
See Appendix A for answers to this exercise.

PASS KEY
REALIZED*, BUT NOT RECOGNIZED, GAINS OR LOSSES
Money Received (boot)
C.O.D. (boot)
AMOUNT REALIZED
FMV Property
Less: Selling Expenses
Purchase = Cost
Gift = Rollover Cost

< ADJUSTED BASIS OF ASSET SOLD >
Inherited = Step-up FMV
Homeowners Exclusion
Involuntary Conversion
Divorce Property Settlement

GAIN
Exchange of Like Kind (Business)
Installment Sale
Treasury Capital & Stock
OR
Wash Sale Losses
Related Party Losses

LOSS
And
Personal Losses
* All realized gains and losses are recognized (i.e., reported on the tax return) unless "HIDE IT" or
"WRaP" applies.

C. GAINS (EXCLUDED OR DEFERRED) GAINS OR

LOSSES
A gain is not taxed if the taxpayer can "HIDE IT" all. Gain to the extent of boot
(the part the taxpayer did not "HIDE IT") is taxable:
(1) Cash — Kept and not reinvested Amount
AmountRealized
Realized
(2) C.O.D. — Excess debt assumed by buyer <<Adjusted
AdjustedBasis
Basisof
ofAsset
AssetSold
Sold>>
There is a special group of transactions on which any realized Gain
Gain
gain is excluded or not currently recognized. These special OR
OR
statutory provisions are based on the idea that the taxpayer's
investment has not substantially changed and, therefore, Loss
Loss
recognition of the gain or loss on the transaction should be
deferred. This is done through the device of substituting the
taxpayer's basis in the property given up for the basis of the property acquired.
HIDE IT 1. Homeowner's Exclusion
The sale of the taxpayer's personal (primary or principal) residence is subject to an
exclusion from gross income for gain:
a. $500,000 is available to married couples filing a joint return and PERSONAL
certain surviving spouses. RESIDENCE
b. $250,000 is available for single, married filing separately, and head of household.
c. To qualify for the full exclusion (up to the applicable dollar limit):
(1) Taxpayer must have owned and used (subject to item (2), below) the
property as a principal residence for two years or more during the five-year
period ending on the date of the sale or exchange a taxpayer.
(2) Either spouse for a joint return must meet the ownership requirement, and
both spouses must meet the use requirement with respect to the property.
d. Taxpayers may be eligible for a partial (on a prorated basis) exclusion if the sale
is due to a change in place of employment, health, or unforeseen circumstances,
and the exclusion has been claimed within the previous two years or the taxpayer
fails to meet the ownership and use requirements.
e. There is no age requirement to receive the exclusion.
f. No rollover to another house is required.
g. The exclusion is renewable. A taxpayer may use the homeowner exclusion as
often as available over his or her lifetime provided he or she meets the other
requirements, but the exclusion may not be used more than once every two (2)
HIDE IT
years.
2. Involuntary Conversions
Nonrecognition treatment is given to gains realized on involuntary
conversions of property (e.g., destruction, theft, condemnation) on the INVOLUNTARY
rationale that the taxpayer's reinvestment of the involuntarily received CONVERSIONS OF
PROPERTY
proceeds restores him to the position he held prior to the conversion.
To tax him under such circumstances would produce undue hardship.
If the taxpayer does not reinvest all the proceeds, his gain on the transaction will be
recognized to the extent of the unreinvested amount.

a. No Gain Recognized
When no gain is recognized because of the direct conversion of the property into
other similar property, the basis of the new asset is the same as the basis of the
old asset. (Increased by any additional amounts invested.)
b. Personal Property (Two Years from Year-End)
The reinvestment must occur within two years after the close of the taxable year
in which any part of the gain was realized and be in property "similar or related in
service or use" (i.e., the replacement property must serve the same function in
the taxpayer's business as did the old property which is a narrower standard than
the "like-kind" test). For principal residences destroyed in a federally declared
disaster area, the replacement period is four years instead of two years.
c. Business Property (Three Years from Year-End)
The reinvestment must occur within three years after the close of the taxable
year in which any part of the gain was realized and be in property "similar or
related in service or use" (i.e., the replacement property must serve the same
function in the taxpayer's business as did the old property, which is a narrower
standard than the "like-kind" test).
The basis of property acquired as a result of an involuntary conversion will be the
cost of such property decreased by the amount of any gain not recognized upon
such conversion.
EXAMPLE
Land owned by McIntyre had an adjusted basis of $30,000. It was condemned by the state and McIntyre received
similar property from the state to replace his condemned land. The basis of his new land is $30,000.
d. Gain Recognized (Boot)

