EA1 Study Unit 5.1-5.8 Above-the-Line Deductions and Losses

Above-the-Line Deductions

• Compute taxable income deductions are tested on the EA exam
• Business expense deductions are also tested in a corporate context
• It's important to classify each deduction as either above-the-line or itemized and apply each deduction limit
• Gross income is reduced by deductions to compute taxable income
• No amount is deductible from gross income unless allowed by the Internal Revenue Code (IRC).
• Above-the-line deductions are deducted from gross income to arrive at adjusted gross income (AGI).
• Several deductions and credits are limited by reference to AGI
• Below-the-line deductions are deducted from AGI to arrive at taxable income
• Above-the-line deductions are also referred to as deductions to arrive at AGI and as deductions for AGI

Educator Expenses

• Primary/secondary school educators can claim an above-the-line deduction of up to $300 in 2024 for unreimbursed books/supplies for classroom use
• Qualified expenses include amounts paid/incurred after March 12, 2020, for personal protective equipment, disinfectant, and supplies to prevent coronavirus spread
• Each taxpayer (educator) can deduct up to $300 on a joint return
• Books, supplies, computer equipment (including related software/services), and supplementary materials for the classroom qualify for the deduction
• An eligible educator is a K-12 teacher, instructor, counselor, principal, or aide for at least 900 hours during a school year
• "School" is defined as an elementary/secondary education provider, as determined under state law

Health Savings Account

• A Health Savings Account is a tax-exempt trust/custodial account set up with a U.S. financial institution where money is saved for future medical expenses
• Must be used with a high-deductible health plan
• The contribution amount depends on coverage nature and age
• For self-only coverage, contributions up to $4,150 are allowed ($5,150 for ages 55-64)
• For family coverage, contributions up to $8,300 are allowed ($9,300 for ages 55-64)
• Contributions aren't allowed for those aged 65+ or enrolled in Medicare
• You don't need insurance for the whole year to contribute the full amount
• Contributions can be made up to amount of the annual healthcare deductible but no more than the maximum
• Contributions for 2024 include those made until April 15, 2025
• The taxpayer can't be claimed as a dependent on another return

Self-Employment Deductions

• A self-employed person can deduct the employer's portion of FICA taxes to arrive at AGI
• The deduction for the employer's share is equal to 50% of the self-employment tax or:
  • 6.2% of the first $168,800 of net self-employment income, plus
  • 1.45% of net self-employment income (no cap)
• Net self-employment income is total net self-employed profits multiplied by 92.35%
• The 0.9% additional Medicare tax is on the employee's portion of FICA taxes and is not deductible

Self-Employed SEP, SIMPLE, and Qualified Plans

• A self-employed individual can deduct amounts paid on their behalf to a qualified retirement or profit-sharing plan, like a SEP or SIMPLE plan
• The most common plan is a SEP (Keogh) plan
• The maximum annual contribution is the lesser of 25% of self-employed earnings or $69,000 (indexed for inflation)
• Self-employed earnings are reduced by the deductible part of self-employment taxes
• Contributions to the plan are subtracted from net earnings to calculate self-employed earnings, creating a circular computation
• A standard rate of 20% is used to calculate the allowed deduction for convenience

Savings Incentive Match Plan for Employees (SIMPLE)

• Self-employed taxpayers can make both employer and elective employee contributions
• Employee contributions are considered deferred compensation and are limited to $16,000 in 2024
• An employer match of up to 3% of self-employed earnings may be deducted as an above-the-line deduction

Self-Employed Health Insurance Deduction

• Self-employed individuals can deduct 100% of health insurance payments for themselves, their spouse, and dependents
• The deduction is limited to the earned income derived from the business for which the insurance plan was established
• No deduction is allowed if the taxpayer is eligible for an employer-sponsored plan by their own employer, their spouse's employer, or a dependent's employer

Alimony

• For divorces before 2019, alimony/separate maintenance payments are gross income to the recipient and deductible by the payor
• For divorces after 2018, alimony is nondeductible to the payor and not included in the recipient's gross income
• Rules apply only to pre-2019 divorces.

