ITEMIZED DEDUCTIONS Recommended CPE Credit: 6 HRS [B] CPElite T.M.

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1 ITEMIZED DEDUCTIONS Recommended CPE Credit: 6 HRS [B] PREPARED BY CPElite T.M. In a Class By Yourself T.M. (800) 9500-CPE 2013 EDITION P.O. BOX 1059, CLEMSON, SC & P.O. BOX 721, WHITE ROCK, SC

2 2013 QUIZ INSTRUCTIONS ITEMIZED DEDUCTIONS There are 7 true-false quiz questions and 23 multiple-choice questions at the end of the course. Choose the best answer based on the limited facts of each question, and record your answer on the enclosed answer sheets. An extra answer sheet below is enclosed for your personal records. The answer sheet to be turned in is on the next page. To test on-line, go to and log into your account page. If you account has not has not yet been created at our website, please contact us for assistance [ cpeliteinc@aol.com; phone or fax: ]. You must score 70% to receive continuing professional education credit for this course. You may take the quiz two additional times without incurring additional expense. If your zip code is below 56000, please return your completed answer sheet to CPElite, T.M P. O. Box 721, White Rock, SC If your zip code is above 55999, please return your completed answer sheet to CPElite, T.M P.O. Box 1059, Clemson, SC After you successfully complete the quiz, your quiz results, a complete set of solutions, and a certificate of completion will be mailed to you within 10 working days of our receipt of your answer sheet. The completion date on your answer sheet will be the date designated on your certificate. The latest recommended completion date is within one year of purchase. ANSWER SHEET FOR YOUR RECORDS ITEMIZED DEDUCTIONS 6 HOURS OF CPE (Based on 50 Minutes of Average Completion Time Per Hour) Delivery Method Self Study (Latest Recommended Completion Date: Within one year of purchase) Please record your answers below and retain this copy for your records We appreciate your business and hope that you were satisfied with the course. COMPLETION DATE ii

3 2013 ANSWER SHEET TO BE SUBMITTED ITEMIZED DEDUCTIONS 6 HOURS OF CPE (Based on 50 Minutes of Average Completion Time Per Hour) Delivery Method Self Study (Latest Recommended Completion Date: Within one year of purchase) To test on-line, go to and log into your account page. If you account has not has not yet been created at our website, please contact us for assistance [ cpeliteinc@aol.com; phone or fax: ]. Otherwise, please record your answers below and mail your solutions to: ZIP CODE BELOW ZIP CODE ABOVE CPElite CPElite P.O. Box T.M. 721 P. O. Box T.M White Rock, SC Clemson, SC We appreciate your business and hope that you were satisfied with the course. Please express below your comments on course quality, other topics you would like, or our other products and services NAME ADDRESS [PLEASE PRINT] ADDRESS (Note: We do not share or sell addresses) PHONE NUMBER SIGNATURE COMPLETION DATE PURPOSE OF CPE PTIN (if applicable) (Indicate whether credit is for enrolled agent, CPA, or other purpose. For CPA's and other licensed accountants, please indicate state licensed. For CFPs, please provide either the last four digits of your social security number or your certificant/cfp Board ID number). COURSE EVALUATION (Answer Yes, No, or N/A) 1. The stated learning objective was met. 2. Handout or advance preparation materials were satisfactory. 3. The materials were accurate. 4. The materials were relevant and contributed to the achievement of the learning objective. 5. If applicable, prerequisite requirements were appropriate. 6. The time allotted to the learning activity was appropriate. 7. Additional Comments iii

4 ITEMIZED DEDUCTIONS Recommended CPE Credit: 6 HRS [B] TABLE OF CONTENTS A. STANDARD DEDUCTION 1 B. MEDICAL EXPENSES B.1 General Considerations 4 B.2 Special Situations and What is Deductible 6 B.3 Substantiation Requirements 12 B.4 Self-Employed Health Insurance Deduction 13 C. TAXES 14 D. QUALIFIED RESIDENCE INTEREST D.1 Qualified Residence Debt 16 D.2 Taxpayer's Residence 19 D.3 Interest Computation and Debt Issues 21 D.4 Deductibility of Loan Points 23 E. CHARITABLE CONTRIBUTIONS E.1 General Contribution Rules 28 E.2 Certain Students Who Live With Taxpayers 34 E.3 Contributions Made in Connection With Athletic Events 36 E.4 Appraisals 37 E.5 Recordkeeping and Substantiation Requirements 40 E.6 Special Rules for Donations of Qualified Vehicles 42 F. NONBUSINESS CASUALTY AND THEFT LOSSES F.1 Tax Definition of a Casualty or Theft 45 F.2 Determining the Amount of the Casualty or Theft Loss 47 F.3 Computing the Casualty or Theft Loss Deduction 49 F.4 When the Loss Deduction is Taken 52 F.5 Proving and Documenting the Casualty or Theft Loss Deduction 54 G. MISCELLANEOUS ITEMIZED DEDUCTIONS NOT SUBJECT TO THE 2% OF ADJUSTED GROSS INCOME LIMITATION 56 H. DEDUCTIONS SUBJECT TO THE 2% FLOOR FOR MISCELLANEOUS ITEMIZED DEDUCTIONS H.1 Unreimbursed Employee Business Expenses 57 H.2 Other Deductions Subject to the 2% Floor 59 I. CONCLUDING REMARKS 60 QUIZ QUESTIONS 61 ENDNOTES 68 iv

