EA Review

Part 1: Individuals

May 1, 2025 - February 28, 2026

Testing Cycle

Joel Busch, CPA, JD

Christy Pinheiro, EA, ABA®

Thomas A. Gorczynski, EA, USTCP

 PassKey EA Review 2025-2026 Edition

Table of Contents

Essential Tax Law Figures for Individuals ............................................. 15

Unit 1: Preliminary Work with Taxpayer Data..................................... 27
Unit 2: Determining Filing Status and Residency ................................ 60
Unit 3: Dependency Relationships ........................................................... 89
Unit 4: Taxable and Nontaxable Income.............................................. 106
Unit 5: Investment Income and Expenses ........................................... 140
Unit 6: Calculating the Basis of Assets .................................................. 153
Unit 7: Capital Gains and Losses ............................................................ 171
Unit 8: Nonrecognition Property Transactions ................................. 191
Unit 9: Rental and Royalty Income........................................................ 216
Unit 10: Other Taxable Income .............................................................. 243
Unit 11: Adjustments to Gross Income ................................................ 270
Unit 12: Standard Deduction and Itemized Deductions .................. 286
Unit 13: Individual Tax Credits .............................................................. 323
Unit 14: The ACA and the Premium Tax Credit ................................. 360
Unit 16: Individual Retirement Accounts............................................ 392
Unit 17: Foreign Financial Reporting ................................................... 423
Unit 18: Estate and Gift Taxes for Individuals ................................... 442

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Unit 1: Preliminary Work with Taxpayer Data

More Reading:
Publication 17, Your Federal Income Tax

The enrolled agent exam, Part 1, covers a wide range of topics related to preparing tax returns for
individual taxpayers. This includes essential knowledge of filing status, requirements, and deadlines;
taxable and nontaxable income; deductions, credits, adjustments to income; determining the basis of
property; calculating capital gains and losses; reporting rental income; understanding retirement
income; and navigating estate and gift taxes.
In this section, we will cover the initial steps that tax return preparers must take in order to ensure
accuracy when filing taxes for their individual clients.
For the current exam cycle, Part 1 of the exam is broken down into the following sections and
corresponding number of questions:
1. Preliminary Work with Taxpayer Data – 14 questions
2. Income and Assets – 17 questions
3. Deductions and Credits – 17 questions
4. Taxation – 15 questions
5. Advising the Individual Taxpayer – 11 questions
6. Specialized Returns for Individuals – 12 questions
The current exam specifications are listed in the official Enrolled Agent Special Enrollment
Examination Candidate Information Bulletin, which is available for download on the Prometric
website. We will cover preliminary work with taxpayer data, as well as the importance of a taxpayer’s
biographical information in this unit.
Use of Prior Year Returns
When preparing tax returns for clients, tax professionals are expected to diligently gather and
verify all necessary taxpayer information. This includes reviewing prior-year tax returns for accuracy,
completeness, and compliance with tax laws. If any errors or omissions are discovered on a prior-year
return, the preparer is required by law to inform the taxpayer of the mistake and explain the potential
consequences if it is not corrected. However, the preparer is not obligated to fix the error.
Example: Leslie, an enrolled agent, noticed a serious error on her client Mark's prior-year tax return.
He had self-prepared his return and reported a stock sale incorrectly, resulting in a significant
understatement of tax. Leslie informed Mark of his mistake and advised filing an amended return.
Grateful, Mark promised to correct it, and asked Leslie if she would help him by preparing the amended
return. Leslie agrees to prepare the amended return for Mark for a reasonable fee.
Utilizing prior-year returns can help identify and prevent major mathematical mistakes and alert
the preparer to any issues that may impact the current year’s return. During this review process, the
preparer must also consider any items from previous years that may affect the current year’s return,
such as:
• Carryovers,
• Net operating losses,

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• Tax credit carryovers, examples of which include the prior year AMT tax credit and the
adoption credit.
• Prior-year depreciation and asset basis.

Taxpayer Biographical Information

When filing tax returns, certain client biographical information is required. A tax professional must
collect this information from each taxpayer to prepare an accurate tax return:
• Legal name, date of birth, and marital status
• Residency status and/or citizenship
• Dependent information
• The taxpayer’s identification number (SSN, ITIN, or ATIN)

In order to prevent fraudulent tax filings, it is important for tax preparers to request identification
from taxpayers. Photo IDs are preferable, and should include the taxpayer’s name and current address.
It is also crucial for tax preparers to verify social security cards, ITIN letters, and other documents to
ensure that the correct TINs are used for the taxpayer, their spouse, and any dependents listed on the
return.
Example: Mariana Lopez has always self-prepared her returns, but with a new job and investment
income, she is looking for a professional tax preparer for the first time. She makes an appointment with
Karl, an enrolled agent, to prepare her taxes. Before discussing her tax situation, Karl asks Mariana to
provide a picture ID and a copy of her Social Security card for verification. Karl then carefully reviews
her prior year's return and tax documents to ensure accuracy.
Identity Protection PIN (IP PIN): Taxpayers also have the option to request an Identity Protection
PIN (IP PIN). An IP PIN is a six-digit number that helps protect a taxpayer’s Social Security number
(SSN) or Individual Taxpayer Identification Number (ITIN) from unauthorized use.
This service is now available to anyone, regardless of whether they have been a victim of identity
theft or not. If an IP PIN is issued or requested, the IP PIN must be entered into software for the IRS to
accept an electronically filed tax return.13 The IP PIN can either be requested for a single year (a one-
time enrollment) or for the current and future years (continuous enrollment).
Example: Brenner’s wallet was stolen while he was Christmas shopping. A few days after filing a police
report, Brenner asks Laura, his enrolled agent, what else he should do to protect himself from being a
victim of ID theft. Laura advises Brenner to file an ID theft affidavit with the IRS and request an IP PIN,
which she does on his behalf. On January 20, 2025, Brenner receives his IP PIN, which will help prevent
any fraudulent tax filings. Laura meets with Brenner two weeks later to prepare his 2024 tax return.
She carefully reviews his tax documents, prepares his tax return, and enters his IP PIN into her
software for secure e-filing. Brenner feels reassured about the process and knows his return will be
processed without any issues.

13Protecting a taxpayer from tax-related ID theft is covered in more detail in Book 3, Representation, and is listed on the official
test specifications for that exam section.
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Taxpayer Identification Numbers

The IRS requires all individuals listed on a federal income tax return to have a valid Taxpayer
Identification Number (TIN), including the taxpayer, their spouse (if married), and any dependents
listed on the return. The types of TINs are:
• Social Security number (SSN)
• Individual taxpayer identification number (ITIN)
• Adoption taxpayer identification number (ATIN)14

Note: A taxpayer’s personal and financial information is considered highly sensitive and confidential.
Tax preparers must understand the importance of protecting this information and take all necessary
precautions to ensure it remains secure. A preparer who wrongfully discloses a taxpayer’s information
could face civil and criminal charges.
A taxpayer who cannot obtain an SSN must apply for an ITIN in order to file a U.S. tax return.
Generally, only U.S. citizens and lawfully admitted noncitizens authorized to work in the United States
are eligible for a Social Security number.
Example: Umberto is an Italian citizen who has never been to the United States. On January 20, 2024,
he inherited a rental property from his deceased aunt, Giuseppina, a green-card holder who was living
in the U.S. On his accountant’s advice, Umberto decides to keep the rental property as a passive income
source. He hires a management company to receive the rents and manage the property in his absence.
Umberto requests an ITIN for tax reporting purposes. He will report his U.S. rental income on Form
1040-NR. He will not be taxed on his worldwide income, only on his income from U.S. sources.
Nonresident aliens with a U.S. tax liability generally have ITINs, although not always. For example,
an ITIN would be required when a U.S. soldier marries a foreign spouse and wishes to file jointly. The
couple would need to request an ITIN for the alien spouse to file a joint return.
Example: Kristal is a U.S. citizen living in Norway. In 2024, she met and married Trond, a Norwegian
citizen. The couple plans to live in Norway. Trond does not plan to apply for U.S. residency, but Kristal
and Trond can make the election to file jointly and treat Trond as a U.S. resident alien by checking the
appropriate box on the Form 1040, and attaching a statement to their joint return. To make this
election, Trond must request an ITIN.
People who do not have lawful status in the United States may obtain an ITIN for tax reporting
purposes only.
The issuance of an ITIN does not affect an individual’s immigration status or give the taxpayer the
right to work in the United States. A taxpayer with an ITIN is not eligible to receive Social Security
benefits or the Earned Income Tax Credit. ITINs are for federal tax reporting only and are not intended
to serve any other purpose.
ITIN Application Process
Taxpayers who need an individual taxpayer identification number (ITIN) must fill out Form W-7,
also known as the Application for IRS Individual Taxpayer Identification Number. In addition to

14A special form is used for ATIN requests; Form W-7A, Application for Taxpayer Identification Number for Pending U.S. Adoptions.
This form is used to apply for an ATIN for a child who is placed in the taxpayer’s home for legal adoption.
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submitting this form, taxpayers must provide documentation that proves their foreign status and
verifies their identity. There are three ways to apply for an ITIN.
• Using Form W-7
• Using an IRS-authorized Certified Acceptance Agent (CAA) or
• In-person at a designated IRS Taxpayer Assistance Center
A taxpayer can also engage the services of a CAA, or Certified Acceptance Agent,15 to request an
ITIN. CAAs can authenticate a passport and/or birth certificate for taxpayers who want to request an
ITIN, but do not wish to mail their original documents to the IRS. All ITINs expire unless they are
renewed.
Example: Maude, a U.S. citizen with a Social Security number, currently resides in Canada and is
employed by an international shipping firm. She recently married Santino, a Canadian citizen, who has
a daughter named Lucia from a previous marriage (both Santino and Lucia are Canadian citizens).
Maude and Santino decide to file their taxes jointly as a married couple and claim Lucia as a dependent.
To do so, they need to apply for Individual Taxpayer Identification Numbers (ITINs) for Santino and
Lucia. Maude may enlist the help of a Certified Acceptance Agent (CAA) to obtain these ITINs for her
new husband and stepdaughter.
Note: Typically, the process for obtaining an ITIN involves submitting an application (Form W-7) by
mail along with a taxpayer’s initial tax return. This filing must be done on paper. The Form W-7 cannot
be filed electronically. There are limited situations where a foreign person may apply for an ITIN
without filing a tax return, such as when claiming tax treaty benefits or providing an ITIN for reporting
purposes to a third party, such as a bank or financial institution. A full list of exceptions can be found
in the Form W-7 instructions.

Adoption Taxpayer Identification Number (ATIN)

ATINs are designed explicitly for adopted children who are not yet eligible for a Social Security
number. An ATIN is requested using Form W-7A, Application for Taxpayer Identification Number for
Pending U.S. Adoptions. For an adopted child who does not have an SSN, a taxpayer may request an
ATIN if:
• The child is placed in the taxpayer’s home for legal adoption,
• The adoption is a domestic adoption, or the adoption is a foreign legal adoption,
• The taxpayer cannot obtain the child’s existing SSN, even though they made a reasonable
attempt to obtain it from the birth parents, the placement agency, or other persons.
• The taxpayer cannot obtain an SSN for other reasons, such as the adoption not yet being final.
An ATIN issued for an adoptive child expires two years from the date it is issued, although an
extension can be requested using IRS Form 15100, Adoption Taxpayer Identification Number Extension
Request. An ATIN cannot be used to obtain the Earned Income Tax Credit, the Child Tax Credit, or the
American Opportunity Tax Credit.

