Question

James and Kate Sawyer were married on New Year’s Eve of 2016. Before their marriage, Kate lived in New York and worked as a hair stylist for one of the city’s top salons. James lives in Atlanta where he works for a public accounting firm earning an annual salary of $100,000. After their marriage, Kate left her job in New York and moved into the couple’s newly purchased 3,200-square-foot home in Atlanta. Kate incurred $2,200 of qualified moving expenses. The couple purchased the home on January 3, 2017, by paying $100,000 down and obtaining a $240,000 mortgage for the remainder. The interest rate on this loan was 7 percent and the Sawyers made interest-only payments on the loan through June 30, 2017 (assume they paid exactly one-half of a year’s worth of interest on this loan by June 30). On July 1, 2017, because the value of their home had increased to $400,000, the Sawyers were in need of cash, and interest rates had dropped, the Sawyers refinanced their home loan. On the refinancing, they borrowed $370,000 at 6 percent interest. They made interest-only payments on the home loan through the end of the year and they spent $20,000 of the loan proceeds improving their home (assume they paid exactly one-half of a year’s worth of interest on this loan by year-end).
Kate wanted to try her hand at making it on her own in business, and with James’s help, she started Kate’s Beauty Cuts LLC. She set up shop in a 384-square-foot corner room of the couple’s home and began to get it ready for business. The room conveniently had a door to the outside providing customers direct access to the shop. Kate paid $2,100 to have the carpet replaced with a tile floor. She also paid $1,200 to have the room painted with vibrant colors, and $650 to have the room rewired for appropriate lighting. Kate ran an ad in the local newspaper and officially opened her shop on January 24, 2017. By the end of the year, Kate’s Beauty Cuts LLC generated $40,000 of net income before considering the home office deduction. The Sawyers incurred the following home-related expenditures during 2017:

• $4,200 of real property taxes.

• $2,000 for homeowner’s insurance.

• $2,400 for electricity.

• $1,500 for gas and other utilities.

They determined depreciation expense for their entire house was $8,364.
Also, on March 2, Kate was able to finally sell her one-bedroom Manhattan condominium for $478,000. She purchased the condo, which she had lived in for six years prior to her marriage, for $205,000.
Kate owns a vacation home in Myrtle Beach, South Carolina. She purchased the home several years ago, largely as an investment opportunity. To help cover the expenses of maintaining the home, James and Kate decided to rent the home out. They rented the home for a total of 106 days at fair market value (this included eight days that they rented the home to James’s brother Jack). In addition to the 106 days, Kate allowed a good friend and customer, Clair, to stay in the home for half-price for two days. James and Kate stayed in the home for six days for a romantic getaway and another three days in order to do some repair and maintenance work on the home. The rental revenues from the home in 2017 were $18,400. The Sawyers incurred the following expenses associated with the home:

• $9,100 of interest expense.

• $3,400 of real property taxes.

• $1,900 for homeowner’s insurance.

• $1,200 for electricity.

• $1,600 for gas, other utilities, and landscaping.

• $5,200 for depreciation.

Required:

Determine the Sawyer’s taxable income for 2017. Disregard self-employment taxes for Kate. Assume the couple paid $4,400 in state income taxes and files a joint return. For determining deductible home office expenses and allocating expenses to the rental, the Sawyers would like to use the methods that minimize their overall taxable income for the year.

Answer 1

James and Kate have taxable income of $93,820. See the analysis below Amount Description Explanation Total income James's Sala Kate's Schedule C income before home office deductiorn $100,000 40,000 -8,342 See Note A below for Home-office deduction (for AGI) computation. Not limited by income limitation Rent revenue 18,400 -12,005 Tax court method allows more Rental expenses (for AGI) total deductions for year ($937 more in deductions); See Note B below for computation $478,000-205,000 = $273,000 gain minus 500,000 exclusion Gain on sale of principal residence after exclusion $138,053 (1 Total income (2) Moving expenses (3) AGI Itemized deductions: -2,200 S135,853|(1)+ (2) -4,400 -3,696 $4,200 - 504 (deducted as home State income taxes Real property taxes on principal residence Real property taxes on vacation/rental home Home mortgage interest expense on principal residence Home mortgage interest expense on vacation/rental home (4) Total itemized deductions office expense) = $3,696 expense)-$2,459 home office expense)- $16,896 rental expense) - $6,582 $12,600 so James and Kate -2,459 S3,400 - 941(deducted as rental -16,896S19,200 - 2,304 (deducted as 6.582 $9,100 - 2,518 (deducted as -34,033 Standard deduction for MFJ i:s deduct itemized deductions. -8,000|$4,000X 2 -42,033 (4) (5) $93,820(3) + (6) $8,000 (5) Personal and dependency exemption:s (6) Total from AGI deductions Taxable income

Note A: Home office deduction computation Home Office Deduction (A) Type Office % Home office 384/3,200Expense Amount for indirect) New paint for office New office lightin Real property taxes Home interest expense Utilities Homeowner'& insurinc Depreciation 504 Indirect Indirect Indirect Indirect Indirect 19.200 3,900 2,000 468 Total expenses Total interest expense for the year is computed as follows First loan: $240,000 x 7% x ½ofa year-$8.400 $40,550 $8.342 Second loan: $240,000$20,000$100,000 $360,000 (interest on S10,000 of the $370,000 loan is not deductibl) $360,000 x 6% x $ 10,800 Total interest expense= $ 19,200 ($8.400 form loan l-$10,800 from loan 2). Note B: Rental expenses: The Sawyers used the rental home as follows: Rental days: 101 98 rental to unrelated parties at fair market value 3 maintenance); Personal days: 16 days (6 vacation days 8 rented to brothe2 rented at less tan fair market value). Because personal use of 16 is more than the reater of( 1 ) 14 days or (2)10% of the number of rental days (10.1), their residence qualifies as property with significant personal and significant rental use (mixed use or vacation home)-this means deductions are limited to gross rental income. Because the Tax Court method allows them to deduct $937 more deductions overall (rental +personal taxes and interest), they use the Tax Court methd to determine their deductions from the rental Allocation method to rental use IRS methTas Court Rental Home Expense Allocation nethod (101365 tier 1 pense Amount Tier (101/117) 101/117 other) $9,100 Interest Real estate taxes Total tier 1 expenses Electricity $7,856 $2.518 941 S10.791 S3.459 as/other uilities and landscapin 1.600 900 $4,700 1,640 $4,057$4,057 1,381 1,640 Total tier 2 expenses Depreciation tier 3) Total Expenses on propert Net income from rental 4.489 4489 $22.400 Tax method Court IRS Rental receipts Less tier1 expenses Income after ier1 expenses Less tier 2 expenses Income after ticr 2 expenscs Less: tier 3 expenses Taxable rental income 7,609 14,941 0,884 4.489 O$6,395 S1,709 $9,041 Deductible personal use expenses (interest and property taxes) Deductible rental expenses (sum of tier,2, and 3 expenses) for AGI) 18,400 12,005 iation expense carried over to next vear Total deductions associated with crty (for and from) S20,109$21,046