5 ONGOING DEVELOPMENTS CPElite T.M. CONTINUES TO MONITOR LEGISLATIVE, ADMINISTRATIVE, AND JUDICIAL DEVELOPMENTS AS THEY OCCUR, AND OUR COURSES ARE UPDATED TO REFLECT TAX LAW CHANGES. ALL RIGHTS RESERVED. THE REPRODUCTION OR TRANSLATION OF THESE MATERIALS IS PROHIBITED WITHOUT THE WRITTEN PERMISSION OF CPElite. T.M. v

6 ITEMIZED DEDUCTIONS Recommended CPE Credit: 6 HRS [B] This course contains a discussion of some of the itemized deductions for personal expenditures for individual income taxpayers, i.e., the deductions on Schedule A of Form Topics covered are medical expenses, taxes, qualified residence interest, charitable contributions, nonbusiness casualty and theft losses, and miscellaneous itemized deductions. We also discuss the standard deduction in this course. This course reflects legislative changes made through the American Taxpayer Relief Act of 2012, the ATRA 12, signed by President Obama on January 2, Tax planning strategies are contained throughout the course. The level of knowledge expected to be imparted by this course is basic. Our courses comply with the enhanced standards required of providers of continuing professional education (the Statement of Standards for Continuing Professional Education (CPE) Programs, issued jointly by the AICPA and NASBA). The pass rate percentage for our courses is 70%, our courses contain the required minimum number of quiz questions per CPE hour (5), and our courses contain the required minimum number of review questions per CPE hour (5). We are an IRS-Approved Continuing Education Provider. A. STANDARD DEDUCTION A taxpayer's standard deduction is the sum of five items: (1) the basic standard deduction; (2) the additional standard deduction; (3) for , the real property tax deduction; (4) the disaster loss deduction; and, (5) for 2009, the motor vehicle sales tax deduction. 2 The additional standard deduction is for the elderly and the blind an elderly taxpayer is one who is 65 or older at the end of his / her tax year, and a taxpayer is considered to be 65 on the day before his / her 65 th birthday. 3 The real property tax deduction is for state and local real property taxes, and applies to individual taxpayers who do not itemize their deductions. The real property tax deduction is capped at $1,000 for joint filers, and $500 for others. 4 The disaster loss deduction is for the excess of personal casualty losses attributable to a federally declared disaster that occurred before January 1, 2010, over personal casualty gains. 5 The motor vehicle sales tax deduction is for state sales and excise taxes on new motor vehicles purchased for use by the taxpayer between February 17 and December 31, The deduction is limited to the tax on up to $49,500 of the purchase price and it is phased out for taxpayers with modified AGI between $125,000 and $135,000 ($250,000 and $260,000 for a joint return). 6 The basic standard deduction for joint filers is 200% of the basic standard deduction for single filers. 7 1

7 The basic standard deduction and the additional standard deduction for blind and elderly taxpayers (for all filers except dependents) for and are as follows: Basic Standard Deduction Additional Standard Deduction Filing Status Married Filing Jointly $11,900 $12,200 $1,150 $1,200 Married Filing Separately $ 5,950 $ 6,100 $1,150 $1,200 Head of Household $ 8,700 $ 8,950 $1,450 $1,500 Single $ 5,950 $ 6,100 $1,450 $1,500 Example 1 Bob is 67 years old on January 1, His wife Marla turns 65 on January 1, Neither is blind. Bob and Marla file a joint tax return for They do not itemize their deductions. They are entitled to a standard deduction of $14,600 [$12,200 basic standard deduction plus $2,400 ($1,200 x 2) additional standard deduction for being elderly] on their return. The amount for the additional standard deduction for being elderly and blind in the table above is doubled if the taxpayer is both elderly and blind. A married taxpayer who files separately may take the additional standard deduction for his / her spouse if the spouse has no gross income and is not another taxpayer's dependent TAX SAVER!! The size of the standard deduction for joint return taxpayers coupled with the relatively low mortgage interest rates in recent years increases the number of taxpayers who will be claiming the standard deduction. This makes the timing of deductions that much more important. By shifting certain deductions from one year to another (such as making charitable contributions, real estate tax payments, and the last month s home mortgage payment in the next tax year instead of the current tax year), a taxpayer may alternate between claiming the standard deduction in one year and itemizing deductions in the next year Example 2 Harold Sims, age 27 is single. On December 1, 2012 he prepares a summary of his potential itemized deductions. They total $3,500. In December, he receives his personal property tax bill on his car for $600. He also was planning on making a $1,000 charitable contribution to his church in December, which he normally does each year. If both payments were made in December 2012, his itemized deductions equal $5,100, so he will claim the standard deduction of $5,950. If instead he makes the two payments in January 2013, has the same amount of itemized deductions in 2013, and pays the 2013 property tax and makes the planned 2013 charitable contribution in December, 2013, his total itemized deductions for 2013 equal $6,700 ($3,500 + $1,600 of deductions paid in January 2012 and $1,600 of deductions paid in December 2013). As a result, he will be able to itemize his deductions in 2013 rather than claiming the $6,100 standard deduction, resulting in $600 of additional deductions in