15 A Certified Acceptance Agent (CAA) is an individual or organization that is authorized by the Internal Revenue Service to assist
alien individuals and with obtaining ITINs. The IRS maintains a list of CAAs on its website.
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Special Rules for a Deceased Child

If a child is born and dies within the same tax year and is not granted an SSN, the taxpayer may still
claim that child as a dependent.
Example: On October 9, 2024, Diane had a newborn son. Sadly, he faced health complications and
passed away just one week later. The child was issued both a birth certificate and a death certificate,
but no Social Security number. When filing her taxes for 2024, Diane can still claim her son as a
qualifying child. She will need to mail a paper return in order to do so. Her son will still be considered
a “qualifying child” for tax purposes, even though he only lived for a short time.
The tax return must be filed on paper with a copy of the birth certificate or a hospital medical
record attached. The birth certificate must show that the child was born alive; a stillborn infant does
not qualify. The taxpayer should enter the word “DIED” in the space for the dependent’s Social Security
number on the tax return.
Recordkeeping Requirements for Individuals
It is the responsibility of taxpayers, with or without the assistance of a tax preparer, to maintain
copies of their tax returns and related records for as long as necessary for the administration of federal
tax laws. Typically, taxpayers are required to retain copies of their tax returns and supporting
documentation for at least three years from either the date they were filed or the original due date (if
filed before the original due date), whichever is later. If a taxpayer omits more than 25% of the gross
income that should have been reported, the taxpayer must retain records for at least six years.
While the IRS has not issued specific guidelines on recordkeeping, it is important for individuals to
maintain detailed records for various purposes. These include identifying sources of income, tracking
expenses for tax deductions, documenting property costs and improvements, providing evidence in
case of an audit,16 and helping with future tax preparation.
The IRS allows taxpayers to maintain records in any way that will help determine the correct tax.
Electronic records are acceptable as long as a taxpayer can reproduce the records in a legible format.
The following are examples of necessary records that all taxpayers should keep, including items
related to:
• Income: Forms W-2, Forms 1099, bank statements, pay stubs, brokerage statements, and
Schedules K-1.
• Expenses: Sales slips, invoices, receipts, credit card statements, canceled checks or other proof
of payments, written communications from qualified charities, Forms 1098 to support
mortgage interest and real estate taxes paid (if the taxes are paid through an impound account).
• Home purchase and sale: Closing statements, purchase and sales invoices, proof of payment,
insurance records, receipts for improvement costs.
• Investments: Brokerage statements, mutual fund statements, Forms 1099-DIV.
• Business records: For business owners, keeping detailed records is essential for tracking
income and expenses, managing payroll, invoicing clients, and preparing tax returns.

16In cases of an IRS audit, it is the responsibility of the taxpayer to provide proof and documentation for their claimed expenses.
Even if a tax professional prepares and signs a tax return, the taxpayer is the one ultimately responsible for the accuracy of their
own return.
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Basic Tax Forms for Individuals

Form 1040: The Form 1040 is the primary tax form used by U.S. taxpayers to file their annual
income tax returns. The Form 1040 includes three numbered schedules:
• Schedule 1, Additional Income and Adjustments to Income: Schedule 1 is used to report
income that is not listed directly on the Form 1040, such as taxable alimony, unemployment
compensation, and gambling winnings. It also includes income adjustments, such as the student
loan interest deduction, the self-employed health insurance deduction, and the deduction for
educator expenses.
• Schedule 2, Additional Taxes: Schedule 2 is used to report additional taxes owed, such as the
alternative minimum tax, self-employment tax, or household employment taxes.
• Schedule 3, Additional Credits and Payments: Schedule 3 has two main sections:
nonrefundable credits, and other payments and refundable credits.

Form 1040-SR: This form is specifically for use by seniors who are age 65 or older. This form is
essentially the same as the standard Form 1040 but is designed to be easier to read with a bigger font.
Form 1040-NR: Form 1040-NR is used by nonresident aliens to report their U.S. source income.
Form 1040-NR uses Schedules 1, 2, and 3, just like Form 1040. The 1040-NR is never used by U.S.
citizens or U.S. residents.
The IRS defines an “alien” as any individual who is not a U.S. citizen or U.S. national. A nonresident
alien is an alien who has not passed the green card test or the substantial presence test. Form 1040-
NR is widely used by foreign investors, as well as nonresident taxpayers who earn money while in the
U.S.
Example: Angelo, a Filipino citizen and world-famous boxer, receives permission to enter the U.S. on
a special visa in order to participate in a champion boxing match. He earns a substantial amount of
income of $900,000 for his appearance, but only stays in the U.S. for six days before returning to his
home country. As he is not eligible for a Social Security Number (SSN), Angelo must request an
Individual Taxpayer Identification Number (ITIN) to report his U.S. earnings. Without the ITIN, he
would face automatic backup withholding on his income. Thankfully, Angelo’s tax accountant
requested the ITIN and correctly filed his income taxes using Form 1040-NR, which only required him
to report the income he earned while in the United States and not his worldwide income.
Example: Ferdinand, a Canadian citizen, travels to the United States on a visitor’s visa. During his visit,
he goes to Atlantic City and happens to win $45,000 while playing poker. Since Ferdinand is not a
resident alien of the U.S. for tax purposes and does not have an SSN, he falls under the category of
nonresident alien. Generally, gambling winnings for nonresident aliens are subject to a flat rate of 30%
in taxes, and they are usually unable to claim deductions for gambling losses. However, a beneficial tax
treaty exists between the U.S. and Canada. Ferdinand chooses to request an ITIN, so he can file a Form
1040-NR to receive a partial refund of the U.S. taxes withheld from his gambling winnings.

Form 1040-X, Amended U.S. Individual Income Tax Return: This form is used to correct errors in a
previously filed Form 1040, Form 1040-SR, or 1040-NR. Form 1040-X can be filed electronically.
Taxpayers electronically filing amended returns may now choose direct deposit to obtain a faster
refund.
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Federal Income Tax Rates

An individual’s federal taxable income is taxed at progressive rates in the United States. The IRS
groups individuals by ranges of their taxable income level, or brackets, and applies increasing tax rates
at each successive level. For tax year 2024, there are seven tax brackets for individuals: 10%, 12%,
22%, 24%, 32%, 35%, and 37%. The bottom rate is 10% in 2024.

2024 Federal Income Tax Brackets and Rates

Tax Single Filers MFJ & QSS Head of Household MFS

rate

10% $0 to $11,600 $0 to $23,200 $0 to $16,550 $0 to $11,600

12% $11,601 to $47,150 $23,201 to $94,300 $16,551 to $63,100 $11,601 to $47,150

22% $47,151 to $100,525 $94,301 to $201,050 $63,101 to $100,500 $47,151 to $100,525

24% $100,526 to $191,950 $201,051 to $383,900 $100,501 to $191,950 $100,526 to $191,950

32% $191,951 to $243,725 $383,901 to $487,450 $191,951 to $243,700 $191,951 to $243,725

35% $243,726 to $609,350 $487,451 to $731,200 $243,701 to $609,350 $243,726 to $365,600

37% $609,351 or more $731,201 or more $609,351 or more $365,601 or more

The applicable tax rate for each successive bracket that is applicable to the taxpayer applies only
to the additional amounts of taxable income that fall within that particular bracket.
Example: Melissa files as single, and she has $32,000 of taxable income in 2024 (all of her income was
from wages). This means she is in the 12% tax bracket. But that does not mean she will pay 12% on all
her income. Instead, she would pay 10% tax on the first $11,600 of taxable income, plus 12% on the
remaining amount.

In addition to the regular tax in the United States, there is a “parallel tax” called the alternative
minimum tax (AMT). Taxpayers must pay either the regular tax or the AMT, depending on whichever
amounts to the greater amount of tax. The AMT is covered in more detail later.
Tax Return Due Dates and Extensions
The normal due date for individual tax returns is April 15. If April 15 falls on a Saturday, Sunday,
or legal holiday, the due date is extended until the next business day. The IRS will accept a postmark
as proof of a timely filed return.
A tax return is considered filed “on time” if the envelope is properly addressed, postmarked, and
deposited in the mail by the due date. For example, if a tax return is postmarked on April 15 but does

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not arrive at an IRS service center until April 29, the IRS must accept the tax return as having been filed
on time. This is also called the statutory “mailbox rule.”17
E-filed tax returns are given an “electronic postmark” to indicate the day they are accepted and
transmitted to the IRS. In cases where a tax return is filed close to the deadline, it is highly advisable
for a taxpayer to pay for proof of mailing or certified mail.
Example: Seraphina is an enrolled agent who specializes in handling tax returns. One of her clients,
Watson, is a single father to his 14-year-old daughter, Emily, and provides all financial support for her.
On April 15, 2025, right on the filing deadline, Seraphina attempts to electronically file Watson’s 2024
tax return, but it is rejected due to someone else already claiming Emily as a dependent. Watson
suspects that his estranged ex-wife may have tried to claim their daughter, but he has no way of
confirming or contacting her. Upon realizing the issue cannot be resolved electronically, Seraphina
promptly advises filing a paper return instead. She prints out the necessary forms for Watson. He signs
the return with an original ink signature before mailing them out via certified mail before the post
office closes. Watson’s return is considered timely and undergoes regular processing. Approximately
eight weeks later, Watson receives his full refund.

If a taxpayer cannot file by the due date, the taxpayer may request an extension by filing Form
4868, Application for Automatic Extension of Time to File, which may be filed electronically. The
extension must be filed by the original due date. An extension grants an additional six months to file a
tax return.
Note: Although an extension gives a taxpayer extra time to file a return, it does not extend the time to
pay any tax due. Taxpayers must estimate and pay taxes by the original filing deadline.

Filing Deadline Exceptions

Federal Disaster Areas: Taxpayers in federally declared disaster areas (FEMA disasters) are
granted postponements to file and pay their income taxes and to make estimated tax payments. The
IRS may also abate interest and any late filing or late payment penalties that apply to taxpayers in these
disaster areas. This type of tax relief generally includes:
• Individuals and businesses located in a disaster area,
• Those whose tax records are located in a disaster area, and
• Relief workers who are working in the disaster area.
The IRS identifies taxpayers located in disaster areas by their zip code and will systemically apply
filing and payment relief, however, a taxpayer does not have to be physically located in a federally
declared disaster area to qualify as an “affected taxpayer.”
Taxpayers are also considered “affected” if the records necessary to meet a filing or payment
deadline postponed during the relief period are located in a covered disaster area. Affected taxpayers
who are located outside the disaster area can call the IRS Disaster Hotline to self-identify for disaster
relief. Disaster relief can also apply to clients of tax preparers if their records that are required to meet
a filing or payment deadline are located in the disaster area.

17The statutory mailbox rule in IRC §7502 states that if a tax return, payment, or other document is mailed to the IRS and
postmarked by the U.S. Postal Service on or before the due date, it is considered timely filed or paid, even if the IRS receives it after
the due date.
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Example: Oliver owns a 30% interest in a partnership that is located in a federally-declared disaster
area. However, Oliver himself does not live in the disaster zone. Since he must rely on the information
(Schedule K-1) from the partnership to file his individual tax return, he qualifies as an “affected
taxpayer” for purposes of receiving filing and payment relief. Oliver’s filing and payment deadlines are
suspended until the end of the postponement period, just like the affected partnership. Oliver contacts
the IRS Disaster Hotline directly. The IRS operator places a temporary hold on his account during the
relief period. When he files his return, he writes the disaster declaration number on the first page of
his tax return. This will help the IRS process his return correctly.
When a taxpayer is claiming a loss due to a federally declared disaster, they should write the FEMA
disaster declaration number on their tax return. This helps the IRS process the claim correctly.

June 15 Deadlines (Automatic Two-Month Extension)

Three groups of taxpayers are granted an automatic two-month extension to file:
• Nonresident aliens who do not have wage income subject to U.S. withholding,
• U.S. citizens or legal U.S. residents who are living outside the United States or Puerto Rico, and
their main place of business is outside the U.S. or Puerto Rico,
• Taxpayers on active military service duty outside the U.S.
A citizen or resident alien living abroad must attach a statement to their tax return, explaining
which situation qualifies for this special two-month extension. Even if an extension is filed, the
taxpayer will have to pay interest on any tax not paid by the regular tax deadline of April 15.
December 15 filing extension: For most Americans and U.S. residents living abroad, the six-
month extension to October 15 is sufficient. However, a taxpayer who resides outside the United States
can request an additional “discretionary” two-month extension of time to file their tax return beyond
the regular six-month extension of October 15. For calendar-year taxpayers, the “additional” extension
date would be December 15.18 Unless the extension request is denied, the taxpayer will not receive a
response from the IRS.
Example: Cosima is a U.S. citizen residing and working in Portugal. She has already requested a 6-
month extension for filing her tax return using Form 4868. However, she realizes that she may require
more time to ensure the accuracy and completeness of her return, as she is still waiting on essential
financial documents from a Portuguese bank that has paid her interest during the year. Without these
documents, Cosima fears that her income tax return will not be accurate. Luckily, as an expatriate living
abroad, she has the option to obtain an additional 2-month extension, giving her until December 15th
to file her U.S. tax return.
Special Exception for Combat Zones: The deadline for filing a tax return, claim for a refund, and
the deadline for payment of tax owed, is automatically extended for any service member, Red Cross
personnel, accredited correspondent, or contracted civilian serving in a combat zone. These taxpayers
have their tax deadlines suspended from the day they started serving in the combat zone until 180
days after they leave the combat zone.