When gain is recognized because the amount received exceeds the cost of
replacement, the basis of the replacement property is its cost less the gain not
recognized.
Crudd owned a building with an adjusted basis of $400,000. The state condemned it and awarded him $450,000.
Crudd bought a new building for $440,000. While he realized $50,000, only $10,000 is recognized as follows:
Amount realized $450,000

Adjusted basis (400,000)
EXAMPLE
Realized gain 50,000

Recognized gain ($450,000 - $440,000) (10,000)
Gain not recognized $ 40,000
Cost of new building $440,000
Less: Gain not recognized (40,000)
Basis of new building $400,000
When the gain exceeds $100,000, property acquired from related parties and
certain close relatives does not qualify as replacement property.

e. Loss Recognized
Involuntary conversion rules apply to gains only. Losses would be recognized.
When the loss is recognized, the basis of the new property is its replacement
cost.
EXAMPLE
Rigoli had a factory with a cost basis of $340,000, which was destroyed by a fire. His insurance company paid him
$330,000. Rigoli used the money to buy a new plant for $500,000. The $10,000 loss is recognized and the basis of his
new factory is $500,000.
HIDE IT 3. Divorced Property Settlement

When a divorce settlement provides for a lump-sum payment or property settlement, it
is a non-taxable event. The basis of the property to the recipient spouse will be the
carryover basis.
HIDE IT 4. Exchange of Like-Kind Business/Investment Assets (Tangible)
Nonrecognition treatment is accorded to a "like-kind" exchange of property used in the
trade or business or held for investment (except inventory, stock, LIKE-KIND
securities, partnership interests, and real property in different countries). EXCHANGES
"Like-kind" means the same type of investment, (e.g., realty for realty or
personalty for personalty).
a. Gain When Boot Received
If property other than property qualifying for such an exchange is received (e.g.,
cash known as "boot"), the transaction, while not qualified for complete
nonrecognition, produces recognized gain. The recognized gain is the lower of
the realized gain or the boot.
EXAMPLE
Taxpayer owns investment realty worth $40,000 and having an adjusted basis of $25,000. If taxpayer exchanges this
property for other realty worth $35,000 and $5,000 in cash, the taxpayer's gain of $15,000 ($40,000 proceeds minus
$25,000 basis) will be recognized only to the extent of the $5,000 cash received.
b. Basis Rules
While the basis of the property received in the exchange is ordinarily the same as
the basis of the property given up, this basis is decreased by any money (or other
boot) received and increased by any gain (boot) recognized.
In the prior example, taxpayer's basis would be decreased in the amount of the $5,000 cash received and increased by
the amount of gain recognized ($5,000). Therefore, the taxpayer's basis in the acquired realty will remain $25,000 and,
EXAMPLE
upon a later sale for $35,000, the remaining $10,000 of gain will be recognized.
Carryover basis – Cash (boot) received + Gain recognized = New basis
$25,000 – $5,000 + $5,000 = $25,000

HIDE IT 5. Installment Sale

The installment method is the tax method of reporting gains (not losses) for sales made
by a "nonmerchant" in personal property and "nondealer" in real estate. This
INSTALLMENT
SALES
installment sale method is not available for sales of stocks or securities traded on an
established market. (Immediate recognition can be elected.)
a. Recognize When Cash is Received
Under the installment method, revenue is reported over the period in which the
cash payments are received. This method does not alter the type of gain to be
reported (capital gain, ordinary income).
b. Reportable Installment Sale Gain/Income
(1) Gross Profit = Sale – Cost of Goods Sold.
(2) Gross Profit Percentage = Gross Profit / Sales Price.
(3) Earned Revenue = Cash Collections x Gross Profit Percentage.
Installment Sales Reporting
Assume that a taxpayer had $400,000 in installment sales in Year 1 and a December 31, Year 1, balance in installment
accounts receivable of $150,000. If the taxpayer had $300,000 as its cost of goods sold, he would calculate realized
profit in Year 1 as follows:
Step 1: Gross Profit Year 1
Sale on installment $ 400,000

Cost of goods sold (300,000)
EXAMPLE
Total gross profit $ 100,000

Step 2: Gross profit percentage
Gross profit $100,000
= 25%
Sale on installment 400,000
Step 3: Earned Gross Profit
Sale on installment $ 400,000
Ending installment accounts receivable (150,000)
Collections $ 250,000
Gross profit percentage 25%

Gross profit earned $ 62,500
c. Miscellaneous
(1) All depreciation recaptured shall be reported in income in the year of sale.
(2) Net proceeds from loans which are secured by the installment obligation
shall be reported as amounts received/collected.
d. Gross Profit Percentage
Compute the gross profit percentage from the original sale and apply that gross
profit percentage to cash received in the year to record realized profit for the
year.