8 TAX SAVER!! With job losses and investment losses characterizing the current and projected economic situations, marginal tax rates may be higher in later years than in current years. These facts may suggest deferring deductions / losses to later years when they have more tax value, trumping the usual tax planning strategy of accelerating deductions / losses Certain taxpayers are not entitled to a standard deduction. They must itemize their deductions. Here is a list of taxpayers who are not entitled to a standard deduction: (1) a married taxpayer filing a separate return, where either spouse itemizes deductions; (2) a taxpayer filing a tax return for a short tax year because the taxpayer changes his or her accounting period; (3) a non-resident alien individual; and, (4) an estate or trust, common trust fund, or a partnership. 10 In some cases, the standard deduction is limited. If a taxpayer can be claimed as a dependent on another's tax return, then generally, his / her standard deduction is limited to $950 in 2012 ($1,000 in 2013) or, if greater, the taxpayer's earned income plus $300 in 2012 ($350 in 2013). 11 Earned income consists of the usual items of salary, wages, professional fees, and other amounts received for personal services performed. Also, earned income includes the taxable portion of a scholarship or fellowship. Example 3 Jonathan is single. His parents take a dependency exemption for him on their 2013 joint return. Jonathan has the following items of gross income for 2013: Summer wages... $1,800 Taxable part of scholarship to the local university... 1,200 Interest income Dividend income Jonathan is entitled to a standard deduction on his own 2013 return of $3,350 ($1,800 + $1,200 + $350). There is a limitation on the standard deduction to which Jonathan and similar taxpayers are entitled. The limitation equals the amount of the basic standard deduction for single taxpayers ($5,950 in 2012 and $6,100 in 2013) TAX SAVER!! Dependents generally can earn up to the basic standard deduction amount taxfree. On the other hand, unearned income of a dependent will be taxed after it exceeds $950 for 2012 ($1,000 for 2013). Therefore, when income shifting is considered, to the extent that a dependent can work in a self-employed person's business for wages up to $5,950 in 2012 ($6,100 in 2013), this strategy generally should be implemented before asset transfers generating unearned income are made

9 ** REVIEW QUESTIONS AND SOLUTIONS ** Multiple Choice Questions 1. For 2013, Doug and Jean, married taxpayers, file separate returns. Doug itemizes his deductions, claiming $13,000 of personal deductions on Schedule A. Jean has $3,000 of personal deductions that she could claim on Schedule A. What is the amount of Jean s itemized or standard deduction for 2013? a. $6,100. b. $ 800. c. $3,000. Solutions 1. C is the correct response. Where married taxpayers file separate returns, if either spouse itemizes deductions, the other spouse must itemize deductions. Thus, Jean is entitled to a $3,000 deduction for her personal itemized deductions. A is an incorrect response. While $6,100 is the amount of the basic standard deduction for a married taxpayer who files a separate return, Jean must itemize since Doug itemizes. B is an incorrect response. $800 is the difference between Doug s itemized deductions of $13,000 and the $12,200 basic standard deduction for married taxpayers who file a joint return for 2013, not Jean s deduction for B. MEDICAL EXPENSES B.1 General Considerations A deduction for unreimbursed medical expenses is available only for medical expenses paid for the taxpayer, his / her spouse, and a person who was his / her dependent when the medical services were provided or the cost of the services was paid. 12 Status as a dependent is determined without regard to whether the dependent claims dependency exemptions, or whether the dependent files a joint return or has gross income that exceeds the 2013 exemption amount of $3, Example 4 For 2013, Bob and Jill Mason file a joint return. Their son Bill is 23 and not a student. Bill earns more than $3,900 in Bill lives at home, and the Masons provide more than half of Bill's support. Included in Bill's support is $750 of medical expenses paid by the Masons. Bob and Jill can claim the $750 of medical expenses in computing their medical expense deduction. Example 5 Bob and Jill Mason from Example 4 also provide more than half of their daughter Milly's support for Included in their support is $625 of medical expenses paid for Milly. Milly gets married during 2013, and she and her husband file a joint return for their 2013 taxable year. Bob and Jill can not claim Milly as a dependent on their 2013 return. Nevertheless, they can claim the $625 of medical expenses for Milly in computing their 2013 medical expense deduction. 4

