Can I Deduct This?

IRS allows individuals to reduce taxable income by deducting certain expenses. These expenses relate to the following:

• Investment /creation or production of income
• Trade or business

To be deductible, expenses must be

• Reasonable in amount
• Necessary and helpful in the production of income / business / industry
• Ordinary or typical in production of income / business / industry

Prepaid expenses

Portion of a prepaid expense that covers a period outside of the current year can be deducted in the current year tax return provided the expense adheres to the “one-year principle rule”, which dictates:

• Prepaid expense must cover a benefit covering the earlier of

â–º a period up to 12 months after the payment was made or

â–ºThe end of the taxable year following the taxable year in which the payment is made

• Payor must demonstrate that expense is required
• Payment is NOTused to manipulate reduction in taxable income

Taxpayers on accrual basis must deduct expenses if the following criteria are met:

• All events test – all the events have occurred to establish the liability for the expense
• Economic performance test - only expenses which have been performed can be deducted. No prepayment can be deducted since this situation precedes the economic performance of the expense.
• Deduction for expense liability can be established with reasonable accuracy

!  One exception to prepaid expense deductibility is attributed to recurring payments. IRS allows an accrual basis taxpayer to deduct a prepaid expense, provided the expense is recurring and economic performance occurs no later than 8.5 months after the close of the taxable year.

Startup / investigative expenses for a new business:

If taxpayer IS already in the same type of business being investigated / researched:

•  All such expenses are deductible in the year incurred, whether the business starts or not.

If taxpayer IS NOT already in the same type of business being investigated / researched:

â–ºIf the business starts: All such expenses ARE deducted

â–ºIf the business does NOT start, NO deduction is allowed

! The allowable deduction is $5,000 in the current year with excess over that amount capitalized over a 15-year period (180 months). If the total cost exceeds $50,000 a dollar for dollar reduction is subtracted from the $5,000, over the excess of $50,000. Eg. For a total startup cost of $53,000, a taxpayer can only deduct ($53,000 less $50,000) = $2,000. This is the allowed current year deduction, with $51,000 to be capitalized over 15 years.

Losses from Hobbies are NOT deductible based on the IRS's Presumptive rule, which states that a hobby is presumed to be a business if the activity nets a profit for 3 out of the last 5 years of activity.  Expenses from a hobby are deductible up to the income amount. Income from a hobby is reported as Other Income on an individual’s tax return while hobby expenses are reported as Itemized deduction, limited by a 2% of AGI excess. No hobby loss beyond income is deductible. If a hobby is determined to be a business, losses can be deducted on Sch. C. 

Losses from a business ARE deductible in the current year.

Rentals

Vacation home Rental

• Non-Rental (Considered Non-Rental) Property

â–ºVacation property rented LESS than 15 days a year - Income and expenses of vacation property rented for less than 15 days a year is NOT treated as Rental.

Rental income is NOT taxable, and expenses related to rental are NOT deductible.

• Rental (Considered Primarily Rental Property)

â–ºVacation property rented Less Than 15 days a year and is NOT used personally more than the GREATER of

1. 14 days OR
2. 10% of total days rented

Rental income is fully reported, and expenses are deducted based on the number of days allocated to rental activity. A loss from rental activity can be deducted based on at risk rules.

• Rental (Considered Personal / Rental Use Property)

â–ºVacation Property rented more than 15 days in a year and is USED personally MORE than the GREATER of

1. 14 days OR
2. 10% of total days rented

• Rental income is fully reported, and expenses are deducted up to allocation based on the rental and personal use. The order of deducted expenses starts with Mortgage interest and Property taxes, followed by Utilities, Maintenance and other related expenses. Depreciation is deducted last. 

Legal expenses relating to tax matters are deductible. Legal costs associated with matters that affect your taxes are deductible to the extent they relate to activities associated with

1. production, collection or enforcement of income
2. matters associated with trade or business
3. fees associated with tax matters

Political donations / lobbying costs paid are NOT deductible.