18In addition to the normal 6-month extension, taxpayers who are out of the country can request a discretionary 2-month
additional extension of time to file their returns (to December 15). See Publication 54 for how to request this extension.
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The deadline postponement provision also applies to estate, gift, employment, and excise tax
returns. These deadline extensions also apply to the spouses of armed service members serving in
combat zones. The extension applies to both spouses, whether joint or separate returns are filed.
Example: Ramon is a U.S. Marine who has served in a combat zone since March 1, so he is entitled to
extra time to file and pay his taxes. The 46 days between the date he entered the combat zone and the
normal April 15 filing deadline are added to the normal extension period of 180 days, so he has a 226-
day extension period after he leaves the combat zone. IRS deadlines for assessment and collection are
also suspended during any period that a U.S. service member is in a combat zone.

Penalties and Interest

The IRS can assess a penalty on individual taxpayers who fail to file, fail to pay, or both. The failure-
to-file penalty is greater than the failure-to-pay penalty. If someone is unable to pay all the taxes they
owe, they are better off filing on time and paying as much as they can.
The IRS will consider payment options for taxpayers. These penalties can be abated if the taxpayer
qualifies for an administrative waiver, or can establish that there was a reasonable cause for not paying
or filing on time. Common penalties include:
• Failure-to-file: When a taxpayer does not file their tax return by the return due date (or
extended due date, if an extension to file is requested and approved).
• Failure-to-pay: When a taxpayer does not pay the taxes reported on their return in full by the
due date, April 15. An extension to file does not extend the time to pay.
• Failure to pay properly estimated tax: When a taxpayer does not pay enough taxes due for
the year with their quarterly estimated tax payments (or through withholding) when required.
• Interest on the amount due: In addition to filing penalties, the taxpayer will also be charged
interest on the amount due.

Failure-to-File Penalty: The penalty for filing the Form 1040 late is usually 5% of the unpaid
balance due for each month, or part of a month, that a return is late. The penalty is based on the tax
that is not paid by the due date. This penalty will not exceed 25% of a taxpayer’s unpaid taxes.
If both the failure-to-file penalty and the failure-to-pay penalty apply in any month, the 5% failure-
to-file penalty is reduced by the failure-to-pay penalty. For the tax year 2024 (for returns filed in 2025),
the failure-to-file penalty is as follows:
• 5% of the unpaid balance per month (or part of a month) for a maximum penalty of 25% of the
unpaid tax.
• If the return is more than 60 days late, the minimum penalty is the lesser of (1) $510 or (2)
100% of the unpaid tax.
Example: Lenny does not file his tax return on time, or request an extension, because he believes that
he does not owe any income tax this year. When he finally gets around to filing his return on July 30,
Lenny discovers that he owed $25 in taxes. He electronically pays the amount due when he submits
his return, but the return is already over 60 days late. Lenny later receives a bill with a late filing
penalty of $25, which is 100% of the tax that was due on his return. He will also owe a small late
payment penalty of $2, as well as an additional $1.50 of interest on the amount due.
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Failure-to-Pay Penalty: If a taxpayer does not pay their taxes by the original due date (determined
without regards to any extension), the taxpayer could be subject to a failure-to-pay penalty of ½ of 1%
(0.5%) of unpaid taxes for each month, or part of a month, after the due date that the taxes are not
paid. This penalty can be as much as 25% of the unpaid taxes on the return.
The failure-to-pay penalty rate increases to a full 1% per month for any tax that remains unpaid
the day after a demand for immediate payment is issued, or ten days after notice of intent to levy
certain assets is issued.
Note: A taxpayer may request penalty abatement due to “reasonable cause.” Acceptable reasons for
abatement include: fire, casualty, natural disaster or other disturbances, inability to obtain records due
to a casualty or a disaster, death, serious illness, incapacitation, or unavoidable absence of the taxpayer
or a member of the taxpayer’s immediate family.
The failure-to-file penalty is reduced by the failure-to-pay penalty if both penalties apply. No
penalty will be assessed if the taxpayer is due a refund. If a taxpayer files their return on time, but does
not pay on time, then only the 0.5% failure-to-pay penalty will be assessed, which will increase per
month until 25% is reached.19
Example: Hannah knows that she will owe tax in 2024, but she doesn’t file an extension or file her tax
return on time. When she finally self-prepares her return on July 15, 2025, the return is already three
months late. She discovers that she owes $6,000 in taxes for the 2024 tax year. She will owe both the
“failure-to-file” penalty, and the “failure-to-pay” penalty. The failure-to-file penalty is usually
calculated at 5% per month for each month the return was late, but the penalty rate is reduced to 4.5%
per month when the failure-to-pay penalty also applies. Hannah’s failure-to-file penalty is calculated
for 3 months at a rate of $270.00 (4.5% of $6,000) per month, for a total penalty of $810. While the
failure-to-pay penalty is calculated for 3 months at a rate of $30.00 (0.5% of $6,000) per month, for a
total penalty of $90. Interest will be calculated on the entire amount, including the penalty of $810,
bringing the amount on which interest is based to $6,810. The IRS will also assess approximately $106
in interest on the full amount.20 Her software automatically calculates the penalty and interest, and she
pays this amount in full on the same day she submits her return, on July 15. The combined penalty is
calculated as follows:

Income tax due: $6,000

Failure to File Penalty: $810
Failure to Pay Penalty: $90
Interest on the full amount: $106
Total amount: $7,020

19 If the taxpayer’s failure to file on time is determined to be fraudulent, the late filing penalty increases to 15% of the unpaid
balance per month (or part of a month) for a maximum penalty of 75% of the unpaid tax.
20 IRS interest rates vary every year primarily due to changes in the federal funds rate, which is set by the Federal Reserve. The IRS

interest rate on unpaid taxes and tax refunds for individuals is 8% for all of 2024 and 7% for the first quarter of 2025, but you will
not need to know this rate for the EA exam.
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Example: Ximena does not have all her paperwork ready to file her return on April 15, so she requests
an extension by filing Form 4868. She is not sure if she owes taxes or not, because she is waiting for a
copy of a brokerage statement that was lost in the mail. Ximena finally receives her missing documents
and files her return on October 10, before the extended deadline. Once she enters all her tax
information into her software, she discovers that she owes $1,000 in tax, which she pays electronically
when she files her return on October 15, right on the deadline. She does not owe a late filing penalty,
because her tax return was filed on time (on extension). However, she will owe a late payment penalty
of approximately $30. She will also owe a small amount of interest (about $2) on the amount due.
Interest on the Amount Due: In addition to penalties, the taxpayer will also be charged interest
on the amount due. Generally, interest accrues on any unpaid tax from the due date of the return until
the date of payment in full. The interest rate is determined quarterly and is the federal short-term rate,
plus 3%. Interest compounds daily.
Unlike late filing penalties, interest cannot be reduced or abated for reasonable cause. Taxpayers
may request abatement of interest by filing Form 843, Claim for Refund and Request for Abatement, or
by submitting a request by letter. Interest will only be abated in extremely unusual circumstances,
such as in the case of a mathematical error made by the IRS.
Example: Nicole died two years ago. She had a filing requirement when she passed away. However,
Nicole died without a will, and an executor was not named by the probate court until November 10,
2024. Nicole’s brother, Ezequiel, was named the executor. Ezequiel filed two years of delinquent tax
returns on behalf of his deceased sister, and also requested a penalty abatement for filing Nicole’s final
tax returns late. The IRS granted the penalty abatement, although the interest on the amount due was
not abated and still had to be paid by Nicole’s estate. As the executor, Ezequiel would be responsible
for filing and signing all his late sister’s tax returns and making sure her estate pays any assessed tax.
Note: These are the penalties that apply to individual taxpayers only. Different penalty amounts apply
to business entities, which are covered in detail in Book 2, Businesses.

Estimated Taxes for Individuals

The federal income tax is a “pay-as-you-go” tax. This means that people need to pay most of their
tax during the year, as they earn their income. This can be done either through withholding or
estimated tax payments. Estimated tax payments can be used to pay income tax, self-employment tax,
and alternative minimum tax. Taxpayers who are working as employees and wish to increase (or
decrease) their withholding amounts must use Form W-4, Employee’s Withholding Certificate. The
Form W-4 is not submitted to the IRS. Instead, it is submitted to the taxpayer’s employer.
Example: Alwin is a full-time employee at Tech Resolutions, Inc. His regular withholding usually
covers his entire tax liability. However, during the year, Alwin sold a valuable comic book for a large
profit. He knows that he will owe additional taxes, but he does not want to make estimated payments.
Instead, he submits a new Form W-4 to his HR department, in order to increase his withholding and
avoid any surprises when filing his tax return. His payroll department will increase his withholding as
he has indicated, and Alwin avoids having to make estimated payments directly to the IRS.

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Safe Harbor Rules: Taxpayers can avoid making estimated tax payments by ensuring they have
enough tax withheld from their income. To avoid an underpayment penalty, the law provides several
safe harbor rules for estimated tax payments. Here are the key points:
• 90% Rule: Pay at least 90% of the tax owed for the current year.
• 100% Rule: Pay 100% of the tax owed in the previous year.
• $1,000 Rule: Owe less than $1,000 in tax after subtracting withholdings and credits.
• No prior-year tax liability: If a taxpayer had no taxes owed in the previous year, they are
typically not subject to the underpayment penalty for the current year, regardless of the
amount due.
For high-income taxpayers (with an adjusted gross income over $150,000, or $75,000 if married
filing separately), the safe harbor is adjusted to 110% of the previous year's tax.
“90% Rule” Example: Emily is a freelance graphic designer. Emily owed $24,000 in income taxes in
the prior year. For the 2024 tax year, she lost a few clients, and her income decreased. She estimates
that her total tax liability will only be about $10,000 in 2024. Emily does not need to pay 100% of the
tax she paid in the prior year, as long as she can reasonably estimate what she will owe in 2024. To
avoid an underpayment penalty, Emily needs to ensure that she pays at least 90% of her total tax owed
for the year. Throughout the year, Emily makes estimated tax payments totaling $9,000 (90% ×
$10,000 = $9,000). When Emily files her tax return, she owes an additional $1,000 ($10,000 total tax
liability - $9,000 estimated payments). However, because she met the 90% rule, she does not incur any
underpayment penalties. By paying at least 90% of her total tax liability, Emily meets the safe harbor
and avoids an underpayment penalty.

“100% Rule” Example: Gilbert earned $95,000 in wages during 2024. His employer withheld $8,200
in tax, which was enough to cover his tax liability for the year, so he did not owe any taxes when he
filed his return on March 1, 2025. Also in March, Gilbert gets a promotion. Because of his promotion,
Gilbert’s income will increase significantly in 2025. He believes he will owe over $10,000 in taxes in
2025, but he will not be assessed a penalty for underpayment of estimated taxes, provided he pays at
least $8,200 in estimated tax during the year (100% of the tax liability on his prior-year return).

The $1,000 Rule: A taxpayer will also not face an underpayment penalty if the total tax liability on
their return (minus the amounts of tax credits or paid through withholding) is under $1,000.
Example: Yvonne is a full-time secretary. She also earns money part-time as a self-employed
manicurist. She did not make any estimated payments during the year. However, Yvonne made sure to
increase her withholding at her regular job to cover any amounts that she would have to pay on her
self-employment earnings. When she self-prepares her tax return, she discovers that she still owes an
additional $750 in tax. She e-files her return on April 15. Using Direct Debit through her tax software,
she pays the full amount of additional tax that she owes ($750). Although she is responsible for paying
the additional tax that she owes on or before the deadline, she will not owe any penalties because her
total tax liability, after withholding, is still less than $1,000 for the year.