Qualified Alimony Payments

• Requirements:
  • Payment is made in cash or equivalent
  • Payment is received by or on behalf of a spouse under a divorce/separation agreement
    • Payments made to a third party on behalf of a spouse at the written request of the payee spouse qualify as alimony
    • Examples are mortgage payments, rent, medical costs, and education
  • Payments can't be for upkeep of property owned by the payor, such as when the payor retained ownership of the house and pays the mortgage
  • The payee/payor spouses must not be members of the same household during payments
  • The payor spouse isn't liable for payments after the payee spouse's death
  • The spouses must not file joint returns

Jointly Owned Home Rules

• If a divorce/separation instrument states the taxpayer must pay expenses for a home owned by the taxpayer/former spouse, some payments may be alimony.
• If required to pay all mortgage payments (principal/interest) on a jointly owned home, and payments qualify as alimony, a taxpayer can deduct half of total payments as alimony
• If deductions are itemized and the home is a qualified home, a taxpayer can claim half of the interest in figuring deductible interest
• The spouse must report one-half of the payments as alimony received.
• If the spouse itemizes deductions and the home is a qualified home, (s)he can claim one-half of the interest on the mortgage in figuring deductible interest.
• If required to pay all real estate taxes/insurance on a home held as tenants in common, a taxpayer can deduct one-half of these payments as alimony
• The spouse must report one-half of these payments as alimony received.
• If a taxpayer/spouse itemize deductions, each can claim one-half of the real estate taxes and none of the home insurance.
• If the home is held as tenants by the entirety/joint tenants, none of the payments for taxes/insurance are alimony.
• If a taxpayer itemizes deductions, (s)he can claim all real estate taxes and none of the home insurance.

Child Support

• Child support payments and any part of an alimony payment designated as child support are not deductible
• If any amount of an alimony payment is reduced based on a contingency relating to a child (e.g., age or graduation), the amount of reduction is treated as child support
• If divorce/separation instrument specifies payments of both alimony and child support, and only partial payments are made, the partial payments are considered child support until the obligation is fully paid
• Treat any excess as alimony

Retirement Savings (IRA) Contributions

• An individual who isn't an active participant in an employer-maintained retirement plan may make fully deductible IRA contributions, up to the lesser of $7,000 ($8,000 if age 50+) or 100% of compensation
• Contributions must be made by the return due date (without extensions) to qualify for the return year
• Compensation includes earned income but not pensions, annuities, or other deferred compensation distributions
• An additional $7,000 may be contributed to the IRA for the taxpayer's nonworking spouse if filing jointly
• Combined IRA contributions by both spouses can't exceed their combined compensation

IRA Contribution Phaseout

• If a taxpayer is an active participant in an employer-sponsored retirement plan and has a modified AGI of over $123,000 in 2024 ($77,000 in 2024 for single/head of household taxpayers and $0 for taxpayers married filing separately), the IRA maximum ($7,000) deduction is proportionately reduced over a phaseout range (fully phased out at $143,000)
• An individual isn't labeled active plan participant due to their spouse's status
• If an individual's spouse is an active plan participant, that individual's deductible contribution is phased out when modified AGI is between $230,000 and $240,000
• The amount deducted is the lesser of contribution made or the phased-out (i.e., limited) maximum deduction
• If the taxpayer has reached 50 before the close of the tax year, the contribution limit increases by $1,000 for that tax year
• Excessive contributions (over $7,000 limit) may be subject to a 6% excise tax
• The distribution of excess contribution is reported on Form 1099-R in box 2a and coded in box 7
• An IRA owner must begin receiving distributions by April 1 of the calendar year following the calendar year in which they reach age 73 (or the calendar year they retire, if later, for active participants in an employer-sponsored plan)

10% IRA Penalty

• IRA distributions before age 59 1/2 for reasons other than death/disability are subject to taxation and a 10% penalty tax
• Exceptions to this penalty include distributions for:
  • Medical expenses exceeding 7.5% of AGI
  • Qualified first-time homebuyer expenses (up to $10,000)
  • Qualified higher education expenses for the individual/lineal relatives
  • Qualified first-year birth or adoption of a child expenses (up to $5,000)

Roth IRA Contributions

• Roth IRA contributions are not deductible, but income can accumulate tax-free.
• The contribution amount for a Roth IRA is the same as for a traditional IRA
• Total contributions to both deductible/nondeductible IRAs in a tax year cannot exceed $7,000 per taxpayer ($8,000 if age 50+)
• Roth IRA contributions are subject to income limits/phaseout rules.