6. Treasury and Capital Stock Transactions (by Corporation)

HIDE IT
The following corporate transactions are exempt from gain:
a. Sales of stock by corporation
Amount
AmountRealized
Realized
b. Repurchase of stock by corporation
<<Adjusted
AdjustedBasis
Basisof
ofAsset
AssetSold
Sold>>
c. Reissue of stock
Gain
Gain
D. LOSSES (NONDEDUCTIBLE) OR
OR
WRAP "WRaP" up these losses because they are nondeductible.
Loss
Loss
1. Wash Sale Loss
A wash sale exists when a security (stock or bond) is sold for a loss and is repurchased
within 30 days before or after the sale date. WASH
SALES
a. Disallowed Loss
The loss on the wash sale is disallowed for tax purposes.
b. Basis of Repurchased Security
The basis of the repurchased security is equal to the purchase price of the new
security plus the disallowed loss on the wash sale (or, alternatively, the basis of
the old security, less the proceeds from the sale, plus the purchase price of the
new security).
c. Date of Acquisition
The date of acquisition of the repurchased security is the date of acquisition of
the original security.
d. Gain
If a security is sold resulting in a gain and it is repurchased within 30 days, the
taxpayer cannot use "substituted basis." Instead, he must pay capital gains tax
and use the new purchase price as the basis.
Bob DeFilippis entered into the following transactions in April 2007.
Date of Date of Selling Indicated

Item Purchase Cost Sale Price Loss
EXAMPLE
(A) 100 shares of IBM 09/08/82 $22,000 04/20/07 $21,000 $(1,000)

(B) 100 shares of IBM 04/25/07 21,500
Although there appears to be a loss of $1,000 on the sale of the shares purchased 9/8/82, the loss will be disallowed
because the same stock (IBM) was purchased within 30 days of the sale. The basis of the stock in the second
purchase is now $22,500, as the indicated loss is added to the basis.
PASS KEY
The CPA Examination has often tested the wash sale rules by having the taxpayer purchase shares of the same stock 30 days
before the sale of the stock, that resulted in a loss. This is still a wash sale, and the loss is disallowed. For example, on
1/4/X8 you buy one share for $100. On 3/5/X9 you buy another share for $40. Then, on 3/15/X9, the first share is sold for
$41. While you have "realized" a $59 loss, it will not be recognized due to the wash sale rules.

WRAP 2. Related Party Transactions

a. Definition
Sales between related parties are not considered "arms-length," and the loss
recognition rules are different. Related parties are:
RELATED
TAXPAYERS (1) Brothers and sisters
(2) Husband and wife
(3) Lineal descendants (father, son, grandfather)
(4) Entities that are more than 50% owned by individuals, corporations, trusts
and/or partnerships
Note: In-laws are not related parties.
b. Capital Gains
(1) General Rule
Capital gains taxes are imposed on all sales of nondepreciable property
(e.g., land) between all related parties except:
(2) Exception
Sales between the following related parties do not receive capital gain
treatment:
(a) Husband and wife (where basis is merely transferred), and
(b) An individual and a 50% + controlled corporation or partnership
(where the gain is taxed as ordinary income).
c. Capital Losses
Losses are disallowed on (most) related party sales transactions even if they
were made at an "arms-length" FMV price.
d. Basis Rules
The basis (and related gain or loss) of the (second) buying relative depends on
whether the second relative's resale price is higher, lower, or between the first
relative's basis and the lower selling price to the second relative.
e. Gain Rules
Gain is recognized only to the extent the future sale price exceeds the previous
relative's cost basis.
Ned bought stock for $20,000 that he sold to his brother Ray for $16,000. The $4,000 loss is disallowed. Ray then
sells the stock to Bobby, an unrelated party, for $21,000. Ray's recognized gain from the sale is $1,000, calculated as
follows:
EXAMPLE
Ray's selling price $21,000

Less: Ray’s cost 16,000
Disallowed loss 4,000
Ray’s basis (20,000)
Ray’s gain $ 1,000

(1) Loss Rules

Loss is recognized only to the extent that the future sale price is lower than
the acquiring relative's purchase price (FMV).
(2) No Gain or Loss Rules
No gain or loss is recognized when the future sale price is between the two
related parties' purchase prices.
f. Holding Period
The holding period starts with the new owner's period of ownership.
PASS KEY
The purchasing relative's basis rules are the same as the gift tax rules:
Relative's • Sell higher → Use "relative's basis" to determine gain.