No prior-year tax liability: A U.S. citizen or U.S. resident is not required to make any estimated
tax payments if they had zero tax liability in the prior year. However, late payment penalties will
generally apply if a taxpayer does not pay all the taxes they owe by April 15, 2024 (the filing deadline).
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Example: Edgar, 27 and single, earned $4,700 in wages before he was laid off in the prior year. He did
not file a tax return or pay any income tax that year because his income was below the filing
requirement. In 2024, he started working as a self-employed rideshare driver. He paid no estimated
tax during the year. He files his 2024 return on March 30, 2025, and discovers that he owes $5,500 in
tax. Although Edgar owes the full amount of tax, he will not owe an underpayment penalty as long as
he pays the full amount due by April 15, 2025, because he had zero tax liability in the prior year.
Safe Harbor Rule for Higher-Income Taxpayers: If the taxpayer’s adjusted gross income was
more than $150,000 ($75,000 if MFS), the taxpayer must pay the smaller of 90% of their expected tax
liability for the current year or 110% (instead of the normal 100%) of the tax shown on their prior-
year return to avoid an estimated tax penalty.
Example: Massimo earned $205,000 in 2024. After applying all his deductions and credits, he had a
$30,000 tax liability for the year. In 2025, he expects his income to increase substantially. He estimates
that he will earn over $450,000. As long as Massimo pays at least 110% of his tax liability for the prior
year (110% × $30,000 = $33,000), he will not owe an estimated tax penalty, regardless of how much
he owes when he files his 2025 return.

Estimated Tax Due Dates for Most Individuals

The year is divided into four payment periods for estimated taxes, each with a specific payment
due date. If the due date falls on a Saturday, Sunday, or legal holiday, the due date is the next business
day. A taxpayer must complete Form 1040-ES, Estimated Tax for Individuals, to pay estimated tax. If a
payment is mailed, the date of the U.S. postmark is considered the date of payment.
• First Payment Due: April 15
• Second Payment Due: June 15
• Third Payment Due: September 15
• Fourth Payment Due: January 15 (of the following year)

To calculate an estimated tax penalty, or to request a waiver of the penalty, taxpayers use Form
2210, Underpayment of Estimated Tax by Individuals, Estates and Trusts. The IRS may waive the
underpayment penalty in certain situations, such as when a taxpayer’s income varies throughout the
year. For instance, if a taxpayer’s business operates on a seasonal basis or if a person receives a large
capital gain towards the end of the year. This is called the “annualized income installment method.”
Example: Camila is self-employed as a hairdresser. She usually makes estimated payments throughout
the year. Her income doesn’t usually fluctuate much during the year, and she usually makes estimated
payments of $500 each quarter. However, at the very end of the year, on December 25, 2024, she
receives a large sum from a bridal contract where she was hired to do makeup and hairstyling for a big
wedding party. Because of this, she will owe a lot more tax for the year. She plans to increase her final
estimated tax payment for the year, but she also wants to avoid an estimated tax penalty. Since she
received a large sum in December, she can use Form 2210 to report the large variance in her taxable
income. By using the annualized income installment method, she can avoid a penalty.
If a taxpayer qualifies for a waiver due to special circumstances, such as a casualty, disaster, or
other unusual situations, they can also request a waiver of penalties using Form 2210.

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Estimated Taxes for Farmers and Fishermen

Special rules apply to the payment of estimated tax by qualified farmers and fishermen (those who
file on Schedule F). If at least two-thirds of the taxpayer’s gross income in the current year comes from
(or in the prior year came from) farming or fishing activities, the following rules apply:
• March 1 deadline: The taxpayer does not have to pay estimated tax if the taxpayer filed their
return and pays all tax owed by the first day of the third month after the end of the tax year
(generally, this is March 1).
• January 15 deadline: If the taxpayer must pay estimated tax, they are only required to make
only one estimated tax payment (called the “required annual payment”) by the fifteenth day
after the end of their tax year (for individuals, this is usually January 15).
For this special tax treatment, “qualified farming income” includes gross farming income on
Schedule F, gross farming rental income, gains from the sale of livestock, and crop shares for the use
of a farmer’s land. This rule also applies to qualified fishermen.
Note: If a qualified farmer (or fisherman) files their 2024 Form 1040 by March 1, 2025, and pays all
the tax they owe at that time, they do not need to make any estimated tax payments during the year.
This rule doesn’t apply to any other type of business activity—it only applies to farmers and fishermen.
Example: Granville is the sole proprietor of a commercial oyster farm, which is his main source of
income. He files on Schedule F and does not make any quarterly estimated tax payments due to his
farming income, because he always files and pays his taxes due on March 1. However, when his
bookkeeper suddenly quits at the end of the year, Granville's records are incomplete. Granville informs
his accountant that he will not be able to meet the March 1st deadline for filing his tax return, and
requests an extension. As a result, Granville should make a single payment of estimated taxes by
January 15, 2025, in order to avoid any underpayment penalties. With incomplete records, he will have
to estimate the amount owed as accurately as possible based on the information he does have.
Example: Naomi’s sole source of income is her organic strawberry farm. She reports all of her profits
on Schedule F. Since she is a qualified farmer, she is not required to make quarterly estimated tax
payments. On February 28, 2025, Naomi filed her 2024 tax return, including a check for the full balance
of $9,900. Because she submitted her return and paid the full amount due before March 1, 2025, she
will not face any penalties for underpaying estimated taxes, regardless of the amount she owes.
Example: Aaron is a farmer who grows hothouse orchids and sells them to florists in his community
and online. He makes a tidy profit selling the flowers every year. Aaron also earns a considerable sum
as an occasional handyman. In 2024, his net income from farming is $47,000. His net income from his
handyman business is $33,000. Since two-thirds of his income is not from farming activities, Aaron is
not eligible for the special rule for estimated payments. He is required to pay quarterly estimates
throughout the year, just like every other business.
Note: This special estimated tax rule also applies to a person’s share of gross income from
partnerships, where the majority of the income is derived from farming or fishing. This safe harbor for
estimated payments does not apply to C corporations, regardless of the business activity.

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Backup Withholding
There are times an entity is required to withhold certain amounts from a payment and remit the
amounts to the IRS. For example, the IRS requires backup withholding if a taxpayer’s name and Social
Security number on Form W-9, Request for Taxpayer Identification Number and Certification, does not
match its records. The IRS will sometimes require backup withholding if a taxpayer has a delinquent
tax debt, or fails to report their interest, dividends, or other income. Income subject to backup
withholding may include: wages, interest, dividends, royalties, and payments to independent
contractors.
Backup withholding also applies following notification by the IRS, where a taxpayer underreported
interest or dividend income on their federal income tax return. To stop backup withholding, the payee
must correct any issues that caused it. They may need to give the correct TIN to the payor, resolve the
underreported income and pay the amount owed, or file a missing return.
The current backup withholding rate in 2024 is 24% for all U.S. citizens and legal U.S. residents.
Generally, backup withholding applies only to U.S. citizens, and resident aliens, and usually not to
nonresident aliens. However, a nonresident alien may be subject to withholding, as well. Most types of
U.S. source income received by a foreign person may be subject to withholding of 30% (unless an
exemption or tax treaty applies). Under the current backup withholding rules, a business, financial
institution, or bank must withhold taxes from a payment if:
• The individual did not provide the payor with a valid taxpayer identification number;
• The IRS notified the payor that the taxpayer’s SSN or ITIN is incorrect;
• The IRS notified the payor to start withholding on interest and dividends because the payee
failed to report income in prior years; or
• The payee failed to certify that he was not subject to backup withholding for underreporting of
interest and dividends
Backup withholding is not a penalty, and taxpayers may report the backup withholding amount as
taxes withheld when filing their tax return. As with any overpayment, backup withholding tax can be
refunded.
Example: Marco is a frequent visitor to the local casino, where his favorite activity is playing slot
machines. One day, he hits it big and wins over $20,000 from one of the machines. However, when he
goes to collect his winnings, the casino asks for his SSN. Marco declines, expressing concerns about
privacy. As a result, the casino is legally required to withhold 24% of his winnings and remit them to
the IRS. Marco will later receive a Form W-2G, Certain Gambling Winnings, which reflects his winnings
as well as the withheld amounts. Marco reports the backup withholding amount as taxes when filing
his tax return. Marco does not earn very much income for the year, other than gambling winnings, so
he receives a tax refund of most of the withheld amounts.
Example: Dario is a U.S. citizen who holds investments through XYZ Brokers, an online brokerage firm.
The IRS notifies the brokerage firm that Dario’s Social Security number is incorrect. Dario fails to
update his SSN, despite being informed by mail and email. A month later, XYZ Brokers starts backup
withholding on his investment income until the issue is resolved, resulting in a 24% withholding that
will be taken from any future payments to ensure the IRS receives the tax due on this income.

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Example: Federico is a citizen of Spain who also lives in Spain. He does not have a green card or live
in the U.S., but he visits the United States occasionally. He owns several U.S. investments, including a
limited partnership interest and U.S. Treasury bonds. He is treated as a nonresident for U.S. tax
purposes, but he is required to provide an ITIN to his investment firm, where his U.S. investments are
held. If he does not provide a tax identification number, the investment firm will be required to
automatically withhold 30% from all his U.S.-source income.

Gross Income and Filing Thresholds

Not everyone is obligated to file a tax return. The determination of whether a taxpayer must file a
federal income tax return is based on several factors. According to the IRS, “gross income” includes all
forms of taxable income received by a taxpayer, including money, goods, property, and services that
are not exempt from taxes.
“Earned income” encompasses all taxable income earned through work, such as wages, salaries,
tips, and other forms of employee compensation. This category also includes self-employment
earnings from business or farm ownership. Other types of income, such as interest income, dividends,
capital gains, retirement income, gambling winnings, and prizes, are considered “unearned income.”
The 2024 filing requirement thresholds for most taxpayers, expressed as levels of gross income,
are as follows:

Filing Status Age Filing threshold

Single Under 65 $14,600
65 or older $16,550
Married Filing Joint and Under 65 (both spouses) $29,200
Qualifying Surviving 65 or older (one spouse) $30,750
Spouse (QSS) 65 or older (both spouses) $32,300
Married Filing Separate Any age $5 (not a typo)
Head of Household Under 65 $21,900
65 or older $23,850
Any filing status The taxpayer had net earnings from self-employment of at least $400.21

Any filing status Church employee income of $108.28 or more.

The gross income filing thresholds are adjusted for inflation each year, and they vary by age and
filing status. In most cases, if a taxpayer’s gross income is less than the standard deduction for their
filing status, it is not necessary to file a tax return.

Example: Francine and Kevin are married and file jointly. Francine is 66 and had a gross income of
$18,000 for the year, all of which was from Social Security. Kevin is 65 and only had wage income of
$10,900 for the year. All their income is from Social Security and wages. Based on their combined gross
income, they are not required to file a tax return for 2024. The filing requirement threshold for joint
filers when both spouses are 65 or older is $32,300 in 2024.

21 Table source: Publication 501, Section: Filing Requirements for Most Taxpayers. In some cases, taxpayers with gross income below
these thresholds may still be required to file a return, such when special taxes are owed.
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However, there are situations where taxpayers may still be required to file, even if their income
falls below the standard deduction threshold.

Example: Alexis is a freelance graphic designer who works on various projects throughout the year.
In 2024, Alexis earned $9,000 from different clients. After deducting business expenses like software
subscriptions, marketing costs, and office supplies, her net earnings from self-employment on
Schedule C is $4,200. Since her net earnings from self-employment exceed $400, Alexis is required to
file a tax return for the year.
Example: Elena is 65, married, and had $3,500 of wage income in 2024. Her husband, Ricardo, age 65,
had $19,600 in wage income. They have no dependents. Normally, Ricardo and Elena would not have
a filing requirement because their gross income is under the filing threshold for joint filers age 65 and
over. However, Elena wants to file separately from her husband this year. Ricardo cannot choose to file
jointly with his wife unless she agrees, so Ricardo’s filing status is MFS by default, since both spouses
are required to sign a joint return. They are both required to file a tax return because the filing
threshold for MFS taxpayers of any age is $5 in 2024.

Filing Requirements for Dependents

Sometimes, dependents are required to file their own tax returns. A dependent child must file a tax
return if their earned income is more than the standard deduction for their age and filing status. The
filing thresholds are different for taxpayers that can be claimed as dependents, than for those that
cannot, and they are also different depending on whether a dependent has “earned income” or
“unearned income.”
The filing threshold is much lower for those with “unearned” income. Earned income includes
wages, tips, and self-employment income. Unearned income includes interest, dividends, and capital
gain distributions.
For a child with only unearned income, the first $1,300 of unearned income is not taxed in 2024.
The next $1,300 is taxed at the child’s rate. Anything above $2,600 is then taxed at the parents’ rate.
This is the “kiddie tax.”22
This means that, normally, a dependent child 18 or under (23 or under if a full-time student) with
only unearned income for the year will have to file a return in 2024 if their unearned income is greater
than $1,300.
Example: Chloe is 10 years old and lives with her mother, Louise. Chloe inherited some stock when
her father died a few years ago. Chloe receives $1,100 in dividends in 2024. She has no other sources
of income. She is not subject to the kiddie tax, and she is not required to file a return, because her
investment income is less than the filing threshold that would trigger a filing requirement.
For 2024, a dependent child who has received more than $14,600 of earned income (like wages or
tips) also needs to file a return (i.e., the total cannot be more than the standard deduction for their
filing status, which is $14,600 for most dependents in 2024).