Expenses incurred on behalf on another taxpayer (other than a depended or spouse) are NOT deductible. Howerver, an exception to this rule relates to medical / dental expenses. The exception allows a taxpayer to deduct costs of health care expenses paid for a relative even if the relative is not the taxpayer's dependent. Accurate records must be kept to substantiate the expense. 

Costs associated with acquisition or production of an Asset used in production of income (ex; building, machinery) are NOT deductible in the year incurred. Instead they are capitalized and written off based on the property’s useful life. The exception is employee’s salaries and overhead expenses. These can be capitalized or deducted in the year business or taxpayer took ownership of or acquired a liability against the asset.

De minims expenses – Acquisition costs or improvements made to an income producing asset or property can be expenses in the year incurred, provided these costs are less than $5000. To expense these costs, the taxpayer or business must have a written policy of amounts to be expensed.

A taxpayer can deduct cost of improvements made to a real estate under the following circumstances:

• The business’s annual receipts is less than $10 million in the last 3 years
• Property has an adjusted basis less than $1million
• Total costs of improvements LESS than or equal the smallest of the following: 2% of unadjusted basis of the building or $10,000, where unadjusted basis is the building’s purchase costs without deduction of depreciation.

If a taxpayer can not meet above requirements, all costs for improvement must be capitalized

Losses between related parties (individuals related by ancestry or marriage, corporations owned more than 50% by a taxpayer or corporations that have common ownership) are NOT deductible. Individual ownership of one related party includes ownership of others in the related party. For example: an individual owns stock in a corporation, is also considered to own stock of his family members in that corporation. However, a loss may be deducted upon the subsequent sale of an asset or property from the related party to an unrelated party. The loss is calculated using the original adjusted basis by the first related party where that basis is subtracted from the sale price to an unrelated party. The loss becomes attributed to the related party making the final sale. 

Accounting Methods – Cash vs Accrual

A cash method taxpayer can deduct expenses that he/she paid. That also includes payments made through a loan. Promises of a payment do NOT constitute a tax-deductible expense for a cash basis taxpayer.

Accrual method taxpayer can deduct expenses which have NOT been paid yet, but to qualify for the deduction these expenses must meet below requirements:

1. All events test and Economic Performance test – to claim an expense that has not been paid yet, unless all the events have occurred to make the taxpayer liable for the expense
2. Liability expense determination – the value of the liability can be determined with reasonable accuracy

! One exception to the accrual expense deductibility rule applies to recurring expenses. If a liability arises out of recurring expenses where All events and economic performance tests have NOT been met, the taxpayer CAN deduct the recurring expense provided:

• Expense is recurring
• Accrued expense is immaterial to determine in matching income to expenses
• Economic performance occurs prior to 8.5 months after the close of the taxpayer’s taxable year.

Reserves for bad / uncollected debt made by accounting departments in preparing financial reports are typically disallowed on tax returns.

Costs or interest paid associated with tax exempt income ( ex: municipal bonds) are NOT deductible).

Bad or worthless debt deduction - Both business and personal debts can be deductible, but the circumstances of the deduction differ:

Uncollectable Personal debt is allowed in the year it is determined to be worthless in its entirety.  The deduction is reported as a short-term capital loss deduction, subject to $3,000 limitation. Balance can be taken in future years.

Uncollectable Business debt is permitted to be deducted in the year it's determined to be WHOLLY or PARTIALLY worthless. The loss is deducted as an ordinary loss and can be netted against ordinary income. This loss is not subject to limitations. 

! If in future years the loss is recovered, the amount must be reported as income only to the extent it generated a tax benefit to the taxpayer. 