Basis
• Sell between → No gain or loss.

Lower
Purchase
Price by
• Sell lower → Use "purchase price" to determine loss.
Relative
3. Personal Loss
WRAP No deduction is allowed for the loss on a non-business disposal or loss. An itemized
deduction may be available in the category of casualty and theft.
E. INDIVIDUAL CAPITAL GAIN AND LOSS RULES
1. Net Capital Gains Rules
a. Long Term HOLDING
(1) Holding period – more than one year PERIOD
(2) Tax rate – 15% is the maximum, use 5% if taxpayer is in the 10% or 15%
income tax bracket
b. Short Term
(1) Holding period – one year or less
(2) Tax rate – treated as ordinary income
c. Unrecaptured Section 1250 Gain
Any unrecaptured section 1250 gain from depreciation that is not treated as
ordinary income is taxed at 25% for taxpayers not in the 10% or 15% income tax
bracket (see detailed discussion of Section 1250 gains in the R-2 lecture).
d. Collectibles and Small Company Stock
Long-term gains on collectibles, antiques, and small company (Section 1202)
stock are taxed at 28% (for taxpayers not in the 10%, 15% or 25% income tax
brackets).
e. Netting Procedures
Gains and losses are first netted within each tax rate group, creating net short-
term and long-term gains or losses by rate group. Resulting short-term and long-
term losses are then offset against short-term and long-term gains (respectively)
beginning with the highest tax rate group and continuing to the lower rates.

2. Net Capital Loss Deduction and Loss Carryover Rules

a. $3,000 Maximum Deduction
LOSSES Individual taxpayers realizing a net long- or short-term capital loss may only
DEDUCTIBILITY recognize (deduct) a maximum of $3,000 of the amount realized from other types
of gross income (ordinary income, passive income, or portfolio income). A joint
return of husband and wife is treated as one person. If the husband and wife file
separately, the loss deduction is limited to half ($1,500).
b. Limitation
Capital losses are also limited to taxable income before personal exemptions.
c. Excess Net Capital Loss
Carry forward an unlimited time until exhausted. It maintains its character as
long-term or short-term in future years.
d. A Personal (Non-Business) Bad Debt
A personal (non-business) bad debt loss is treated as a short-term capital loss in
year debt becomes totally worthless.
e. Worthless Stock and Securities
The cost (or other basis) of worthless stock or securities is treated as a capital
loss, as if they were sold on the last day of the taxable year in which they
became totally worthless.
F. CORPORATION CAPITAL GAIN AND LOSS RULES (Applies to C Corporations Only)
1. Net Capital Gains (Long-Term and Short-Term)
Net capital gains (net of short-term and long-term capital gains and losses) of a
corporation are added to ordinary income and taxed at the regular tax rate.
a. Corporations do not get the benefit of lower capital gains rates.
b. Section 1231 gains are entitled to capital gain treatment. (Section 1231 assets
are capital assets used in the business and are covered in a later lecture.)
2. Net Capital Losses (Long-Term and Short-Term)
Corporations may not deduct any capital loss from ordinary income.
a. Net capital losses are carried back three years and forward five years as a short-
term capital loss.
b. Net capital losses are deducted from capital or Section 1231 gains. (Section
1231 gains are treated as "capital" assets used in the business while Section
1231 losses are treated as ordinary losses.)
PASS KEY
Excess
Offset Income Carryback Carryforward
• Operating Losses: Yes 2 years* 20 years
• Individual Capital Losses: $3,000 No Forever
• Corporate Capital Losses: No 3 years 5 years
*Taxpayer can elect to forego the carryback.

