Question

James and Kate Sawyer were married on New Year's Eve of 2015. 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, 2016, 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, 2016 (assume they paid exactly one-half of a year's worth of interest on this loan by June 30). On July 1, 2016, 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, 2016. 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 2016:

Page 14-51

$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 8 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 2 days. James and Kate stayed in the home for 6 days for a romantic getaway and another 3 days in order to do some repair and maintenance work on the home. The rental revenues from the home in 2016 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 2016. Disregard self-employment taxes for Kate. Assume the couple paid $4,400 in state income taxes and files a joint return. The Sawyers would like to use the method for determining deductible home office expenses and the method for allocating expenses to the rental that minimize their overall taxable income for the year.

Answer 1

NOTE: This solution assumes 2012 has 365 days.

James and Kate have taxable income of $117,220. See the analysis below.

Description	Amount	Explanation
Total income
James’s Salary	$100,000
Kate’s Schedule C income before home office deduction	40,000
Home-office deduction (for AGI)	(8,342)	See Note A below for computation. Not limited by income limitation
Rent revenue	18,400
Rental expenses (for AGI)	(12,005)	Tax court method allows more total deductions for year ($937 more in deductions); See Note B below for computation
Gain on sale of principal residence after exclusion	23,000	$478,000 – 205,000 = $273,000 gain minus 250,000 exclusion
(1) Total income	$161,053
(2) Moving expenses	(2,200)
(3) AGI	$158,853	(1)+ (2)
Itemized deductions:
State income taxes	(4,400)
Real property taxes on principal residence	(3,696)	$4,200 – 504 (deducted as home office expense) = $3,696
Real property taxes on vacation/rental home	(2,459)	$3,400 – 941(deducted as rental expense) =$2,459
Home mortgage interest expense on principal residence	(16,896)	$19,200 – 2,304 (deducted as home office expense) = $16,896
Home mortgage interest expense on vacation/rental home	(6,582)	$9,100 – 2,518 (deducted as rental expense) = $6,582
(4) Total itemized deductions	(34,033)	Standard deduction for MFJ is $11,900 so James and Kate deduct itemized deductions.
(5) Personal and dependency exemptions	(7,600)	$3,8 00 × 2 = $7,6 00
(6) Total from AGI deductions	(41,633)	(4) + (5)
Taxable income	$117,220	(3) + (6)

Note A: Home office deduction computation

Home Office Deduction	Type	(A) Amount	(B) Office % (384/3,200 for indirect)	(A) × (B) Home office Expense
New flooring	Direct	$2,100	100%	$2,100
New paint for office	Direct	1,200	100%	1,200
New office lighting	Direct	650	100%	650
Real property taxes	Indirect	4,200	12%	504
Home interest expense*	Indirect	19,200	12%	2,304
Utilities	Indirect	3,900	12%	468
Homeowner’s insurance	Indirect	2,000	12%	240
Depreciation	Indirect	7,300	12%	876
Total expenses		$40,550		$8,342

*Total interest expense for the year is computed as follows:

First loan: $240,000 × 7% × ½ of a year = $8,400.

Second loan: $240,000 of initial acquisition debt plus $20,000 of refinanced loan to improve home (can be considered acquisition indebtedness) plus $100,000 of home equity debt equals $360,000 of qualifying debt (interest on $10,000 of the $370,000 loan is not deductible). $360,000 × 6% × ½ = $10,800.

Total interest expense = $19,200 ($8,400 from loan 1 + $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 brother + 2 rented at less than fair market value). Because personal use of 16 is more than the greater 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 method to determine their deductions from the rental.

Rental Home Expense Allocation			Allocation method to rental use
Expense	Amount	Tier	IRS method (101/117)	Tax Court method (101/365 tier 1 101/117 other)
Interest	$9,100	1	$7,856	$2,518
Real estate taxes	3,400	1	2,935	941
Total tier 1 expenses	$12,500	1	$10,791	$3,459
Electricity	1,200	2	1,036	1,036
Gas/other utilities and landscaping	1,600	2	1,381	1,381
Insurance	1,900	2	1,640	1,640
Total tier 2 expenses	$4,700	2	$4,057	$4,057
Depreciation (tier 3)	5,200	3	4,489	4,489
Total Expenses on property	$22,400
Net income from rental			IRS method	Tax Court method
Rental receipts			$18,400	$18,400
Less tier 1 expenses			(10,791)	(3,459)
Income after tier 1 expenses			7,609	14,941
Less tier 2 expenses			(4,057)	(4,057)
Income after tier 2 expenses			3,552	10,884
Less: tier 3 expenses			(3,552)	(4,489)
Taxable rental income			$0	$6,395
Deductible personal use expenses (interest and property taxes)			$1,709	$9,041
Deductible rental expenses (sum of tier 1 , 2, and 3 expenses) (for AGI)			18,400	12,005
Depreciation expense carried over to next year			937	0
Total deductions associated with property (for and from)			$20,109	$21,046