10 TAX SAVER!! If a taxpayer partially supports another sufficient to claim an exemption (such as a taxpayer who supports ill parents), generally it will be better for the taxpayer to pay the dependent's medical expenses directly, and let the dependent pay for other items which are not deductible. Under this arrangement, the taxpayer will obtain the medical expense deduction for amounts paid for the dependent. The taxpayer will want to ensure that the support test still is satisfied under this arrangement For purposes of computing the medical expense deduction on Schedule A, the floor is 10% of adjusted gross income. 14 For alternative minimum tax purposes, the floor also is 10% TAX SAVER!! Taxpayers who have fairly consistent, recurring medical expenses may want to consider a bi-annual shifting program, if their situation permits it. Under this strategy, the taxpayer can bunch medical expenses in one year and then have very few medical expenses in the next year. As an example, if a married couple's annual medical expenses run about 5% of adjusted gross income, a strategy, to the extent practicable, to postpone or accelerate some medical treatment and its costs could result in a medical expense deduction which otherwise would not be obtained Medical expenses include amounts paid for the diagnosis, treatment, or prevention of disease, or for the treatment affecting any part or function of the body. Amounts paid for insulin, and medicines and drugs which require a prescription also count as a medical expense. 16 The cost of medicines and drugs, which may be written as a prescription by a doctor for a patient, but which can be obtained over-the-counter, is not deductible as a medical expense. The cost of certain medical equipment, e.g., crutches and eyeglasses, that may be obtained over-the-counter, though, is deductible as a medical expense. 17 Also, the cost of certain nondeductible medical costs, e.g., nonprescription drugs, may reduce an individual s taxable income through the use of a flexible spending arrangement through The IRS has ruled on whether amounts that an individual pays for expenses of attending a medical conference relating to the chronic disease of the individual's dependent qualify as a medical expense deduction. 19 The amounts the individual paid include costs of transportation to the city where the conference was held, local transportation to the conference site, registration fees, and meals and lodging while attending the conference. The IRS ruled that generally, if the costs are primarily for and essential to the medical cost of the dependent, the expenses of admission and transportation to a medical conference relating to the chronic disease of the individual's dependent are deductible as medical expenses. However, the costs of meals and lodging while the taxpayer is attending the conference are not deductible as medical expenses. 5

11 The cost of medically-prescribed controlled substances is not deductible as a medical expense. The IRS has addressed this situation in one of its rulings. 20 In the ruling, based on the recommendation of a physician, the taxpayer purchased marijuana and used it to treat the taxpayer's disease in a state whose laws permitted such purchase and use. Amounts incurred for illegal operations or treatments are not deductible for federal income tax purposes. 21 Although the purchase of marijuana was permitted under state law, marijuana is listed as a controlled substance under the Controlled Substance Act (CSA). Generally, the CSA does not permit the possession of controlled substances even if prescribed by a physician for medical purposes. The IRS concludes in the ruling that, notwithstanding state law, a controlled substance such as marijuana, obtained in violation of the CSA, is not legally procured within the meaning of Treasury regulations, and therefore its costs are not deductible as a medical expense. ** REVIEW QUESTIONS AND SOLUTIONS ** Multiple Choice Questions 2. Amounts paid for which one of the following do not qualify as a medical expense deduction? a. Insulin. b. A drug, where the drug is permitted under state law but is a controlled substance under the Controlled Substance Act. c. Prescription medicine that is not available over-the-counter. Solutions 2. B is the correct response. In a ruling, the IRS concludes that the cost of medically-prescribed controlled substances in violation of the Controlled Substance Act is not deductible as a medical expense. A is an incorrect response. As insulin is for the treatment of disease, its cost is deductible as a medical expense. C is an incorrect response. As prescription medicine is for the treatment or prevention of disease, its cost is deductible as a medical expense if it is not available over-the-counter. B.2 Special Situations and What is Deductible Children of divorced or separated parents, and a dependent who is claimed under a multiple support agreement are special situations. The taxpayer must be especially discerning in order to properly obtain a medical expense deduction in these cases. Special rules exist for who may claim a dependency exemption for a child in the divorced / separated parents situation. If either parent can claim a child as a dependent under these rules, each can count as a medical expense what he / she pays for the child's medical expenses. 6

12 A multiple support agreement is used to claim a dependent when at least two people together provide more than half the support for a dependent, but no one person provides more than half of the support. The person entitled to the dependency deduction may claim a deduction for the medical expenses which he / she pays. The person entitled to claim the deduction may claim the expenses even if the potential dependent can not be claimed as a qualifying relative because he / she has gross income of at least the exemption amount of $3,800 for 2012 and $3,900 for Medical expenses paid by others who are parties to the agreement may not be claimed as a medical expense deduction by anybody TAX SAVER!! If one of the parties to a multiple support agreement has deductible medical expenses, perhaps that person should claim the dependency exemption. This strategy seems appropriate because so few taxpayers are entitled to a medical expense deduction due to the 10% of adjusted gross income limitation Example 6 Three sisters, Mary, Kerry, and Sherry, each provides a third of their mother's total support. Mary is entitled to claim their mother as a dependent under a multiple support agreement. Mary pays all of her mother's $3,000 medical expenses in However, she is reimbursed $1,000 by Kerry, and $1,000 by Sherry. Mary is entitled to claim $1,000 of her mother's medical expenses under her return. Neither Kerry nor Sherry is entitled to claim any of her mother's medical expenses. Example 7 Assume the same facts as in Example 6 above, with one change: Mary's mother has gross income of $3,901. The results are the same: Mary may claim $1,000 of her mother's medical expenses, and neither Kerry nor Sherry is entitled to claim any of her mother's medical expenses TAX SAVER!! From a tax planning standpoint only, the sisters in Examples 6 and 7 should consider the tax value of the deduction to Mary, and adjust their mother's nondeductible expenses which they pay. In other words, Mary should pay their mother's medical expenses, recognizing the after-tax cost, and Kerry and Sherry should pay after-tax equivalent amounts of other expenses which their mother has. If Mary is in the 28% tax bracket, she otherwise would itemize her deductions, and her mother has sufficient total expenses, she should pay the $3,000 of medical expenses. Since Mary can deduct the $3,000 for tax purposes, the after-tax cost of the $3,000 to Mary is $2,160, the amount to be shared by the sisters for their mother's medical expenses Payments for the following items qualify as medical expenses: (1) legal abortion, (2) acupuncture, (3) payments to a treatment center for alcoholics or drug addicts, 7

