Homework Solutions
Week 4: C Corporations -You Decide
John Smith tax issues:
1(a) How is the $300,000 treated for purposes of federal tax income?
I feel that for federal income tax purposes the $300,000 in fees income should be reported as ordinary income. Ordinary income is taxable and must be reported on your return as such.
1(b) How is the $25,000 treated for purposes of federal tax income?
The $25,000 will be treated as a business expense and will be reported as a deduction on your return.
1(c) What is your determination regarding reducing the taxable amount of income for both (a) and (b) above?
Increasing the amount of tax deductible expenses taken, including the $25,000, will result in a reduction of taxable income reported to the IRS. To reduce your tax liability, in regards to the $300,000 in fee income, you may opt to receive it in the form of an annuity. Annuities, must be paid for a period of over a year, are offered as fixed or variable. Taxation is based on the type of annuity (immediate or deferred) and how you chose to take the money in the annuity. However, all taxes will be paid according to your ordinary income tax rate. Income paid through immediate and annuitized deferred annuities are tax free.
Jane Smith tax issues:
2(a) What are the different tax consequences between paying down the mortgage (debt) and assuming a new mortgage (debt) for federal income tax purposes?
According to the IRS, there may be a penalty assessed for paying off your mortgage debt early. However, the penalty incurred maybe deducted as mortgage interest it the penalty is not for a cost or service given in relation to your current mortgage loan. Also, you will lose the annual mortgage interest deduction reported under itemized deductions. When assuming a new mortgage, according to the IRS, acquisition debt only applies to any home acquired after “October 13, 1987, to buy, build, or substantially improve a qualified home (your main or second home) and the debt must also be secured by that home (IRS Publication 936). Also, only the debt that is does not exceed the cost of the home plus repairs can be considered acquisition debt.
2(b) Can John and Jane Smith utilize a 1031 tax exchange to buy a more expensive house using additional money from Johns case?
The following, according to the IRS, applies to the 1031 exchange rule for the sale of a personal residence:
You have resided in the home for two of the past five years
If married, $500,000 of the gain is tax exempt
If single, $250,000 of the