Week 4 You Decide

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How is the $300,000 treated for purposes of Federal tax income?

The tax issue here is that John Smith wants to know how the $300,000 he earned through his client fee is taxed. The $300,000 is taxed as ordinary income and is taxed in the year received. John Smith worked on the case for two years but he did not earn the $300,000 until this year so he will include it in this year’s taxable income. Therefore John Smith needs to include the entire $300,000 as ordinary income on his Federal tax return. Gross Income means all income from whatever source derived which includes compensation for services, including fees, commissions, fringe benefits, and similar items. (IRC Sec. 61(a),(1))

b. How is the $25,000 treated for purposes of Federal tax income?

The tax issue at play here is how to handle the additional $25,000 received by John Smith from expenses he paid up front. If John previously expensed the $25,000 then the recovery of the $25,000 will be considered as income in the current year. If he didn’t then he may use the $25,000 to offset the deferred expenses and it will have no impact on his taxable income. “Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter.“ (IRC Sec. 111 (a))

c. What is your determination regarding reducing the taxable amount of income for both (a) and (b) above?

John wants to know what would be the best way to go about reducing his taxable income for the current year. The best way for John to reduce his taxable income in this scenario would be to set up annuity payments. Taxpayers are allowed to recover their contributions free of tax to a non-qualified annuity. This would allow John to reduce his taxable income by the amount of the annuity payments. (IRC Sec. 72(b)) This would be preferable to having the entire $300,000 settlement fee taxed in the current year.

What are the different tax consequences between paying down the mortgage (debt) and assuming a new mortgage (debt) for Federal income tax purposes?

Jane wants to know how their taxes would be affected if they chose to continue paying down their current mortgage vs. assuming a new mortgage. The difference in tax consequences between the two options would likely be pretty minimal. There are certain factors to consider that we don’t know (amount of mortgage payments, years left on mortgage, etc.) which would help truly analyze the two options. That being said, married couples are allowed to exclude up to $500,000 of gains every two years from sale of their principle residence if a new house is purchased. Also, homeowners are allowed to deduct the amount of mortgage interest payments from their taxable income. Therefore if the Smith’s can sell their house and purchase a ‘bigger’ one as Jane mentioned it would probably be beneficial to go ahead and do so. The reason for this is because a) any gain from the sale of their current resident (up to $500,000) will be excludable for tax purposes and b) the new mortgage will likely result in higher interest payments since the house will likely be more expensive and thus they will be able to deduct a larger amount from their taxes as itemized deductions for mortgage interest. (http://www.alllaw.com/articles/tax/article3.asp)

b. Can John and Jane Smith utilize a 1031 tax exchange to buy a more expensive house using additional money from John’s case?

The 1031 tax exchange states that “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” (IRC Sec. 1031 (a) (1)) I don’t think John and Jane would be able to utilize a 1031 tax exchange in this...
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