13 (4) smoking-cessation programs and prescribed drugs for the treatment of nicotine addiction programs, 22 (5) the cost of medical care, including meals and lodging, for the taxpayer, his / her spouse, or dependents, in a nursing home or home for the aged, if the main reason for being there is to get medical care (If the reason for the person's being in a nursing home is a personal or family one, the cost of meals and lodging for the person is not deductible as a medical expense. In that instance, medical expenses include only those amounts which are paid for medical or nursing care.), (6) charges for medical care which are included in the tuition fee of a college or private school if the charges are separately stated in the bill, or given to the taxpayer by the school, (7) up to $50 per night for lodging for medical care away from home, where a separate $50 limitation applies to the patient and a person traveling with the patient, (8) mileage rate for transportation: cents per mile; cents per mile, 24 and (9) the expenses for certain weight-loss programs TAX SAVER!! If the school in item 6 includes the amount it charges for medical care in tuition, the individual taxpayer should request an itemized bill which reflects a separate amount for medical care In a ruling, the IRS permitted taxpayers a medical expense deduction for tuition costs of a special school. 25 The taxpayers child was diagnosed with several developmental disorders. The diagnosis covered a wide range of learning, social, and psychiatric difficulties, one of which was shown by testing to be severe ( severe condition ). The neuropsychologist who conducted the tests concluded that the child needed an educational environment that was more therapeutic and specialized for the child s disabilities than what the child was receiving in the special education program at the child s public school. 26 With respect to item (9) above, the IRS has stated in a ruling that expenses for certain weight-loss programs may be deducted as a medical expense. 27 In order for uncompensated amounts that individuals pay for participation in a weight-loss program to be deductible, the program must be undertaken as treatment for a specific disease or diseases diagnosed by a physician. The ruling adds obesity to diseases for which unreimbursed amounts paid qualify as a medical expense deduction. The costs are not deductible for taxpayers who participate in weight-loss programs to improve their general health or appearance. Further, the cost of diet food items that the taxpayer purchases is not deductible. You may not deduct the cost of your meals and lodging while you are away from home for medical treatment which you do not receive at a medical facility, or for the relief of a specific condition, even if you made the trip based on your doctor's advice. As an example, assume that you have a heart condition. 8

14 You live in an area which has cold winters. The cold winters make your condition worse. Based on your doctor's advice to spend your winters in a warmer place, you spend your winters in a rented house in Florida. You may not deduct the costs for food and lodging between your home and Florida, as well as your costs while you are in Florida, as a medical expense. Likewise, your family's transportation cost is not deductible. However, you may deduct your share of transportation costs between your home and Florida as a medical expense. Amounts paid for special equipment which is installed in one's home, or for improvements, if the main reason is for medical care, qualify as medical expenses. In this regard, amounts spent primarily to accommodate one's personal residence to the taxpayer, his / her spouse, or a dependent's handicapped condition, qualify as deductible medical expenses. However, generally the cost must be reduced by the increase in the value of the property. Competent, documented appraisals before and after the improvements will lessen taxpayer / IRS disputes. The costs of operation and upkeep for a capital item which qualified as a medical expense also are a medical expense, provided the medical reason for the capital item still exists. These costs qualify, even though no deduction originally was permitted because the fair market value increase exceeded the cost of the capital item. Example 8 Willie Waters has a heart ailment. His doctor prescribes that Willie install an elevator in his home so that Willie will not have to climb stairs. In 2012 Willie has an elevator installed. The cost of the elevator is $10,000. Willie obtains appraisals that show the value of his home increased by $2,500. Willie's medical expense with respect to this capital improvement is $7,500 ($10,000 - $2,500). Example 9 Assume the same facts as in Example 8, except that the appraisals show that the fair market value increase is $10,200. Willie has no medical expense with respect to the cost of installing the elevator. Example 10 In 2013, the condition of Willie's heart has not changed. Willie spends $200 for electricity to operate his elevator, and $400 for repairs to the elevator. Willie has a $600 medical expense in 2013 for the elevator. The $600 is a medical expense under the set of circumstances in either Example 8 or Example 9. Special attention must be paid to amounts spent for the care of a disabled dependent. Wages and other amounts paid for nursing services qualify as a medical expense. The services do not have to be performed by a nurse as long as the services are of a kind generally performed by a nurse. Included are 9