APPENDIX A
(FROM PAGE 46)
EXERCISE: BASIS OF GIFTED STOCK AND GAIN OR LOSS ON RESALE
General Rule: Exception:

FMV Higher FMV Lower
1 2 3 4
Donor's (Rich Uncle) Basis $20,000 $20,000 $20,000 $20,000

EXERCISE
FMV at Gift Date 40,000 13,000 13,000 13,000
Nephew's Selling Price 30,000 25,000 10,000 15,000
"Basis" to Nephew 20000 20,000 13,000 15,000
Taxable Gain (if any) 10,000 5,000 -0-
Deductible Loss (if any) 3,000 -0-
(FROM PAGE 47)
EXERCISE: BASIS OF INHERITED PROPERTY

1. Assume a taxpayer inherited property from a decedent. The FMV at date of death was $20,000 and
it was $15,000 six months later. It had a cost basis to the deceased of $5,000.
What is the basis of inherited property to the taxpayer:
EXERCISE
a. If the alternate valuation date was not elected? $ 20,000
b. If the alternate valuation date was elected? $ 15,000

2. Assuming the beneficiary sold that property for $25,000, compute the capital gain:
a. Assuming the alternate valuation date was not elected. $ 5,000 (25,000-20,000)
b. Assuming the alternate valuation date was elected. $10,000 (25,000-15,000)

APPENDIX B
I. FARMING INCOME
A. GENERAL
As mentioned in the text earlier in this chapter, a person (or entity) who engages in the
management or operation of a farm with the intent of earning a profit will report income and
expenses (either cash or accrual basis) using a Schedule F (which carries to the face of the
Form 1040, line 18, in the same way that net income reported on a Schedule C carries to the
Form 1040 on line 12). Essentially, income from farming activities is treated the same as
income from other business activities.
B. CASH BASIS AND ACCRUAL METHOD
1. Cash Basis
a. Most farmers use the cash basis.
b. Inventories of produce, livestock, etc. are not considered.
c. Gross income includes cash and the value of all other items received from the
sale of produce, livestock, etc. that has been raised by the farmer.
d. For livestock or other items a farmer may have bought, profit is computed by
subtracting the purchase price (cost) from the sales price.
2. Accrual Method
a. The accrual method is required for certain corporate and partnership farmers as
well as for all farming tax shelters.
b. Inventories must be used and maintained, and they must be taken at the start
and end of the tax year.
c. Gross profit equals the value of inventories at year-end plus the proceeds
received from the sales during the year, less the value of inventories at the
beginning of the year, less the cost of inventory purchased during the year.


APPENDIX C
I. FEDERAL INCOME TAX RESEARCH ISSUES

In Regulation simulations, you will be required to research federal tax issues. The research
database will include excerpts from the Internal Revenue Code.
A. THE INTERNAL REVENUE CODE – ORGANIZATION
1. The Code is divided into subtitles, chapters, parts, subparts, and sections. Some
subtitles of the code are:
a. Subtitle A Income Taxes
b. Subtitle B Estate and Gift Taxes
c. Subtitle C Employment Taxes
d. Subtitle F Procedures and Administration

2. Each Subtitle is divided into chapters.
3. The chapters are again subdivided into subchapters.
4. Each subchapter is further divided into parts and subparts, as required.
5. The smallest unique part of the Code is the section. The sections in the code are
numbered from 1 to over 9,000.
PASS KEY
Tax Research Steps
STEP 1: Carefully review the inquiry stated in the Research tab of the tax simulation.
STEP 2: Identify the "call of the question."
STEP 3: Choose a Keyword or IRC section and execute your search.
STEP 4: Evaluate the database results. Carefully examine each "hit" to determine if it is the correct response.

APPENDIX D
Hierarchy of Authority in the Tax Law and Definitions
I. INTERNAL REVENUE CODE

The Internal Revenue Code (IRC) holds the most authoritative value in the tax law. It was enacted
by Congress in Title 26 of the United States Code (26 U.S.C.).
II. IRS REGULATIONS (Federal Tax Regulations)

The IRS Regulations are the U.S. Department of Treasury's interpretation of the Internal Revenue
Code (IRC). They give directions on how to apply the law outlined in the IRC and have the second
most force and effect (second only to the IRC).
III. TAX COURT DECISIONS

Tax court decisions also interpret the Internal Revenue Code, but they do not have the authority of
the IRC.
IV. IRS AGENTS' REPORTS

The reports of IRS agents are used to report on specific taxpayer situations. IRS agents' reports
apply the Internal Revenue Code, IRS Regulations, and other forms of authoritative literature, but
they do not hold the value that the IRC, the IRS Regulations, or even tax court decisions have.

