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Deductions or losses are not allowed for tax purposes unless the statute

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specifically provides for them (approves them)

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Three general categories of Deductions

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1- Expenses incurred in connection with TRADE or BUSINESS 2- Expenses incurred by an individual in connection with the PRODUCTION OF INCOME 3- Other types of expenses; interest expense, taxes, bad debts, and others by individuals for personal reasons; medical expenses, alimony, and moving cost

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For individuals, the difference between a trade or business and the production of income is important because

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it can affect both the amount and type of deduction.

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Section 262 also provides, in general, that a deduction is not allowed for any

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personal, living, or family expenses

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The concept of AGI applies to

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individual taxpayers, not other entities such as corporations or partnerships

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Section 62 specifically identifies deductions

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FOR AGI, all other deductions for individuals are deductions FROM AGI

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Deductible business or investment expenses must be

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- Related to PROFIT MOTIVATED ACTIVITY - ORDINARY - NECESSARY - PROPERLY DOCUMENTED - EXPENSE OF THE TAXPAYER

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Expenditures ARE NOT deductible if it is

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-CAPITAL EXPENDITURE -EXPENSE RELATED TO TAX-EXEMPT INCOME -ILLEGAL -SPECIFICALLY NOT ALLOWED BY LAW

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Generally, expenses incurred in an investment activity other than those incurred to produce rent and royalties are

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deductions for AGI

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Taxpayers must capitalize and depreciate the same expenditures over several years if they are

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incurred in an INVESTMENT activity rather than a trade or business

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Expenses incurred in an investment activity are

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miscellaneous itemized deductions from AGI and are deductible only to the extent they exceed 2% of the taxpayers AGI of the year

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In order for an expense to be ordinary, it must be

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reasonable in amount and it must bear a reasonable and proximate relationship to the income-producing activity or property.

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An expense is considered necessary if it is

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"appropriate and helpful" in the taxpayer's business.

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Capital Expenditures

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expenses that add value of, substantially prolong the useful life of, or change the use of the property

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Capital Expenditures include

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- Cost of acquiring or construction of buildings - Machinery - Equipment - Furniture - And any similar property that has a useful life that extends substantially beyond the end of the tax year

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Interest expense on debt incurred to purchase or carry tax-exempt securities is

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not tax deductible.

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Payments of fines and penalties resulting from an ILLEGAL ACT

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are NOT tax deductible

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Other expenditures specifically disallowed for deduction

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political contributions and lobbying expenses

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IRC allows a deduction in the year in which a business starts for start-up expenses. The deduction amounts to the

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lesser of the amount of start-up expenses OR $5,000 the remaining of the portion must be AMORTIZED over a 180 month period

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The burden of providing the existence of a deduction or loss falls on

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the taxpayer

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Taxpayer may not take a deduction on an expense if

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they do not substantiate the expense with an adequate record or sufficient evidence.

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Recordkeeping requirements for deductions for the following expenses

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travel, entertainment, business gifts, computers, and vehicles. Cohan rule does not apply!

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Cash method

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expenses are deductible when actually paid

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A capital expenditure or the prepayment of expenses by cash method taxpayers does not result in a current deduction if

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the expenditure creates an asset having a useful life that extends substantially beyond the close of the tax year

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Points paid in connection with the purchase of a principal residence may be

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deducted in the year paid.

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Points paid in connection with a purchase of a principal residence are automatically deductible in the year paid if they satisfy the following

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- closing agreement designates amounts as points - amount involves a computation as a percent of amount borrowed - charging of points is an established business practice in the area - points are paid in connection with the purchase of the taxpayers principal residence which is used to secure loan

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A taxpayer may NOT deduct points paid to

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refinance a mortgage on a principal residence

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If the taxpayer sells a home and pays off the refinanced mortgage

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any unamortized portion of the points is deductible in the year of repayment

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The purpose of the wash sale is to prevent taxpayers from generating artificial tax losses in situations where taxpayers do not

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intend to reduce their holdings in the stock or securities sold

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If the wash sale provisions disallow a loss, then the disallowed loss increases

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the basis of the recently acquired stock. This increase in basis causes loss to be deferred

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Related taxpayers may not take current deductions on two specific types of transactions

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Losses on sales of property, Accrued expenses that remain unpaid to the related cash method taxpayer at the end of the year

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If Sec.267 disallows the loss,

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the original seller of the property receives no tax deduction, disallowed loss has NO effect on purchaser's basis.

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On a subsequent sale of the property

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the related purchaser may reduce the recognized gain by the amount of the disallowed loss

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If the disallowed loss is larger than the subsequent gain, or if the purchaser sells the property at a loss,

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the taxpayer may NOT take a deduction for the unused loss

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Generally, Section 267 requires that unpaid expenses may not be deducted by a taxpayer in a different year than when

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the related payee recognizes the amount as income.

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The success of the taxpayer in other dissimilar activities

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is NOT used to determine if activity is a hobby or a business

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If the IRS asserts that an activity is personal one (hobby) rather than a business or investment, the burden of proof test

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rests on the taxpayer to prove otherwise

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The activity meets the test if it shows a profit for any

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THREE years during a consecutive FIVE year period.

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The five year period consists of

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the year in question plus the previous four years

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If it is determined that the activity is a business (for profit) the taxpayer may deduct

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all qualified business expenses from gross income, even if it has a net loss

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If it is determined that an activity is a Hobby the taxpayer may

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deduct as a miscellaneous itemized ded but only to the extent of gross income, net loss is not to be reported

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A taxpayer may not generate a tax loss from a hobby and then use it to

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offset other types of income

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Because owning a second home may have both personal and profit motivated attributes, Sec. 280A may disallow or limit deductions for expenses related to the rental of a vacation home that is

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also a residence by the taxpayer

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The determining factor is whether the property provides shelter and accommodations for

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eating and sleeping

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A dwelling unit qualifies as a residence if the number of days during which the taxpayer uses the property for personal use throughout the year exceeds the greater of the following

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- 14 days, or - 10% of the number of days during the year that the property is rented at a fair rental

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Residence test, a day of personal use includes

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- Any day taxpayer and family uses property for personal use - Any day any individual uses property under reciprocal-use arrangement - Any day any individual used the property and does not pay a fair rental for its use

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Despite the family-use rule, if taxpayer rents property at a fair rental to a family member that uses property as a principal residence, such use does not

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constitute personal use by taxpayer

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The taxpayer may carryover and deduct

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in a subsequent year expenses that are not currently deductible because they exceed the gross income from the property

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Rental Expenses Use Formula

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(Number of rental days/Total number of days used)x Total expenses for the year

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The formula does not include

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the days that no one uses the property

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Expenses of an office in a home are

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NOT deductible

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To be able to deduct expenses for an office in a home they must use the office regularly for either of the following

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- The principal place of business for a trade or business of the taxpayer, or - A place where the taxpayer meets or deals with clients in the normal course of business

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The term "principal place of business" includes a home office used by a taxpayer for administrative or management activities of the business if

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no fixed location exists where the taxpayer conducts these

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For employees to take a deduction for home office expenses, the use must also have been for the convenience of the

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employer

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Taxpayers should use care in timing the realization of

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items of income and expense

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Meeting the three-out-of-five-year test does not automatically ensure

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the activity will be treated as a business

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It compels the IRS to prove the activity is

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not a business causing the IRS less likely to challenge the deductions

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In the case of travel and entertainment expenses, the Code states that taxpayers may not

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take a deduction for an improperly documented expense

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Documentation must include the

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Amount of expense Time and place of travel or activity Business purpose Business relationship of the people entertained

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