15 services connected with caring for the patient's condition, such as giving medication or changing dressings. There could be amounts which qualify both as a medical expense deduction and for the child and dependent care credit. For example, for purposes of the child and dependent care credit, qualifying work expenses include the expenses for the care of a qualifying person. Qualifying persons include: (1) your child who, with certain modifications, meets the definition of a qualifying child -- (a) the child must reside with the taxpayer more than half of the year; (b) the child must be a U.S. citizen, national, or resident alien, or resident of Canada or Mexico; the child must be a dependent under 13 or incapable of self-care; (d) the child cannot be self-supported (more than 50%); and, (e) the child must have a valid social security number or individual taxpayer identification number; (2) a dependent of the taxpayer who is physically or mentally incapable of caring for himself or herself, if the person has the same principal place of abode as the taxpayer for more than half of the tax year; and, (3) your spouse who is physically or mentally not able to care for himself or herself. A divorced or legally separated taxpayer having custody of a child, where the child is disabled or under 13 years of age, may claim the dependent care credit even if the taxpayer has released the right to the dependency exemption for the child. The value of claiming a deduction for the expenses (whether the taxpayer will be an itemizer, the 10% floor under medical expenses, and the taxpayer s marginal tax bracket) must be compared to the value of claiming a credit for the expenses (applicable credit percentage) to make the best tax decision. If the expenses are claimed for purposes of the credit, they can not be claimed also as a medical expense deduction. Example 11 William and Claudia Case both have salaried positions for separate corporations. Claudia's dependent mother comes to live with William and Claudia. The Cases must hire a nurse to care for Claudia's mother, so that William and Claudia may continue to be gainfully employed. The amounts paid for the nurse qualify both as a medical expense deduction and for the child and dependent care credit. Because of their excellent health and their substantial combined income, the Cases would have no medical expense deduction for the amounts paid for the nursing services. On the other hand, they would be able to obtain a credit for some of the amounts spent for the nursing services. They should complete a Form 2441 and file it with their federal income tax return TAX SAVER!! Taxpayers who have amounts which qualify as a medical expense deduction and for purposes of the child and dependent care credit should evaluate the impact of using the amount as a deduction or a credit. The child and dependent care credit is not refundable, and any unused credit can not be carried to another tax year

16 The cost of unnecessary cosmetic surgery does not qualify as a deductible medical expense. Cosmetic surgery is any procedure which is directed at improving the patient's appearance and does not meaningfully promote the proper function of the body or prevent or treat illness or disease. Examples of costs which do not qualify as a medical expense are the costs for face lifts, hair transplants, hair removal (electrolysis), and liposuction. However, the cost of a radial keratotomy procedure to correct for an individual's nearsightedness constitutes a deductible medical expense. 28 Also, expenses for medical procedures that are medically necessary to promote the proper function of the body and only incidentally affect the patient s appearance, or expenses for treatment of a disfiguring condition that arises from a congenital abnormality, personal injury or trauma, or disease, are deductible. For example, the cost of reconstructive surgery after removal of a malignancy is deductible. 29 Cosmetic surgery will be considered unnecessary unless the surgery or procedure is necessary to improve one of the following conditions: 1. A deformity which arises from, or is directly related to, a congenital abnormality. 2. A personal injury which results from an accident or trauma. 3. A disfiguring disease. If expenses for cosmetic surgery are not deductible as medical expenses, amounts paid for insurance coverage for the expenses are not deductible as a medical expense. Also, reimbursement for the expenses is not excludable from gross income under an employer-provided health plan, for example a flexible spending arrangement. 30 ** REVIEW QUESTIONS AND SOLUTIONS ** True False Questions 3. A taxpayer diagnosed by her physician as obese may deduct as a medical expense deduction the cost to join a weight-loss program and the cost of reduced-calorie diet foods. Multiple Choice Questions 4. Payments for which one of the following do not qualify as a medical expense? a. The cost of meals and lodging for a taxpayer s dependent who is in a nursing home, where the reason for the dependent s being there is limited space in the taxpayer s home. b. Tuition costs of a special school. c. 24 cents per mile for transportation for medical purposes in

17 Solutions 3. False is the correct response. The cost to join a weight-loss program qualifies as a medical expense deduction. True is the incorrect response. The cost of purchasing reduced-calorie diet foods does not qualify as a medical expense deduction. 4. A is the correct response. While the cost of meals and lodging for a dependent in a nursing home is deductible if the main reason for the dependent s being there is to get medical care, if the reason for the dependent s being in the nursing home is a personal one the cost of meals and lodging is not deductible as a medical expense. B is an incorrect response. In a ruling, the IRS holds that a taxpayer was entitled to a medical expense deduction for the tuition costs of a special school. Specific requirements with respect to the student s condition and the school s teaching techniques, the principal reasons for the child s attending the school, and the school s qualification as a special school must be met. C is an incorrect response. For 2013, the mileage rate for transportation is 24 cents per mile. B.3 Substantiation Requirements In some Tax Court cases, the taxpayer has been denied a medical expense deduction because of failure to substantiate. 31 The Treasury regulations give the substantiation requirements. 32 The taxpayer must document the name and address of each person to whom payment for medical expenses is made, as well as the amount and date of the payment in each case. If requested by the district director of the Internal Revenue Service, the taxpayer must provide a statement or itemized invoice from the individual or entity to which payment for medical expenses is made, showing the following: 1. the nature of the service rendered, 2. to or for whom the service was rendered, 3. the nature of any other item of expense and for whom and what specific purpose it was incurred, 4. the amount paid, 5. the date of payment, and 6. such other information as the district director may deem necessary TAX SAVER!! Clients should be reminded from time to time of the substantiation requirements generally, and also in particular what is necessary to sustain a medical expense deduction should they be called on to support it TAX SAVER!! If the taxpayer is near the 10% of adjusted gross income limitation, he / she may be able to time the payments for medical care, such that one year's otherwise nondeductible expenses are moved into a deductible year