22The kiddie tax only applies to investment income and other types of unearned income. We cover the kiddie tax in more detail
and with additional examples in Unit 15, Additional Taxes and Credits.
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Example: Barrett is a 17-year-old high school student living with his parents. He earned $5,650 from
a part-time job and received $200 of dividends from stocks gifted by his grandmother. Barrett’s
parents claim him as a qualifying child. Barrett’s total income is below the gross income filing threshold
for dependents. His investment income is also below the filing requirement for the kiddie tax. Barrett
is not required to file a tax return in 2024, and his parents can claim him as a qualifying child on their
tax return. Even if Barrett is not required to file a tax return, he may still choose to file to receive a
refund of any taxes he had withheld from his wages.
Example: Elizabeth is 19 and is claimed as a dependent on her parents’ tax return. She is a full-time
college student. She worked part-time at an ice cream parlor during the year and earned a total of
$14,950 in wages in 2024. She had no other income, and her parents provide the majority of her
financial support, as well as paying for her college tuition and her food and housing. Elizabeth is not
subject to the kiddie tax, because all her income is from wages, but she must file a tax return because
her total earned income is more than $14,600 (the normal standard deduction amount in 2024 for
single filers), but her parents can still claim her as a dependent.

Filing Requirements for Self-Employed Taxpayers

There are different filing requirements for self-employed taxpayers. Generally, a taxpayer is
required to file a tax return if they have net self-employment earnings of $400 or more. Net self-
employment earnings are calculated by subtracting any business expenses from your total self-
employment income.
Most self-employed taxpayers report their business income on Schedule C, Profit or Loss from
Business, which is for reporting income and expenses related to their business. For self-employed
farmers, there is a different form called Schedule F, specifically for reporting profit or loss from
farming. Do not confuse the filing threshold amount for self-employed taxpayers with the filing
requirement for information returns (most notably, Forms 1099-NEC and 1099-MISC).
Form 1099-NEC is used to report payments to an independent contractor who is paid at least $600
during the year. This $600 “reporting threshold” has nothing to do with the income tax filing
requirement for a self-employed person. Form 1099-MISC is still used to report other types of
payments, such as rents, royalties, prizes, and awards.
Example: Santiago is 67 years old and single. He has no dependents. Santiago is retired and receives
$12,600 in Social Security. Normally, he would not have to file a tax return, but he also earned $2,100
in self-employment income working as a rideshare driver on the weekends. He has a profit motive in
the rideshare activity and received a Form 1099-K from the rideshare service. His gross income is
$14,700, which is less than the filing threshold for his age and filing status (single, plus he is over the
age of 65). However, his self-employment income exceeds $400, which will trigger a filing requirement.
Santiago is required to file an income tax return. He will report his Social Security, and his self-
employment income on Schedule C.
Note: The Social Security Administration uses information from tax returns (specifically Schedule SE)
to determine a person’s benefits under the social security program. Not reporting a taxpayer’s self-
employment income could cause their social security benefits to be lower when they retire.

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Example: Janessa is 32 and earns $11,800 in wages during the year. Normally, she would not have a
filing requirement, but she also has $590 in self-employment income for two modeling gigs that she
did during the year. She had a profit motive in the modeling activity and hopes to pick up more
modeling gigs in the future. Although she did not receive a 1099-NEC for the contract work, any
taxpayer that has $400 or more in self-employment income during the year is required to file a return.
Therefore, Janessa must file Form 1040. She will report her wages, and she must also attach a Schedule
C to report her self-employment income.

Additional Filing Requirements

Sometimes, a taxpayer is required to file a tax return even if the gross income threshold is not met,
such as in the previous example, when a taxpayer has self-employment earnings of $400 or more. Other
filing requirements include the following:
• A taxpayer who earned $108.28 or more as a church employee. For the purposes of this rule, a
“church employee” is an employee of a church or religious organization that has a certificate
electing an exemption from employer social security and Medicare taxes. 23
• If the taxpayer owes Social Security tax or Medicare tax on unreported tips.
• If the taxpayer must pay the alternative minimum tax.
• If the taxpayer owes additional tax in connection with a retirement plan, such as an IRA, or
401(k).
• If the taxpayer received a distribution from a Medicare Advantage MSA, Archer MSA, or health
savings account (HSA).
• If the taxpayer owes household employment taxes for a household worker, such as a nanny. If
a taxpayer is filing a return only because they owe this tax, the taxpayer can also choose to file
Schedule H by itself.
• If the taxpayer must recapture an education credit, investment credit, or other credit.
• If the taxpayer received advance payments of the Premium Tax Credit. The taxpayer should
receive Forms 1095-A showing the amount of the advance payments, if any.24
Example: Calhoun is 32 and single. In 2024, he was unemployed for most of the year, and only earned
$9,100 in wages until he was suddenly laid off from his job. Normally, he would not have a filing
requirement. However, he withdrew $1,200 from his traditional IRA account at the beginning of the
year to pay his bills. The IRA withdrawal triggers a filing requirement for Calhoun. He must file a tax
return and report the distribution as taxable, even though his gross income is less than the filing
threshold for single filers.
Even if a person is not legally required to file a tax return, it is still recommended that they do so if
they are eligible for a tax refund. This includes situations where taxes were withheld from their income,
or if they qualify for refundable tax credits, like the Earned Income Tax Credit (EITC).

23 For the purposes of this rule, a “church employee” does not include an ordained minister, a member of a religious order (such as
a nun or a monk), or a Christian Science practitioner.
24 This list is not exhaustive. A detailed list of filing requirements can be found in Publication 501.

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Example: Susie is 32 and unmarried. She has a 9-year-old son and qualifies for head of household filing
status. She can claim her son as a dependent. In 2024, she earns $10,050 of wages and $1,900 of self-
employment income from cleaning houses on the weekends. Although Susie makes less than the filing
threshold for her filing status, she must file a tax return because her earnings from self-employment
exceed $400. Even if Susie did not have self-employment earnings, she should still file a tax return,
because she likely qualifies for the Earned Income Tax Credit as well as the Child Tax Credit. The EITC
and CTC are valuable credits that could give Susie a sizable tax refund.

Relief from Joint Tax Liability

When spouses file a joint return, they are both legally responsible for the entire tax liability.
However, in some instances, a spouse can be relieved of the tax, interest, and penalties on a joint return.
A taxpayer can file a claim for spousal relief under three different grounds:
• Innocent Spouse Relief
• Separation of Liability Relief
• Equitable Relief
The same form, Form 8857, Request for Innocent Spouse Relief, is used to request all three types of
relief. Note that all of these types of relief apply to joint filings. If a married taxpayer files a separate
return (MFS) then there is no joint liability.
Innocent Spouse Relief: This is when a joint return has understated tax liability due to “erroneous
items” attributable to a taxpayer’s spouse or former spouse. Erroneous items include income received
by a spouse that is omitted from the return. Deductions, credits, and property basis are also “erroneous
items” if they are incorrectly reported on the joint return. To be considered an “innocent” spouse, the
taxpayer must establish that they did not know (or have reason to know) there was an understated tax
liability at the time of signing the joint return. In other words, a taxpayer could seek innocent spouse
relief from the IRS if they later become aware of a tax liability and they believe that it is not theirs.
Example: Salma and Barton have always filed joint returns throughout their marriage. On February 2,
2024, Salma leaves Barton and files for divorce. Their divorce became final on December 10, 2024. On
January 30, 2025, the following year, Salma receives an IRS notice for a prior-year joint return,
indicating that $25,000 in gambling income was not reported. Salma discovers that Barton was hiding
a gambling problem, and he had won that money during their marriage and failed to report it. Salma
had no knowledge of the gambling winnings because Barton hid the money in a separate bank account
and never told her about it. Salma immediately files for innocent spouse relief by filing Form 8857,
Request for Innocent Spouse Relief.
The taxpayer must generally request relief within two years after the date on which the IRS begins
collection activity. In most cases, innocent spouse relief is limited to taxpayers who are no longer
married, including when one spouse is deceased.
Note: Acquiring Innocent Spouse Relief can be a difficult process, as it involves proving that one spouse
was not aware of the other spouse's actions, which resulted in a tax understatement. Other types of
relief, like Separation of Liability Relief or Equitable Relief, may be more attainable depending on the
taxpayer’s specific circumstances.

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Separation of Liability Relief: The restrictions mentioned above also apply to “separation of
liability” relief. The taxpayer must either no longer be married or legally separated from their spouse,
be widowed, or have lived apart for at least a year from the spouse with whom they filed a joint return.
Any unpaid taxes, along with any additional interest and penalties, will be separated and allocated to
each spouse based on their individual responsibility. Separation of liability relief only applies to
amounts owed that have not yet been paid. Separation of liability relief will not generate a refund.
In order to qualify for separation of liability relief, the requesting spouse cannot have had
knowledge of the tax item leading to the deficiency unless the return was signed under duress or if the
spouse can establish (1) that they were a victim of spousal or domestic violence before signing the
joint return, and (2) because of that abuse they feared retaliation from their spouse if they challenged
any items on the return.
Example: Athena and Roman have always filed joint returns. In 2022, they filed a joint return together,
reporting Roman’s $42,000 salary and self-employment income of $10,000 for Athena. On January 3,
2024, Athena and Roman filed for divorce, and began living in separate homes. Their divorce becomes
final on May 2, 2024. Seven months later, on December 2, 2024, the IRS initiates an audit of their 2022
joint return. The IRS finds that Athena claimed over $20,000 of improper business deductions. This
results in understated tax, plus interest and penalties for that tax year. Roman was not involved in
Athena’s business and was unaware of the improper deductions when he signed their joint return.
Athena had been hiding business records and did not give Roman access to her business bank account,
but Roman knew about her business's existence. Since Roman is now legally divorced from Athena, he
can file Form 8857 to request separation of liability relief. Roman must generally be able to prove that
he didn’t know about his ex-wife’s improper business deductions at the time he signed the joint return
with his wife. In the event that separation of liability is approved, the IRS will divide the underpayment
of taxes on their joint return between Roman and his ex-wife, and any understatement of tax shall be
allocated as if they had filed separate returns for the year.

Equitable Relief: If a taxpayer does not qualify for the first two types of relief, they may be eligible
for “equitable relief.” The IRS will review the facts and circumstances of the taxpayer’s case and
determine whether holding the taxpayer liable for the understated tax would be unfair. Unlike the
other two forms of relief, equitable relief may be granted for an underpaid tax, meaning it was properly
reported on a tax return but not paid. Further, in some cases, the spouse requesting relief may have
known about the understated or underpaid tax but did not challenge the treatment for fear of their
spouse’s retaliation.
Example: Margot was a victim of domestic violence, and she now lives apart from her husband. She
filed a joint return in the prior year with her ex-husband, and the return was later audited. When
Margot signed the joint return, she knew her husband was underreporting income and falsifying
deductions from his business, but she was afraid of what would happen if she refused to sign. After the
IRS audited their return, and the IRS discovered the understated tax, Margot filed for equitable relief.
She was able to document her history of spousal abuse using affidavits from family members and other
legal proof. The IRS granted her request for relief of her portion of the understated tax, penalties, and
interest.

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If the tax was paid, the taxpayer has until the expiration of the refund statute of limitations to
request equitable relief. If the tax is unpaid, the taxpayer has until the expiration of the collection
statute of limitations (ten years) to seek equitable relief.25
Injured Spouse Claims
An “injured spouse” claim and “innocent spouse” relief have similar-sounding names, but they are
very different. To be considered an injured spouse, the taxpayer must meet all the following criteria:
• Have filed a joint return
• Have paid federal income tax or claimed a refundable tax credit
• All or part of the taxpayer’s refund was, or is expected to be, applied to the other spouse’s past
financial obligations, and
• Not be responsible for the debt
Injured spouses can file Form 8379, Injured Spouse Allocation, to request their portion of the refund
on a joint return.
Example: Gerard and Kimberly got married in 2024 and decided to file jointly. Kimberly has
delinquent student loan debt, which she incurred before she married her husband. Gerard files Form
8379 to request his portion of their tax refund as an injured spouse. The IRS will retain Kimberly’s
share of the couple’s tax refund to offset her debt but will allow Gerard to obtain his portion of the
refund.