IMPORTANT NOTE TO STUDENTS:

Please check the Becker KnowledgeBase (http://www.beckercpa.com/knowledgebase) regularly for
supplemental materials, errata postings, software downloads, and other information provided to assist
you in the successful preparation for your CPA Examination.
While every effort is made to ensure the accuracy of the material contained in these textbooks, when
updates, corrections or clarifications are necessary they are posted within the Course Updates shown
above. Below is an example of the Financial Course Updates page. Students are encouraged to sign up
for automatic email notification of course updates by clicking on the "Notify Me by Email if this Answer is
Updated" button located at the bottom of each answer page.
Unlimited academic support questions including suspected errata items can be submitted using the Ask
Becker a Question tab. Please refer to the document "Introducing the New Becker KnowledgeBase!"
located under Important Announcements for more detailed instructions on how to use this system.
REGULATION 1
Class Questions Answer Worksheet

MC Question Number
First Choice Answer
Correct Answer
NOTES
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
Grade:
Multiple-choice Questions Correct / 21 = __________% Correct
Detailed explanations to the class questions are located in the back of this textbook.

NOTES

CLASS QUESTIONS
1. CPA-01404
Which of the following is (are) among the requirements to enable a taxpayer to be classified as a
"qualifying widow(er)"?
I. A dependent has lived with the taxpayer for six months.
II. The taxpayer has maintained the cost of the principal residence for six months.
a. I only.
b. II only.
c. Both I and II.
d. Neither I nor II.
2. CPA-01421
Joe and Barb are married, but Barb refuses to sign a 1992 joint return. On Joe's separate 1992 return, an
exemption may be claimed for Barb if:
a. Barb was a full-time student for the entire 1992 school year.
b. Barb attaches a written statement to Joe's income tax return, agreeing to be claimed as an exemption
by Joe for 1992.
c. Barb was under the age of 19.
d. Barb had no gross income and was not claimed as another person's dependent in 1992.
3. CPA-01415
Jim and Kay Ross contributed to the support of their two children, Dale and Kim, and Jim's widowed
parent, Grant. For 20X7, Dale, a 19-year old full-time college student, earned $4,500 as a baby-sitter.
Kim, a 23-year old bank teller, earned $12,000. Grant received $5,000 in dividend income and $4,000 in
nontaxable Social Security benefits. Grant and Kim are U.S. citizens and were over one-half supported
by Jim and Kay, but neither of the two currently reside with Jim and Kay. Dale's main place of residence
is with Jim and Kay, and he is currently on a temporary absence to attend school. How many exemptions
can Jim and Kay claim on their 20X7 joint income tax return?
a. Two
b. Three
c. Four
d. Five
4. CPA-01609
Perle, a dentist, billed Wood $600 for dental services. Wood paid Perle $200 cash and built a bookcase
for Perle's office in full settlement of the bill. Wood sells comparable bookcases for $350. What amount
should Perle include in taxable income as a result of this transaction?
a. $0
b. $200
c. $550
d. $600

5. CPA-01610
Charles and Marcia are married cash-basis taxpayers. In 20X8, they had interest income as follows:
• $500 interest on federal income tax refund.
• $600 interest on state income tax refund.
• $800 interest on federal government obligations.
• $1,000 interest on state government obligations.
What amount of interest income is taxable on Charles and Marcia's 20X8 joint income tax return?
a. $500
b. $1,100
c. $1,900
d. $2,900
6. CPA-01636
Clark filed Form 1040EZ for the 20X8 taxable year. In July 20X9, Clark received a state income tax
refund of $900 plus interest of $10, for overpayment of 20X8 state income tax. What amount of the state
tax refund and interest is taxable in Clark's 20X9 federal income tax return?
a. $0
b. $10
c. $900
d. $910
7. CPA-01433
Which of the following conditions must be present in a post-1984 divorce agreement for a payment to
qualify as deductible alimony?
I. Payments must be in cash or its equivalent.
II. The payments must end at the recipient's death.
a. I only.
b. II only.
c. Both I and II.
d. Neither I nor II.
8. CPA-01438
Which of the following costs is not included in inventory under the Uniform Capitalization rules for goods
manufactured by the taxpayer?
a. Research.
b. Warehousing costs.
c. Quality control.
d. Taxes excluding income taxes.