Higher Education Deductions

• Taxpayers may deduct up to $2,500 of interest paid on qualified educational loans in 2024 as an adjustment to income
• The deduction is subject to income limits

MAGI Phaseout Ranges

• MFJ: $165,000 to $195,000
• Single, HH, QSS: $80,000 to $95,000
• Calculate the reduction for a single filer: $2,500 × ((MAGI – $80,000) / $15,000 phaseout range)
• Qualified expenses include room and board, tuition and fees, books/supplies/equipment, and other necessary expenses (e.g., transportation)
• This list of qualified expenses is specific to the educational interest expense deduction
• Other educational deductions (credits) are not as liberal (e.g., do not allow for inclusion of room and board)

Above-the-Line Performing Artists Expenses

• Performing artists can deduct employee business expenses as an adjustment to gross income, when
  • Performing-arts services were performed as an employee for at least two employers
  • At least $200 was received from each of any two of the employers
  • Related performing-arts business expenses exceed 10% of total gross income from the services
  • AGI is not more than $16,000 before deducting these expenses.
• Married persons not living apart at all times must file a joint return and figure requirements separately

Penalty on Early Withdrawal of Savings

• A deduction is allowable for an early withdrawal of funds from certificates of deposit or other time savings accounts
• The deduction is taken in the year the penalty is incurred

Archer MSAs

• Archer MSAs (previously called Medical Savings Accounts) allow self-employed individuals or those employed by a small employer and covered by a high-deductible health insurance plan to make tax-deductible contributions and use funds for medical expenses
• The deduction for an Archer MSA is not included with other medical expenses and is not subject to the 7.5% limitation
• Earnings generated by the plan/distributions used for medical expenses are non-taxable
• Distributions not used for medical expenses are taxable and subject to a 20% penalty tax, unless made after age 65 or upon death/disability.
• Contributions to an Archer MSA are subject to an annual limitation, which is a percentage of the deductible of the required high-deductible health plan.
• The Archer MSA program is limited to 750,000 people
• An Archer MSA can be rolled into a Health Savings Account tax-free

Jury Duty Pay

• Jury duty pay returned to an employer is deductible by the employee from gross income

Nondeductible Expenses

• Until 2026, the deduction for job-related relocation (i.e., moving expenses) has been removed except for active duty military service members who move under military order/permanent change of station
• Expenses from the nonbusiness rental of personal property are not deductible

Loss Limitations

• A taxpayer’s deductible loss is limited to the smallest amount of these limitations
  • The loss is limited to the amount of the taxpayer's basis in the activity
    • By the at-risk rules, and
    • By the passive activity rules.

At-Risk Rules

• The allowable deduction for a loss is limited to the amount you're at risk for in the activity from which the loss arose
• A loss is any excess of deductions over gross income attributable to the same activity
• The rules apply to individuals, partners in partnerships, members in limited liability companies, shareholders of S corporations, trusts, estates, and closely held C corporations
• Personal holding companies, foreign personal holding companies, and personal service corporations are not subject to at-risk rules
• The at-risk rules are applied separately to each trade/business or income-producing activity
• A person's amount at risk in an activity is determined at the close of the tax year
• A person's initial at-risk amount includes money contributed, the adjusted basis (AB) of property contributed, and borrowed amounts

Recourse Debt Requirements

• A person's at-risk amount includes amounts borrowed only if, for the debt, the person has personal liability or property pledged as security (no more than the FMV when pledged minus prior/superior claims)
• The at-risk amount doesn't include debt if:
  • Property pledged as security is used in the activity
  • Insurance, guarantees, or stop-loss agreements protect the person from personal liability
  • A person with an interest in the activity or one related to them extended the credit
• Nonrecourse debt is generally excluded from the amount at risk
• The amount at risk in the activity of holding real property includes qualified nonrecourse financing (QNRF)
• In qualified nonrecourse financing, the taxpayer is not personally liable, but the financing is used in real estate, secured by real property, not convertible to ownership interest, and obtained from unrelated party/related party on commercially reasonable terms/guaranteed by government

