1a). How is the $300,000 treated for purposes of federal income tax?
The $300,000 that John Smith received would be treated as income. According to the IRS, income is classified as “earned income includes all the taxable income and wages you get from working,” such as: •wages, salaries, tips, and other taxable employee pay;
•union strike benefits;
•long-term disability benefits received prior to minimum retirement age; •net earnings from self-employment, such as own or operate a business; and •gross income received as statutory employee.
John Smith will be taxed on his income of $300,000 regardless if he received the amount as a lump sum or in annuity. The constructive receipt doctrine states that “… taxpayer is liable for income, which has not been physically received, but has been credited to the taxpayer’s account or otherwise becomes available for him or her to draw upon in the future.” Sources:
1b). How is the $25,000 treated for purposes of federal income tax?
The $25,000 is an out of pocket expense for business use within those 2 years that the case was ongoing. It will not be taxed on and it will help to lower John’s adjusted gross income for the tax year, but depending if John has claim it as part of his deductions yet or not. 1c). What is your determination regarding reducing the taxable amount of income for both (a) and (b) above?
In order to reduce the taxable amount of income for both (a) and (b) John would be better off in taking his $300,000 in annuity payments, rather than one lump sum. It will help John to lower his tax rate because his adjusted gross income is lower.
1d). Is it more beneficial to continue leasing the business space or to buy the building?
In order to determine if it is more beneficial to continue leasing the business space or to buy the building, John will have to compare the advantages and disadvantages of leasing and owning a business building. John will also have to measure his interest expense and compare it to buying or leasing. If John goes with leasing the business building he can still claim deductions for his rent. However, if John purchased the building for his business he would be able to claim interest as part of his deductions as well as any maintenance costs, taxes, and depreciation. It may be in the best interest of John to continue leasing the business space.
Jane Smith tax issues:
2a). What are the difference tax consequences between paying down the mortgage (debt) and assuming a new mortgage (debt) for federal income tax purposes?
If Jane and John Smith were refinanced their home, they wouldn’t be able to claim the entire amount of their refinance as a deduction. In other words, they would lose tax deduction on their loan when their mortgage is paid in full. On the other hand, if Jane and John Smith were to hold onto their mortgage and not pay it off they would be able to receive certain tax deductions for it. For example, their mortgage interest is a part of tax deduction that they can claim every year. The couple will have to analyze every advantages and disadvantages to paying down the mortgage and assuming a new mortgage before being able to take further action.
2b). Can John and Jane Smith utilize a 1031 tax exchange to buy a more expensive house using additional money from John’s case?
Being able to invest in a new home is a great investment and tax savings purposes for John and Jane Smith. Since the IRS has an exchange code that taxes only the gain of a sale of personal home, John and Jane can utilize a 1031 tax exchange to buy a more expensive house using additional money from John’s case. The IRC Section 1031 states, “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.” Since John and Jane is only buying another property (personal property/home, and not for business purposes) they would be able to treat this transaction as an exchange rather than a buy or sell transaction. John and Jane will only be taxed if there is a gain on their transaction. Source:
2c). Does Jane have a business or hobby? Why is this distinction important?
Jane would have to distinguish herself if what she does at home (jewelry making) is a business or hobby. Publication 535 of the IRS helps in answering her question if she is operating a business or just a hobby. 1.Does the time and effort put into the activity indicate an intention to make a profit? 2.Does the taxpayer depend on the income from the activity? 3.Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business? 4.Does the activity make a profit in some years?
If yes is answered to all four questions, then yes, indeed Jane have a business rather than a hobby. It is important that Jane report this as a business because she will be able to claim many more deductions. Jane could deduct up to certain (most) business expenses that she uses, such as her own vehicle.