Refund Claims and Amended Returns

To claim a refund, a taxpayer must generally file an amended tax return (Form 1040-X) within
three years from the date the return was filed (or from the original due date of the return, if filed early),
or two years from the date the tax was paid, whichever is later.
This is also called the refund statute expiration date, or RSED. The RSED is the last day a taxpayer
can request a refund. If a taxpayer finds an error on a previously-filed return, and wants a refund, then
the amended return must generally be filed within three years of the due date in order to preserve the
right to those amounts.
Example: Myles e-filed his 2020 Form 1040 early, on February 1, 2021. He later discovered that he
failed to claim the American Opportunity Credit on his return, which would result in a substantial
refund. Myles mailed an amended return on April 15, 2024. Since returns filed on or before the due
date are considered filed timely, as of the original due date, for purposes of the amended return refund
claim period, his amended return was filed within the three-year statute period. He will receive a tax
refund for the 2020 tax year.
If a refund claim is not filed within the applicable period, a taxpayer is generally not entitled to a
refund unless an exception applies.

25 With regards to spousal relief provisions, we also cover this topic in more detail in Part 3, Representation, because it is a common
type of representation work done by enrolled practitioners.
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Example: Jenny self-prepared her 2020 tax return but filed it late, after the deadline, on November 5,
2021. She did not request an extension, and the return was considered delinquent when she filed it.
She later discovered that she had forgotten to claim the Earned Income Tax Credit. Almost three years
later, she files an amended return on October 5, 2024. Jenny’s refund claim is denied because she filed
her original return past the filing date without a valid extension. Therefore, since her amended return
was not considered timely, her refund from the 2020 tax year is forfeited.
However, if the taxpayer files an extension and files their original return prior to the October 15
extension deadline, the three-year period begins on the date that the taxpayer originally filed their
return.26
Example: Arnold has not filed a tax return for a long time. Arnold hires Patricia, an enrolled agent on
January 23, 2025, and tells her he wants to file all his delinquent tax returns, including his current year
return: 2019 through 2024. Patricia prepares and files all the returns. All his returns show a refund.
The most recent three years can be e-filed, but all the other delinquent returns must be mailed. Arnold
files all the back tax returns and his current-year return before the 2024 filing deadline (April 15,
2025). While he will receive refunds for his 2021-2024 tax returns, he will not be receiving refunds for
any older years, because the refund periods for those years have expired. He cannot receive a refund
for those years unless an exception applies.

Extended Statute for Filing Late and Claiming Refunds

In some cases, a late-filed tax return and claiming a tax refund beyond the deadline will be honored.
If established, sound reasons for this include: financial disability, death, serious illness, incapacitation,
or the unavoidable absence of the taxpayer or a member of the taxpayer’s immediate family.
In the case of a taxpayer who is "financially disabled," the time period for claiming a refund will be
extended. This typically refers to individuals who are mentally or physically unable to handle their
financial responsibilities. For a joint income tax return, only one spouse has to be financially disabled
for the time period to be suspended. Note that a lack of funds, in and of itself, is not considered
“reasonable cause” for failure to file or pay one’s taxes on time.
Example: Samantha timely-filed her tax return for 2020 on April 15, 2021. Her CPA later finds an error
on the return that would result in a refund, and he notifies her that she should amend the return. The
last date for Samantha to file a refund claim under the statute of limitations for the 2020 taxable year
would normally be April 15, 2024. Before she can file an amended return, on March 2, 2024, Samantha
is involved in a terrible car accident. The doctor did not expect her to survive, and she was in a coma
for nine months (until December 2, 2024). If Samantha can prove that she meets the qualifications to
be considered “financially disabled,” the statute of limitations for filing a refund claim would be
extended by the nine-month duration of her disability. 27

26 If the taxpayer had an extension to file (for example, until October 15), but the taxpayer filed earlier and the IRS received it July
1, the return is considered filed on July 1 (Form 1040-X instructions).
27 To claim financial disability, the taxpayer (or their representative) must complete the appropriate income tax return or amended

income tax return and also submit a statement of proof of the financial disability. For full instructions, read the section on financial
disability in Publication 17.
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Several unique scenarios allow a taxpayer to request a refund beyond the “normal” deadline. These
unique scenarios involve:
• A bad debt from worthless securities (up to seven years prior)
• A payment or accrual of foreign tax (up to ten years prior)
• A net operating loss (NOL) carryback
• A carryback of certain tax credits
• Exceptions for military personnel
• Taxpayers in federally declared disaster areas or taxpayers who have been affected by a
terroristic or military action

Example: Garth has been helping his elderly mother, Alma, file her tax returns. Over time, she has
become forgetful of things. In 2024, Garth discovers a file in his mother’s home filled with old
brokerage statements. Several of the brokerage statements show losses from worthless securities,
dating back many years. Alma had been putting the statements away unopened because she believed
that they were unimportant. Alma’s Form 1099-B from 2018 shows a significant loss from worthless
stock (over $18,000 in losses that were never reported). Even though the brokerage statement is six
years old, Alma is still allowed to amend her 2018 tax return to claim the stock losses. That is because
the IRS allows up to seven years to amend a tax return for losses from worthless securities. Alma can
file a Form 1040-X to claim the losses and receive a refund under this extended statute of limitations.

Statute of Limitations for IRS Assessment and Collection

The IRS is generally required to assess tax within three years after the return is filed or, if filed
early, the due date of the return. If a taxpayer files their return on extension, or files their tax return
late, then the IRS has three years from the actual filing date.
Example: Alexandrina e-filed her 2020 tax return on February 27, 2021. Since she filed her return
before the actual due date, the three-year statute period for audit assessment began April 15, 2021,
(the actual due date of her tax return) and ends on April 15, 2024. After that date, the IRS must be able
to prove fraud or a substantial understatement of gross income (over 25%) in order to assess
additional tax on Alexandrina’s 2020 tax return.
The IRS has six years to assess tax on a return if a “substantial understatement” is identified,
meaning that gross income was understated by more than 25%. If a taxpayer never files a return, or if
a return is fraudulent, then there is no statute of limitations for an additional assessment of tax.
Example: Margot had a particularly good year and had $100,000 in income. However, when she filed
her tax return, she only reported $70,000 of income. She did not include $30,000 that she received as
a sweepstakes prize, mistakenly believing it was non-taxable. This is a “substantial understatement”
because Margot understated her income by 30% ($30,000 is 30% of her actual income of $100,000).
The IRS could audit Margot’s return up to six years from the filing date because of the substantial
understatement, and force Margot to pay the additional tax owed on the understated amount, plus
interest and penalties.
The statute of limitations for IRS collection of tax is ten years from the date tax is assessed. The ten-
year collection statute period begins to run on the date of the tax assessment, not on the date of filing.

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For example, if the taxpayer owes when they file their tax return, the IRS will send a bill. The bill date
is the assessment date. The IRS can attempt to collect unpaid taxes for up to ten years from the date
the taxes are assessed.
This is also called the Collection Statute Expiration Date, or CSED. The ten-year CSED period
begins to run on the date of the tax assessment, not on the date of filing. The IRS assigns a collection
statute expiration date or “CSED” to every delinquent taxpayer account. Once the CSED expires, the IRS
loses its right to seize assets or make payment demands. Certain events can extend the amount of time
the IRS has to collect.
Example: Franco has always filed his tax returns on time. Five years ago, Franco was self-employed
and did not understand how to manage his money or pay estimated taxes. He had a large tax bill from
that year. Franco still filed his tax return on time and correctly reported the amount due, intending to
make monthly payments. The IRS issued its assessment and sent Franco a bill for $24,000 (the amount
that Franco owed, including penalties and interest). Franco requested an installment agreement and
began making monthly payments toward his tax debt. Shortly thereafter, Franco had a car accident
and became disabled. He no longer has the means to work or pay the bill. The IRS has five years left to
collect on the debt, and after that, the statute of limitations for collection expires. Although the interest
and penalties will continue to accrue, if Franco has no assets or means to pay the bill, the debt will
likely be deemed uncollectible.
Once again, if a taxpayer fails to file a return, the statute of limitations on assessment remains open
indefinitely.
Example: Joan is 45 years old and unmarried. She makes very little money working part-time at a
grocery store. She is usually under the filing requirement and therefore does not file a return. In 2024,
she receives an audit notice for 2019, 2020, and 2021, stating that she may have underreported income
for those years. Since Joan did not file tax returns for those years, the statute is still open, and she is
forced to respond to the IRS audit notices. Unfortunately, she already shredded all her records for those
years, so it may be more difficult to properly file those returns, if in fact she is required to do so. If Joan
had filed her returns when they were due (even if not required to do so because of her low income),
the assessment statute would have already been closed (unless there was a substantial
understatement or the returns were fraudulent).

Signing Returns Under Penalty of Perjury

A tax return is not considered valid if it is not signed.28 When taxpayers sign their tax returns, they
are affirming that the information provided is accurate and truthful to the best of their knowledge. This
is done under “penalty of perjury,” meaning that they can face serious legal consequences if they
knowingly submit false information.
For individuals who use a tax preparer, the preparer must also sign the return. This signature
confirms that the preparer has reviewed the information and believes it to be accurate and complete,
to the best of their knowledge.

28 The signature requirements for electronic and paper-filed returns are covered in more detail in Part 3, Representation.
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Example: Jessie is an enrolled agent. She has taken on Mario as a client. Mario runs a small business
and provides Jessie with all the necessary financial records, such as his income and expenses for the
year. Jessie carefully reviews these documents and carefully prepares Mario's tax return. She gives
Mario a copy for his review. He signs the return declaring that all information provided is accurate and
complete. Jessie must also sign the tax return, in the preparer’s section. Signatures are required for
both Mario and Jessie, whether the return is filed electronically, or on paper.
Internal Revenue Code Section 7206 makes it a federal crime to knowingly and willingly file a false
tax return, (or to assist or advise someone to do so). For instance, if taxpayers knowingly inflate their
tax deductions or omit income, they can be charged with a felony, facing fines up to $100,000 and
imprisonment for up to three years.
Example: In the case of United States v. Parker, Thomas and Margaret Parker were convicted of filing
false tax returns and willfully failing to pay taxes. The Parkers earned substantial income from multiple
sources but significantly underreported their income on their tax returns. The evidence included
testimony from an IRS agent who interviewed Margaret Parker and established her complicity in the
tax fraud. Thomas Parker tried to argue that he was “confused” about his tax obligations, but the court
found that he was aware of his tax debt, as evidenced by him setting up an installment agreement with
the IRS. The court upheld their convictions, emphasizing the importance of accurate and honest tax
reporting.
These rules ensure that taxpayers and tax preparers are diligent and honest in their reporting
obligations, protecting the integrity of the tax system.

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Unit 2: Determining Filing Status and Residency

For additional information, read:
Publication 17, Your Federal Income Tax
Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad
Publication 519, U.S. Tax Guide for Aliens

The IRS uses a taxpayer’s filing status to determine filing requirements, standard deductions,
eligibility for certain credits, and the amounts of tax owed.
There are five filing statuses, each governed by specific rules. Some taxpayers are eligible to use
more than one filing status. Usually, these taxpayers may choose the filing status that will result in the
lowest overall tax.
In general, a taxpayer’s marital status on the last day of the year (December 31) determines their
marital status for the entire year. You must be familiar with the marital laws of your state in order to
correctly determine filing status. However, there are special rules that apply to annulled marriages,
widowed taxpayers, and surviving spouses who have dependent children.

Note: Federal law does not allow Registered Domestic Partners (RDPs) to file a joint return. This rule
also applies to civil unions.29 However, the IRS does recognize common-law marriages. Currently, the
only states that generally recognize common-law marriage are: the District of Columbia, Colorado,
Iowa, Kansas, Montana, Oklahoma, Rhode Island, and Texas. Common-law marriage laws vary from
state to state, and cohabitation alone does not constitute a common-law marriage. Several states now
recognize same-sex common-law marriages.
Example: Aziel and Gareth are a same-sex couple living together in South Dakota. Both are U.S. citizens.
On May 20, 2024, they took a one-month trip to Canada and got married in a civil ceremony. The United
States recognizes foreign marriages performed in Canada, so Aziel and Gareth are now legally married
for federal tax law purposes. They may file either Married Filing Jointly, or Married Filing Separately
for the tax year. Neither one can file “single.”