Adjustments to at-risk amount

• They're made for events that vary investors' economic risk of loss:
  • Add contributions of money/property (its AB), recourse debt increases, QNRF increases, and income from the activity
  • Subtract distributions, liability reductions, and tax deductions allowable (at year end)
• Disallowed losses are carried forward
• If the amount at risk decreases below zero, previously allowed losses must be recaptured as income
• If a deduction would reduce basis in property and part/all of the deduction is disallowed by the at-risk rules, the basis is reduced

Passive Activity Loss (PAL) Limitation Rules

• A person's passive activity loss amount is deductible/creditable only against income/tax attributable to those activities
• Excess is deductible/creditable in a future year, subject to the same limits
• Passive activity rules apply to individuals, estates, trusts, personal service corporations, and closely held corporations
• Passive activity rules do not apply to grantor trusts, partnerships, and S corporations directly, but the owners of these entities must follow rules
• A passive activity is either rental activity or a trade/business where the person doesn't materially participate
• Following tests determine if a taxpayer materially participated:
  • Participated more than 500 hours
  • Participation constitutes substantially all participation in the activity
  • Participated for more than 100 hours and exceeds participation of any other individual
  • The activity is a significant participation activity in which the taxpayer participated more than 100 hours and more than 500 hours in total activities
  • Materially participated for any 5 of the 10 years preceding taxation year
  • Materially participated in a personal service activity for any 3 years preceding the year in question
  • Satisfied facts and circumstances test on a "regular, continuous, and substantial" basis

Passive Activity Rules Exceptions

• Passive activity rules do not apply to:
  • Active income, loss, or credit
  • Portfolio income, loss, or credit
  • Casualty/theft losses, vacation home rental, qualified home mortgage interest, business use of home, working interest in an oil/gas well held through an entity that doesn't limit the person's liability

Rental Real Estate Rules

• All rental activity is passive
• A person actively participating in rental real estate can deduct up to $25,000 of a tax year loss from rental real estate exceeding passive activity gross income against portfolio or active income
• The $25,000 limit is reduced by 50% of the person's MAGI without regard to PALs, Social Security benefits, and qualified retirement contributions exceeding $100,000
• Excess rental real estate PALs are suspended and treated as other PALs carried over.
• This exception applies when a person is actively participating in the activity, owns 10%+ (by value) for the entire year, and has a lower MAGI than $150,000 (phaseout begins at $100,000)
• Active participation is met with involvement in management decisions of arranging for others to provide services
• No active participation if ownership is less than 10% of the interest in the property
• Passive loss rules do not apply to certain taxpayers in real property trades/businesses
• An individual may avoid passive activity loss limitation treatment if they perform 50%+ of personal services during the year/more than 750 hours if they materially participate
• This provision applies to closely held C corporations if 50%+ of gross receipts are from real property trades/businesses and corporation materially participated
• Any deduction under this isn't considered when determining the taxpayer's AGI for phaseout purposes
• Individual will be subject to passive activity limitation rules if less than 50% of services are in real property trades/businesses
• A PAL that is not allowable in the tax year is carried forward indefinitely and treated as a deduction in future

Loss Exceptions

• PALs continue to be treated as PALs in future even after the activity stops
• Suspension of Loss: A Disposition of a passive activity is subject to these rules
  • Suspended/current year losses from a passive activity become fully deductible when the taxpayer disposes of interest in an activity
  • The loss is first deductible to cover net income or gain from taxpayer's activities, and balance can be treated as non-passive

Wash Sales

• Losses from wash sales are not deductible
• A wash sale occurs when a taxpayer sells/trades a security at a loss and, within 30 days before/after, the taxpayer does one of the following:
  • Purchases a substantially identical asset
  • Acquires one in a fully taxable trade
  • Acquires a contract/option to buy one
• The unrecognized loss is added to the basis of the asset that caused the wash sale
• The holding periods of the original and identical asset are added together