9. CPA-01472
Baker, a sole proprietor CPA, has several clients that do business in Spain. While on a four-week
vacation in Spain, Baker took a five-day seminar on Spanish business practices that cost $700. Baker's
round-trip airfare to Spain was $600. While in Spain, Baker spent an average of $100 per day on
accommodations, local travel, and other incidental expenses, for total expenses of $2,800. What amount
of educational expense can Baker deduct on Form 1040 Schedule C, "Profit or Loss From Business"?
a. $700
b. $1,200
c. $1,800
d. $4,100
10. CPA-01614
Nare, an accrual-basis taxpayer, owns a building which was rented to Mott under a ten-year lease
expiring August 31, 1998. On January 2, 1992, Mott paid $30,000 as consideration for cancelling the
lease. On November 1, 1992, Nare leased the building to Pine under a five-year lease. Pine paid Nare
$10,000 rent for the two months of November and December, and an additional $5,000 for the last
month's rent. What amount of rental income should Nare report in its 1992 income tax return?
a. $10,000
b. $15,000
c. $40,000
d. $45,000
11. CPA-01571
With regard to the inclusion of social security benefits in gross income, for the 20X8 tax year, which of the
following statements is correct?
a. The social security benefits in excess of modified adjusted gross income are included in gross
income.
b. The social security benefits in excess of one half the modified adjusted gross income are included in
gross income.
c. Eighty-five percent of the social security benefits is the maximum amount of benefits to be included in
gross income.
d. The social security benefits in excess of the modified adjusted gross income over a threshold amount
are included in gross income.
12. CPA-01482
Klein, a master's degree candidate at Briar University, was awarded a $12,000 scholarship from Briar in
20X8. The scholarship was used to pay Klein's 20X8 university tuition and fees. Also in 20X8, Klein
received $5,000 for teaching two courses at a nearby college. What amount is includible in Klein's 20X8
gross income?
a. $0
b. $5,000
c. $12,000
d. $17,000

13. CPA-01442
During 20X9, Ash had the following cash receipts:
Wages $13,000
Interest income from U.S. Treasury bonds 350
Workers' compensation following a job related injury 8,500
What is the total amount that must be included in gross income on Ash's 20X9 income tax return?
a. $13,000
b. $13,350
c. $21,500
d. $21,850
14. CPA-01761
Platt owns land that is operated as a parking lot. A shed was erected on the lot for the related
transactions with customers. With regard to capital assets and Section 1231 assets, how should these
assets be classified?
Land Shed
a. Capital Capital
b. Section 1231 Capital
c. Capital Section 1231
d. Section 1231 Section 1231
15. CPA-01736
Hall, a divorced person and custodian of her 12-year old child, filed her 20X9 federal income tax return as
head of a household. She submitted the following information to the CPA who prepared her 20X9 return:
In June 20X9, Hall's mother gifted her 100 shares of a listed stock. The donor's basis for this stock, which
she bought in 1990, was $4,000, and market value on the date of the gift was $3,000. Hall sold this stock
in July 20X9 for $3,500. The donor paid no gift tax. What was Hall's reportable gain or loss in 20X9 on
the sale of the 100 shares of stock gifted to her?
a. $0
b. $500 gain.
c. $500 loss.
d. $1,000 loss.
16. CPA-01669
If the executor of a decedent's estate elects the alternate valuation date and none of the property included
in the gross estate has been sold or distributed, the estate assets must be valued as of how many months
after the decedent's death?
a. 12
b. 9
c. 6
d. 3

17. CPA-01671
In December 20X1, Davis, a single taxpayer, purchased a new residence for $200,000. Davis lived in the
new residence continuously from 20X1 until selling the new residence in July 20X7 for $455,000. What
amount of gain is recognized from the sale of the residence on Davis' 20X7 tax return?
a. $455,000
b. $255,000
c. $5,000
d. $0
18. CPA-01747
In 20X9, Joan Reed exchanged commercial real estate that she owned for other commercial real estate
plus cash of $50,000. The following additional information pertains to this transaction:
Property given up by Reed
Fair market value $500,000
Adjusted basis 300,000
Property received by Reed
Fair market value 450,000
What amount of gain should be recognized in Reed's 20X9 income tax return?
a. $200,000
b. $100,000
c. $50,000
d. $0
19. CPA-01742
In a "like-kind" exchange of an investment asset for a similar asset that will also be held as an investment,
no taxable gain or loss will be recognized on the transaction if both assets consist of:
a. Convertible debentures.
b. Convertible preferred stock.
c. Partnership interests.
d. Rental real estate located in different states.
20. CPA-01726
In 20X2, Fay sold 100 shares of Gym Co. stock to her son, Martin, for $11,000. Fay had paid $15,000 for
the stock in 20X0. Subsequently in 20X2, Martin sold the stock to an unrelated third party for $16,000.
What amount of gain from the sale of the stock to the third party should Martin report on his 20X2 income
tax return?
a. $0
b. $1,000
c. $4,000
d. $5,000