Example: Dwight and Charlotte live together in Texas, which is a common-law state. Although Dwight
and Charlotte never applied for a marriage license30 or went through a formal marriage ceremony,
they tell their family and friends that they are married, use the same last name, own a house together,
and have three children together. In the state of Texas, their conduct rises to the level of “holding
oneself out to the public” as a married couple. Therefore, they are considered “married” under Texas’
common-law statutes and can file a joint federal return together.

29 On the EA exam, you will not be tested on the matrimonial laws of any particular state, but it's important to know that the IRS
only recognizes legal marriages and not civil unions or RDPs.
30 Marriages are usually created by a legal ceremony. Some states, however, recognize common law marriage. In some states, like

Texas, common law marriage allows couples to file taxes jointly without having a formal ceremony. Couples who live in a common
law marriage state can also choose to register their common law marriage by filing a simple declaration with the county clerk, if
they wish.
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Single
Marital status is generally determined on the last day of the year. A taxpayer is considered single
for the entire tax year if, on the last day of the tax year, they were:
• Unmarried,
• Legally separated under a decree of divorce or separate maintenance,
• Legally divorced by the end of the year.

Example: Reuben and Natasha lived together until July 30, when they separated. Reuben filed for
divorce on August 1, and their divorce became final on December 30, 2024. They do not have any
dependents. They each must file as “single” for 2024. It does not matter that they were legally married
and lived together during much of the year. The fact that the divorce became final before the end of the
year means that they are single for tax purposes in 2024.
Example: Margot and Juliet are a same-sex couple living in California. They do not have any
dependents. They have been registered domestic partners (RDPs) since 2004. Margot and Juliet are
both high-income earners. They decide not to get married and instead remain registered domestic
partners because, in their particular situation, their overall tax rate would increase if they were to
marry and file jointly. Since they are registered domestic partners under California law, they will file a
joint California return. However, for federal tax purposes, they are considered “unmarried.” They must
file “single” federal returns.

Married Filing Jointly (MFJ)

The “married filing jointly” status typically offers more tax advantages than filing separately. This
option allows both spouses to report their combined income, expenses, exemptions, and deductions
on one return. Spouses can file a joint return even if only one spouse has income.
This filing status is an election, not the default. This is because both spouses must agree to sign a
joint return, and both are responsible for any tax owed, even if all the income was earned by only one
spouse. If one spouse does not wish to file jointly, then both spouses must default to MFS (unless one
qualifies for a different filing status).
In the event of a subsequent divorce, both spouses are still held liable for any taxes owed from the
original joint return, with exceptions for innocent spouse relief. As long as marriage was valid on
December 31st, taxpayers can file jointly if they:
• Live together as married spouses, or
• Live together in a common-law marriage recognized in the state where they now reside or in
the state where the common-law marriage began, or
• Live apart but are not legally separated or divorced,31 or
• Are separated under an interlocutory (not final) divorce decree.

31 State law governs whether a taxpayer is married or legally separated under a divorce or separate maintenance decree. Single
filing status generally applies if the taxpayer is not married, divorced, or legally separated according to state law.
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Example: Miguel and Jessamine separated on October 9, 2024. Neither Miguel nor Jessamine filed for
divorce yet, but they plan to file for divorce in the future. They do not have any children or dependents.
Since their divorce was not final before the end of the year, and they are not legally separated, they are
considered “married” for tax purposes. Even though they are living apart, Miguel and Jessamine decide
to file a joint return together. They could also choose to file separate returns, if they wish.
In addition, a widowed taxpayer may use the married filing jointly status and file jointly with their
deceased spouse, if the taxpayer’s spouse died during the year and the surviving spouse does not
remarry in the same year.
Example: Pedro and Bernadette were married for 30 years until Bernadette’s passing in June 2024.
Pedro has to handle their taxes for the year. He is eligible to file a joint tax return with Bernadette for
the 2024 tax year. Filling out the return as Married Filing Jointly allows Pedro to take advantage of
benefits like a higher standard deduction and potentially lower tax rates. Pedro includes both his and
Bernadette’s income on the joint return. He will sign the return both for himself and for Bernadette as
a surviving spouse.
Nonresident Alien Spouses: Special rules apply to nonresident alien spouses. A U.S. resident or
U.S. citizen who is married to a nonresident alien can elect to file a joint return as long as both spouses
agree to be taxed on their worldwide income. An election statement must be attached to the joint return. 32
Example: Patricia is a U.S. citizen living in Indonesia. She recently married Vikal, a nonresident alien
and citizen of Indonesia. The spouses elect to treat Vikal as a U.S. resident (for tax purposes). Patricia
and Vikal must request an ITIN for Vikal and report their worldwide income for the year they make
the choice, and for all later years unless the election is ended or suspended. Although Patricia and Vikal
must file a joint return for the year they make the election, as long as one spouse is a U.S. citizen or U.S.
resident, they can file either joint or separate returns for later years.

Married Filing Separately (MFS)

The Married Filing Separately (MFS) filing status is one of the options available to married couples
when filing their taxes. The MFS filing status allows each spouse to report their own income,
exemptions, credits, and deductions on separate returns, even if one spouse had no income. The MFS
status is for taxpayers who are married and either:
• Choose to file separate returns or
• Do not agree to file a joint return.
If one spouse chooses to file an MFS return, the other is forced to do the same, since a joint return
must be signed by both spouses.
Couples might choose to file separately in order to keep their finances separate, protect themselves
from potential tax liability issues of the other spouse, or if it results in a lower overall tax bill due to
specific circumstances.33

32This is called a “§6013(g) election,” and a required election statement must be attached to the return.
33Special rules apply for community property states. In community property states, income and deductions generally need to be
split between spouses, which can complicate the filing process.
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Example: Arush and Namita have always filed jointly in the past. However, Namita has chosen to
separate her finances from her husband this year, even though they are still living together. She opens
a separate bank account and does not share her W-2 information with her husband. Arush wants to
file jointly with Namita, but she has refused. Namita files her tax return using married filing separately
as her filing status; therefore, Arush is forced to file MFS, as well.
Some of the specific features of the MFS filing status include the following:
• The tax rates are generally higher at the same levels of taxable income than those applicable to
MFJ, but there are some scenarios where filing separate returns can produce a better tax result.
• The exemption amount for the AMT is half that which is allowed on a joint return.
• Various credits are either not allowed, or they are more limited than on a joint return.
• The capital loss deduction is limited to $1,500; half of what is allowable on a joint return.
• The standard deduction is half the amount allowed on a joint return and cannot be claimed if
the taxpayer’s spouse itemizes deductions.
• Neither spouse can deduct student loan interest on an MFS return.

Example: Leo and Regina are married and live together in Montana. They have always kept their
income and finances separate and always file separate tax returns. Leo plans to itemize his deductions
this year, so Regina is forced to either itemize her deductions or claim a standard deduction of zero.
Although uncommon, married taxpayers sometimes choose to file separate returns because filing
separately may result in a lower total tax. For example, the couple’s overall tax liability may be lower
on a separate return when one spouse has significant medical expenses or large miscellaneous
itemized deductions (such as a casualty loss). Couples may choose to change their filing status between
MFJ (married filing jointly) and MFS (married filing separately) every year, without limitations. This
allows for flexibility and potential tax benefits depending on the couple’s tax scenario.
Example: Daniel and Inara are married and live together in Florida. They usually file jointly. Daniel
earns $130,000 in wages, while Inara earns much less: $40,000. This year, Inara had very high medical
expenses due to a hip replacement procedure. If they file jointly, the medical expenses cannot be
deducted, because the out-of-pocket medical expenses do not exceed 7.5% of their joint AGI, so they
do not qualify as a deduction. However, if Daniel and Inara file separate returns, Inara’s medical
expenses are deductible on her separate tax return, eliminating her tax liability entirely and resulting
in a large tax refund. They calculate their taxes both ways, and find that their overall tax liability will
be several hundred dollars less by filing separate returns, so they choose to file separately.
Another common reason a taxpayer may choose the MFS filing status is to avoid a refund offset
against the other spouse’s outstanding prior debt. This might include delinquent child support or
student loans, or a tax liability one spouse incurred before the marriage. This is especially true if the
taxpayers reside in a state that does not recognize injured spouse provisions.
Example: Phillip and Dinah were married in 2024. Dinah owes $80,000 in delinquent student loans.
Phillip chooses to file separately from Dinah, so his refund will not be offset by her overdue tax debts.
If they were to file jointly, their entire refund might be retained in order to pay Dinah’s delinquent
debt. Phillip files a separate return from Dinah. He retains his entire refund, which is deposited into
his separate bank account.

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Example: Hillard and Ingrid were married in 2024. They reside in Georgia. Ingrid owes $15,000 in
back child support and delinquent state income taxes. Georgia law does not contain a provision for
injured spouse relief. Hillard decides to file a separate return from Ingrid so he can retain both his
federal and state tax refunds. Hillard does not have to file any injured spouse forms, because he did not
file a joint return with Ingrid. He receives both of his separate refunds. Ingrid files her own separate
return, and her federal and state tax refunds are offset to pay her delinquent debts.

Amending Filing Status

There are rules for when married taxpayers are allowed to change their filing status. Although it is
possible to amend a person’s filing status, there are strict rules for doing so. Taxpayers generally
cannot change from a joint return to a separate return after the unextended due date of the return.
For example, if a married couple files a joint (2024) return on February 1, 2025, and subsequently
decide they wanted to file separately instead, they would have only until April 15, 2025 (the
unextended due date of their original return) to file amended returns using the MFS filing status.
Example: Alvin and Ivana are married and live in Florida. They e-file their 2024 tax return jointly, on
February 5, 2025. A few weeks later, Ivana discovers that Alvin has a hidden bank account and a second
set of books for his business. Ivana is concerned that Alvin may not be reporting all the income from
his business, and she is afraid of being audited in the future. Ivana confronts her husband, and he
refuses to discuss the issue. Ivana decides to quickly amend her joint return to a separate return. She
files Form 1040-X on March 3, 2025, to file a separate return for herself. Since she filed her amended
return before the April 15 filing deadline, the IRS will process the return, and her filing status will be
adjusted to MFS, making her responsible only for her own tax liability.
A notable exception to this strict deadline allows a personal representative for a deceased taxpayer
to change from a joint return, elected by the surviving spouse, to a separate return for the decedent for
up to a year after the filing deadline.34
Example: Landon and Bianca have always filed jointly. Bianca dies suddenly on November 16, 2024,
and her last will and testament names Laura, her daughter from a previous marriage, as the executor
of her estate. Landon files a joint return with Bianca for the tax year 2025, but Laura, as the executor,
decides that it would be better for her deceased mother’s estate if Bianca’s final tax return were filed
as MFS. Laura files an amended return claiming MFS status for Bianca and signs the return as the
executor. Laura has a full year after the filing deadline to submit the amended return, and it will still
be processed and accepted by the IRS.
To change from separate returns to a joint return (MFS to MFJ), taxpayers must file an amended
return using Form 1040-X, and may do so at any time within three years from the due date of the
separate returns (not including extensions).

34The IRM outlines the procedure for returns that are amended from MFJ to MFS (IRM 21.6.1.5.6) by only one of the spouses. The
IRS creates a “dummy” MFS return for the other spouse for processing, and then that dummy return can be amended by the second
spouse, if desired.
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Example: Jackie and Kaleb are married, but have been physically separated for two years. They did
not file for divorce and have been working on their marriage with a counselor. They choose to file
separate returns for 2022 and 2023. On January 2, 2024, Jackie and Kaleb reconcile and move back in
with each other. Jackie and Kaleb decide to file jointly for 2024. They can also choose to amend their
prior-year separate tax returns for 2022 and 2023 to “married filing joint” by filing a Form 1040-X.
They have up to three years to amend their previously-filed separate returns to joint returns, if they
wish.