18 ** REVIEW QUESTIONS AND SOLUTIONS ** True False Questions 5. The taxpayer is denied a deduction for medical expenses if the taxpayer fails to properly substantiate the expenses. Solutions 5. True is the correct response. The Treasury regulations contain substantiation requirements that taxpayers must meet. Also, there have been some Tax Court decisions in which the taxpayer was denied a medical expense deduction due to failure to substantiate. False is the incorrect response. Both administrative law (Treasury regulations) and judicial law (court decisions) deny the taxpayer a medical expense deduction for which there is substantiation failure. B.4 Self-Employed Health Insurance Deduction Self-employed persons (sole proprietors, general partners, limited partners who receive guaranteed payments, and S Corporation shareholders who own more than 2% of the S Corporation) may take an above-the-line business expense deduction for 100% of the amount that they pay during the year for health insurance for themselves, their spouses, their dependents, and any child who has not attained age 27 as of the end of the tax year. 33 A child is an individual who is the taxpayer s son, daughter, stepson, stepdaughter, or eligible foster child. The taxpayer s legally adopted child or an individual who is lawfully placed with the taxpayer for the taxpayer s legal adoption is treated as a child of the taxpayer by blood. A self-employed person can not take the deduction for any month in which he/she was eligible to participate in any subsidized health plan maintained by the taxpayer s, spouse s, dependent s, or any child s (who has not attained age 27) employer. 34 The determination as to whether self-employed individuals or their spouses are eligible for employerpaid health benefits is made on a calendar-month basis. 35 The deduction is limited: it can not exceed the taxpayer s net earned income derived from the trade or business for which the insurance plan was established, less the deductions for 50% of the self-employment tax and Keogh, self-employed SEP, or SIMPLE plan contributions. With respect to the earned income limitation, a more-than-2% S Corporation shareholder s wages are treated as the shareholder s earned income. 36 Late 2010 legislation permits self-employed taxpayers to deduct the above-the-line deduction for health care expenses to compute self-employment tax. The self-employment tax deduction applies to taxable years after

19 ** REVIEW QUESTIONS AND SOLUTIONS ** Multiple Choice Questions 6. Which one of the following individuals may not take a self-employed business deduction for health insurance? a. An S Corporation shareholder who holds a 1% interest in the corporation. b. A partner in a general partnership. c. A sole proprietor. Solutions 6. A is the correct response. The self-employed deduction for health insurance is available to a selfemployed person, which includes a more-than-2% S Corporation shareholder. The deduction is not available to an S Corporation shareholder who owns 1% of the S Corporation. B is an incorrect response. The self-employed deduction for health insurance is available to a partner. C is an incorrect response. The self-employed deduction for health insurance is available to a self-employed person, for example the sole proprietor of a business. C. TAXES State, local, and foreign income taxes, state, local, and foreign real estate taxes, and state and local property taxes are deductible as itemized deductions in the year paid. 38 Through 2013, taxpayers may elect to deduct either state and local income taxes paid or general state and local sales taxes paid on personal purchases. 39 There are two ways to arrive at the deduction for sales taxes. One way is to deduct the total taxes paid that can be substantiated with receipts (actual method). The other way is to use the amount from IRS tables, increased by general state and local taxes that are paid on the purchase of motor vehicles, boats, aircraft, homes (including mobile and prefabricated homes), and materials to build a home (optional method). If married taxpayers file separate returns, and both deduct state and local sales taxes, both must use the optional method if one uses the optional method. The deduction for state and local income (or sales) and property taxes can work against the taxpayer in some cases. Taxpayers who live in states where these amounts are high obtain valuable itemized deductions which lower their regular federal income tax liability. However, these amounts are not deductible to compute the alternative minimum tax. Consequently, if the taxpayer's regular taxable 14

20 income is high enough to cause the alternative minimum tax exemption to be phased out, the addback of regular tax deductions for income and property taxes could surprise individual taxpayers and cause them to be subject to the alternative minimum tax. If an individual is in a trade or business or an income-producing activity, sales taxes are treated in accordance with the capitalization rules for property transactions. Under the capitalization rules, the tax is treated as a part of the cost of the property acquired, 40 or as a reduction in the amount realized when the property is sold. The sales tax on items where the cost is deductible as a business expense, e.g., supplies, is deductible as part of the business expense. Example 12 Jason Bach pays the following amounts for sales taxes during 2013: $1,200 for sales taxes on personal purchases; $475 for sales taxes on restaurant meals paid as part of a deductible business meal in his sole proprietorship (after considering the 50% limitation); and, $775 for sales taxes on the purchase of appliances for one of his rental units. Jason may deduct the $1,200 under the actual method for deducting sales taxes. Jason may deduct the $475 of sales tax paid as a part of deductible business meals in his trade or business. 41 The deduction is taken on Schedule C of Form Jason capitalizes the $775 of sales tax with respect to the appliances as a part of the cost of the appliances TAX SAVER!! If the income tax rate is expected to decline, the taxpayer may want to overpay his / her estimated state income tax for the higher-rate year in order to obtain a more valuable deduction. Even without future reduced rates that are established by legislation, this strategy is useful if an individual anticipates a decline in his or her top marginal rate from one tax year to the next. This planning strategy, though, must take into account the possibility of the increased state income tax deduction s placing the taxpayer in an alternative minimum tax situation ** REVIEW QUESTIONS AND SOLUTIONS ** Multiple Choice Questions 7. Willie Wilson spends the following amounts for taxes: $4,500, state income taxes; $500, local income taxes; and, $3,000, local property taxes. How much may Willie deduct for alternative minimum tax purposes? a. $5,000. b. $-0-. c. $8, For 2012, Mark Swanson pays $5,000 in state income taxes and $7,000 in state sales taxes on personal purchases for which he has receipts. The amount from IRS tables for Mark s state sales tax deduction is $4,000. He pays no other state taxes. How much is the largest deduction that Mark can claim for taxes on his federal income tax return in 2012? a. $ 16,000. b. $ 0. c. $ 7,