! Uncollected loans between family members may be deemed as gifts. To establish validity of an uncollected loan between family members the IRS will take into consideration the following:

1. Was there a written loan agreement and payoff date

2. Was there a reasonable rate charged on the loan

3. Were reasonable collection efforts made to recover loan

4. What was the intent of the parties

Stocks or bonds from a Non-Small Business Corporation which become worthless can be deducted as a capital loss, subject to the $3,000 limitation. Worthlessness is deemed to have occurred on the last day of the taxable year. Losses on stock from a Small Business Corporation can be deducted as an ordinary loss (netted against ordinary income) up to $50,000 for single taxpayers and up to $100,000 for MFJ taxpayers. Losses over these thresholds are deducted as a capital loss subject to $3,000 annual limitations.

! To be considered a stock from Small Business Corporation (Sec. 1244 Stock) , the company's equity must be below $1,000,000 at the time of stock issuance and it must have derived more than half of its income from business operations and not from passive activity for a minimum of 5 preceding years.

Monetary personal loss due to an accident such as automobile is deductible as a personal casualty loss. The loss must NOT have been incurred willful or intentional. Other losses include damage sustained due to weather conditions or theft. These conditions must have occurred suddenly and unexpectedly. As a result, loss due to progressive deterioration such as termite damage is not a deductible casualty loss. 

Loss is deductible when it becomes reasonably certain that the loss will not be recovered. If an insurance recovery is expected, the loss is deductible after the insurance claims determines unrecovered portion of the loss. Recovered loss is reported as income in the year recovered, and only to the extent it provided a tax benefit on the filed tax return. 

Loss on fully destroyed business property can be fully deducted. The deduction is equal to the property's basis.

Loss on partially destroyed business property OR fully or partially destroyed personal property can be deducted but the deduction is based on the  LESSER of:

• Adjusted basis of the property
• Difference between FMV of property before casualty event and FMV following the event

Personal casualty loss deduction can be based on an estimate to restore the property to its original condition before the loss. If the property was covered by insurance, the taxpayer must first file a claim, before a loss can be deducted.

To calculate the deductible loss:

Add total loss

deduct $100 (per event NOT per item destroyed or damaged)

deduct excess of 10% over AGI

Balance equals allowable net loss deduction

Casualty loss incurred by an employee in connection with production of income / trade / business are deducted as Itemized deductions subject to excess of 2% of AGI threshold. Employee casualty losses are NOT subject to $100 and 10% threshold in excess of AGI. 

!  Gains from casualty losses are reported as capital gains (when gains exceed losses, all are treated as capital gains / capital losses)

!  Losses from casualty losses are reported as Itemized deductions (losses exceed gains) less $100 per event and to the extent they exceed 10% of AGI

Disaster area casualty loss can be carried back to prior year tax return. To be eligible the casualty loss must be designated as disaster area by the government.

Tax treatment of research and development:

1. Current Deduction

You can elect to deduct all the R&D costs incurred in a year as a business deduction. This deduction can be particularly beneficial for cash strapped or startups because it allows the business to lower taxable income before the R&D investment starts to produce revenue. 

2. Deferred Amortization Deduction 5 years or more

Here the business can postpone deduction until it starts to produce revenue from the R&D efforts and the deduction is prorated over a minimum of 5 years. 

Domestic Production Activities Deduction is a business deduction on income from domestic manufacturing

Net Operating Losses sustained in one year can be carried back 2 years and forward 20 years or until used up if sooner.  

To calculate Net Operating Loss (NOL):

1. Add back personal and dependency exemptions

2. Exclude NOL from other years

3. Add back excess of non-business capital losses over non-business capital gains. This provision cannot exceed $3000 due to limitation on capital losses deduction

4. Add back excess of non-business deduction (deductions not related to taxpayer’s trade or business such as an IRA deduction, alimony, itemized deductions or standard deduction) over non-business income (income not related to taxpayer’s trade or business such as interest, dividends, alimony) plus non-business NET capital gains (excess of non-business capital gains over non-business capital losses)

5. Add back excess of business capital losses over the sum of business capital gains PLUS (excess of non-business income plus (net non-business capital gains over non-business deductions)) This provision cannot exceed $3000 due to limitation on capital losses deduction