21. CPA-01876
Lee qualified as head of a household for 20X9 tax purposes. Lee's 20X9 taxable income was $100,000,
exclusive of capital gains and losses. Lee had a net long-term loss of $8,000 in 20X9. What amount of
this capital loss can Lee offset against 20X9 ordinary income?
a. $0
b. $3,000
c. $4,000
d. $8,000

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2. Individual taxation—exemptions .................................................................................... 10

3. Individual taxation—gross income .................................................................................. 16

4. Individual taxation—capital gains and losses.................................................................... 41

9. Class questions ........................................................................................................... 63

< ADJUSTMENTS >

FEDERAL INCOME TAX

< TAX CREDITS >

< PAYMENTS >

TAX DUE OR REFUND

© 2009 DeVry/Becker Educational Development Corp. All rights reserved. R1-3

ADJUSTED GROSS INCOME

Medical (in excess of 7½% of AGI)

R1-4 © 2009 DeVry/Becker Educational Development Corp. All rights reserved.

© 2009 DeVry/Becker Educational Development Corp. All rights reserved. R1-5

R1-6 © 2009 DeVry/Becker Educational Development Corp. All rights reserved.

INDIVIDUAL TAXATION—FILING STATUS

© 2009 DeVry/Becker Educational Development Corp. All rights reserved. R1-7

II. FILING STATUS

A. SINGLE/END OF YEAR TEST

R1-8 © 2009 DeVry/Becker Educational Development Corp. All rights reserved.

Dependent Lives With

W Widow/widower = Whole year

H Head of household = Half a year (more than)

© 2009 DeVry/Becker Educational Development Corp. All rights reserved. R1-9

R1-10 © 2009 DeVry/Becker Educational Development Corp. All rights reserved.

II. DEPENDENCY EXEMPTIONS

QUALIFYING CHILD OR QUALIFYING RELATIVE

Close Relative Support (over 50%) test

Age Limit Under a specific amount of (taxable) gross income test

Residency Requirements Precludes dependent filing a joint tax return test

Support Test Changes Relative test

Taxpayer lives with individual for whole year test

• Died during the year.

CARES 3. Residency Requirement

CARES 5. Support Test Changes

SUPORT 2. Under Exemption Amount of (Taxable) Gross Income

© 2009 DeVry/Becker Educational Development Corp. All rights reserved. R1-13

Tim Rick Dennis

R1-14 © 2009 DeVry/Becker Educational Development Corp. All rights reserved.

III. PHASE-OUT OF PERSONAL AND DEPENDENCY EXEMPTIONS

© 2009 DeVry/Becker Educational Development Corp. All rights reserved. R1-15

GROSS INDIVIDUAL TAXATION—GROSS INCOME

I. GROSS INCOME IN GENERAL

Taxable = FMV FMV

Non-taxable = N -0- N E NBV

C. REALIZATION AND RECOGNITION

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D. TIMING OF REVENUE RECOGNITION

II. SPECIFIC ITEMS OF INCOME AND EXCLUSIONS COMPENSATION

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6. Partially Taxable Fringe Benefits: Portion of Life Insurance Premiums

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g. Qualified Employee Discounts

© 2009 DeVry/Becker Educational Development Corp. All rights reserved. R1-19

R1-20 © 2009 DeVry/Becker Educational Development Corp. All rights reserved.

4. Forfeited Interest (Adjustment): Penalty on Withdrawal from Savings

R1-22 © 2009 DeVry/Becker Educational Development Corp. All rights reserved.

2. Prior year used standard deduction = nontaxable state or local refund.

© 2009 DeVry/Becker Educational Development Corp. All rights reserved. R1-23

E. PAYMENTS PURSUANT TO A DIVORCE

R1-24 © 2009 DeVry/Becker Educational Development Corp. All rights reserved.