21 Solutions 7. B is the correct response. Amounts spent for state and local income and property taxes are not deductible to compute the alternative minimum tax. A is an incorrect response. Amounts spent for state and local income taxes are deductible only for regular tax purposes. C is an incorrect response. Amounts spent for state and local income and property taxes are deductible only for regular tax purposes. 8. C is the correct response. Mark claims a deduction either for his $5,000 in state income taxes or for the larger of his substantiated sales taxes ($7,000) or the amount from the IRS tables ($4,000). The largest deduction that Mark can claim is $7,000. A is an incorrect response. Mark deducts either his state income taxes, or the larger of his actual sales taxes or the amount from the IRS tables. Mark is not permitted to deduct state income taxes and both amounts for potentially deductible state sales taxes. B is an incorrect response. Mark is permitted to deduct either state income or state sales taxes in D. QUALIFIED RESIDENCE INTEREST D.1 Qualified Residence Debt Qualified residence interest expense is the only type of interest attributable to personal expenditures that is deductible as an itemized deduction (educational loan interest of up to $2,500 may qualify for an above-the-line deduction 42 ). Qualified residence interest is defined as interest paid or accrued on the sum of the following types of debt: 1. Acquisition indebtedness. 2. Home equity indebtedness. Although the rules for qualified residence interest were not effective until 1988, debt incurred on or before October 13, 1987, which is secured by a qualified residence is labeled acquisition debt. D.11 Acquisition Indebtedness Acquisition indebtedness includes any debt incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer where the debt is secured by the residence. 43 There is no guidance as to the meaning of the term substantial improvement. Acquisition debt also includes refinancing with respect to the above items, but only to the extent of the principal amount of the acquisition debt immediately before the refinancing. 16

22 Example 13 On December 1, 2002, Billy purchased a residence for $100,000. He financed $90,000 of the purchase. On April 1 of the current year Billy refinanced his home mortgage when his existing mortgage had a balance of $80,000. He received $95,000 of loan proceeds which was used to pay off the $80,000 balance of the existing mortgage and to purchase an automobile. With respect to the refinancing, $80,000 of the new loan is considered acquisition indebtedness, since the principal balance immediately before the refinancing was $80,000. The remaining $15,000 may qualify as home equity indebtedness (see Section D.12 below). The maximum amount of total acquisition indebtedness per year for which interest is deductible is $1,000,000 ($500,000 for a separate return). 44 If the taxpayer has more than one qualifying residence, the limit applies to the sum of the debts. The Congressional Committee Reports suggest a first-in first-out ordering to determine which debt qualifies for residence interest treatment. Example 14 On January 15, Baker purchased a principal residence for $1,300,000, financing $800,000 of the purchase price. On November 1 of the same year, Baker purchased a second residence for $600,000, financing $500,000 of the purchase price. Assuming that the full $1.3 million of debt qualifies as acquisition indebtedness, it is necessary to determine which debt qualifies under the $1,000,000 limitation. Based on the committee reports, all $800,000 of the first debt and $200,000 of the second debt qualify as acquisition debt. How does the $1,000,000 limit work if there are two taxpayers, rather than two residences? Suppose that two taxpayers buy a personal residence, share in the payment of the mortgage, and the debt exceeds $1,000,000. For purposes of calculating the residence interest deduction, is the debt limitation $1,000,000 or $2,000,000? The IRS rules that the language of the statute (IRC Section 163(h)(3)) limits the debt incurred in acquiring a qualified residence of the taxpayer not as debt incurred in acquiring the taxpayer s portion of a qualified residence. As a result, the IRS concludes that the limitation is $1,000,000. The taxpayer s share of the interest deduction is computed by multiplying the amount of interest actually paid by the taxpayer by a fraction, the numerator of which is $1,000,000 and the denominator of which is the average balance of the outstanding debt during the year. 45 Recall that with respect to indebtedness incurred on or before October 13, 1987 (transition debt), all qualified residence secured debt (including home equity debt) is treated as acquisition debt and the $1,000,000 limitation does not apply. 46 The amount of the debt reduces the $1,000,000 limitation, but not below zero. 17