Head of Household (HOH)

A taxpayer who qualifies to file as “head of household” will usually have a lower tax rate than a
single or MFS taxpayer and will receive a higher standard deduction. The head of household status is
available to taxpayers who meet all of the following requirements:
• The taxpayer must be single, divorced, legally separated, or “considered unmarried” on the last
day of the year.
• The taxpayer must have paid more than half the cost of keeping up a home for the year.
• The taxpayer must have had a qualifying person living in their home for more than half the
year.35
For IRS purposes, “temporary absences” include time away from home going to college, vacation,
business, medical care, hospitalization, military service, summer camp, and detention in a juvenile
facility. It must be reasonable to assume that the absent person will return to the home after the
temporary absence.
Example: Rhonda is unmarried. Her son, Nathaniel, was eighteen years old at the end of the year.
Nathaniel lived away from his mother all year because he was going to college. He lived on campus, in
the dorms, returning home only on holidays. Nathaniel does not work and does not provide any of his
own support. Since his time away from home to attend school is considered a “temporary absence,”
Rhonda may claim head of household filing status, and claim Nathaniel as her dependent.
When determining head of household filing status, valid household expenses used to calculate
whether a taxpayer is paying more than half the cost of maintaining a home include:
• Rent, mortgage interest, property taxes
• Home insurance, repairs, and utilities
• Food eaten in the home
Valid expenses do not include: clothing, education, medical treatment, vacations, life insurance, or
transportation. Government welfare payments are not considered amounts that the taxpayer provides
to maintain a home. The “qualifying person” for the HOH filing status must generally be related to the
taxpayer either by blood, adoption, or marriage. However, a foster child also qualifies if the child was
legally placed in the home by a government agency.

35 There are exceptions for temporary absences, as well as for a qualifying parent, who does not have to live with the taxpayer.
This
would include hospitalization and stays in a nursing home. A taxpayer cannot file HOH if their only dependent is a Registered
Domestic Partner. To see a full list of these rules, see:
https://apps.irs.gov/app/vita/content/globalmedia/head_of_household_qualifying_person_4012.pdf

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For purposes of the head of household filing status, a “qualifying person” is defined as:
• A qualifying child,
• A married child who can be claimed as a dependent, or
• A dependent parent,
• A qualifying relative that meets certain relationship tests
A taxpayer’s qualifying person may include: a child or stepchild, sibling or step-sibling, or a
descendant of any of these. For example, a niece or nephew, stepbrother or stepsister, or grandchild
may all be eligible as qualifying persons for the HOH filing status.

Example: Kevin is unmarried and is 64 years old. He earns $49,000 in wages during the year. His
disabled sister, Francesca, has lived with him since their parents passed away six years ago. Francesca
is 42 and has severe autism. She cannot engage in any substantial gainful activity, but she does receive
a small amount of State Disability Assistance every month. These amounts are not taxable and
Francesca does not have a filing requirement. Kevin can file as head of household and claim Francesca
as his qualifying child, because she meets the “relationship” test (she is his sibling), and she meets the
“age” test for a qualifying child, because she is permanently disabled.
Example: Lamonte is 71 years old and unmarried. His daughter, Brooke, lived with him the entire year.
Brooke turned 29 at the end of the year. She does not have a job, did not provide any of her own
support, and cannot be claimed as a dependent by anyone else. She is not disabled. Although she cannot
be Lamonte’s qualifying child, because of her age, she is a qualifying relative. As a result, Lamonte may
use the head of household filing status, by claiming his daughter as a qualifying relative.
An unrelated individual, and even certain family members, may still be considered a “qualifying
relative” for dependency purposes but will not be a qualifying person for the HOH filing status.
An example of someone who could be a qualifying relative, but not a qualifying person for the head
of household filing status, are cousins. A cousin is not a close enough relative to be a qualifying child
(unless the cousin is placed in the taxpayer’s home as a qualifying foster child). A cousin can be a
qualifying relative, but only if the cousin lives with the taxpayer the entire year. A spouse or registered
domestic partner also cannot be a qualifying person for head of household purposes.
Example: Aria is age 36, unmarried, and does not have any children. On January 2, Aria’s 15-year-old
cousin, Bailey, is put into foster care because her mother is arrested for drug trafficking. Aria does not
want her cousin Bailey to be in foster care, so she applies to be Bailey’s foster parent, and she is
approved. On March 1, Bailey is placed in Aria’s home as her foster child. Aria may file as head of
household and claim her cousin Bailey as a qualifying child, because Bailey was legally placed in her
home as a foster child.
Example: Adina and Paola are registered domestic partners (RDPs) who live together in California.
They do not have any children or other dependents. Adina works full-time and earns $90,000 in wages
for the year. Paola does not have a job and has no taxable income. Adina fully supports Paola, but she
cannot file as head of household because a registered domestic partner is not a “qualifying person” for
head of household status. Adina may be able to claim Paola as a qualifying relative on her federal
income tax return, but she will be forced to file “single.”

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Example: Richard is unmarried and age 54. He earns $62,000 in wages for the year working for a
grocery store. His old Army friend, Emmet, lives with Richard all year long. Emmet does not work,
because he is disabled. Emmet and Richard are not related, but they are best friends. Richard pays for
all the household costs as well as food and utilities for both of them. As a result, Richard can claim
Emmet as a “qualifying relative” dependent, but Richard cannot file as “head of household” because
Emmet is not a qualifying person for HOH filing status (i.e., Emmet is not related to Richard by blood,
marriage, or adoption).
Example: William is unmarried and age 42. He earns $60,000 as a self-employed contractor. William’s
cousin, Jimmy, age 22, has lived with William all year. Jimmy is attending junior college and also has
$3,100 in wages from a part-time job on campus. William cannot file as head of household, because
Jimmy cannot be a qualifying child. However, William can claim Jimmy as his qualifying relative,
because Jimmy earned less than the deemed exemption amount and lived with William all year.
Death or Birth during the Year: A taxpayer may file as head of household and claim a child as a
dependent if the child is born or dies during the year. The parent must have provided more than half
of the cost of keeping up a home that was the child’s main home while the child was alive.
Example: Brigitta is unmarried and lives alone. Brigitta gives birth to a son on September 1, 2024. She
takes her child home, but the child is sickly. The infant dies one month later. Brigitta can claim her
deceased son on her tax return, and file as Head of Household, even though the child only lived a short
time. Assuming Brigitta qualifies, the child would also be a qualifying child for the Child Tax Credit and
the Earned Income Tax Credit. This is true even if Brigitta is unable to obtain a Social Security number
for the child.36
Divorced and Noncustodial Parents: A taxpayer may qualify as head of household, even though
they may not have a qualifying child being claimed as their dependent. This happens most often with
divorced parents. This is because the head of household filing status applies to the taxpayer who
maintains the main home of a qualifying child.
However, a custodial parent may choose to release the dependency exemption to a noncustodial
parent.37 In this scenario, the custodial parent may still claim head of household filing status, while the
noncustodial parent would claim the dependency exemption.
Example: Nicolas and Mirella have been divorced for two years and they live apart. They have a
twelve-year-old daughter named Selena, who lives with her mother during the week. Selena only sees
her father on weekends. Therefore, Selena’s mother is considered Selena’s custodial parent. The
parents agree, however, to allow Nicolas to claim the dependency exemption for Selena on his tax
return. Nicolas correctly files as “single” and claims his daughter as his dependent. This entitles him to
the Child Tax Credit. Mirella may still file as head of household if she otherwise qualifies, but she will
not claim the dependency exemption for Selena.

36 If a child was born and died in the same year and was not issued an SSN, the taxpayer may enter “DIED” on the Form 1040, and
attach a copy of the child’s birth certificate. The tax return must be filed on paper.
37 To release the dependency exemption, the custodial parent must sign Form 8332, Release/Revocation of Release of Claim to

Exemption for Child by Custodial Parent. The signed release allows the noncustodial parent to claim the child tax credit, additional
child tax credit, and credit for other dependents, (if applicable), for a child.
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Special Rules for Dependent Parents

If a taxpayer’s qualifying person is a dependent parent, the taxpayer can file as HOH even if the
parent does not live with the taxpayer. The taxpayer must pay more than half the cost of keeping up a
home that was the parent’s main home for the entire year. This rule also applies to a parent in a
retirement home. A qualifying “parent” may be a stepparent, in-law, or grandparent who is related to
the taxpayer by blood, marriage, or adoption.
Example: Theodore, age 55, is unmarried and lives alone. Theodore has financially supported his
elderly mother, Agnes, for many years. Agnes is 82 and lives in a senior living facility. Agnes does not
have any taxable income, and Theodore provided more than one-half of her support. Theodore may
file as head of household, and claim his elderly mother as his dependent.
Example: Janie is single and fully financially supports her elderly mother, Leona, who is age 78 and
lives in her own apartment. Leona dies suddenly on February 12, 2024. Janie can claim her mother as
a dependent and file as head of household, even though Leona was not alive for the entire year.
Example: Caroline is 54 years old and single. She pays the monthly bill for Shasta Pines Nursing Home,
where her 79-year-old mother lives. Caroline’s mother, Greta, has lived at Shasta Pines for two years
and has no income. Since Caroline pays more than one-half of the cost of her mother’s living expenses,
Caroline qualifies for head of household, even though her mother lives in a retirement home.

Special Rules for Married Taxpayers who are “Considered Unmarried”

There are some instances where a married person can be “considered unmarried” for tax purposes
only. The “considered unmarried” rules apply in determining who can claim a child for dependency
and head of household purposes. To be “considered unmarried” on the last day of the tax year, a
taxpayer must meet all of the following conditions:
• The taxpayer must not file a joint return with their spouse.
• Pay more than half the cost of a home. and the home must be the main residence of a child,
stepchild, or foster child for more than half the year. 38
• Not live with a spouse in the home during the last six months of the tax year.
• Be able to claim an exemption for the child.
Remember, a married person, if not formally separated or divorced, must live apart for more than
half the year to claim head of household status as “considered unmarried.”
Example: Austin and Cayla physically separated on February 10, 2024, and lived apart for the rest of
the year. They do not have a written separation agreement and have not yet filed for divorce. Their six-
year-old daughter, Brigid, lived with her father all year, and Austin paid more than half the cost of
keeping up the home. Austin claims Brigid as his dependent because he is the custodial parent. Austin
can claim head of household status. Although Austin is still legally married, he can file as head of
household because he meets all the requirements to be “considered unmarried.”

38In the case of a taxpayer who is legally married but seeking to be treated as “considered unmarried” for purposes of claiming
Head of Household filing status, only a child, stepchild, or foster child meets the definition of a “qualifying child” – grandchildren
do not qualify.
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Example: Darya and Craig physically separated on November 4, 2024. Neither spouse had filed for
divorce or legal separation. They have one minor child, Krissy, who is eight years old. Even though
Krissy lived with her mother, Darya does not qualify for head of household filing status because she
and Craig did not live apart for the last six months of the year, and are not legally separated or divorced.
Darya and Craig can choose to file a joint return, or they can choose to file as “married filing separately.”
Neither one qualifies to file as head of household, even if they each had a qualifying dependent.

Special Rules for Nonresident Alien Spouses

A person who is married to a nonresident alien may elect to file as head of household by
“disregarding” the nonresident alien spouse. This is true even if both spouses lived together the entire
year. This is a unique rule that only applies to taxpayers who are married to nonresident aliens.
In order to take advantage of this special rule, the U.S. taxpayer cannot file jointly with the
nonresident alien spouse (by electing to treat the nonresident alien spouse as a U.S. resident). The
taxpayer must also have a qualifying child, or another qualifying dependent, such as a dependent
parent, in order to qualify for head of household status.
Example: Two years ago, Wharton, a U.S. citizen, met and married Esmeralda, a nonresident alien who
is a citizen of Ecuador. The couple lived together in Ecuador all year while Wharton was on sabbatical
from his university teaching position. They had a son, who was born on June 18, 2024. Esmeralda owns
several rental properties in Ecuador, so she declined to file jointly with Wharton because she does not
want to pay tax on her worldwide income, as she would be required to do if she filed jointly with her
husband. Wharton can file as head of household and claim his infant son as a dependent, even though
he and Esmeralda lived together all year, because Esmeralda is a nonresident alien.
Remember, a U.S. citizen or resident who is married to a nonresident alien must have another
qualifying person in order to “disregard” their nonresident alien spouse in order to be eligible to file
as a head of household.
Example: Leanne is a U.S. citizen. She is married to Nunzio, a citizen of Italy. Leanne and Nunzio reside
in Italy together, along with Leanne’s 62-year-old mother, Margaret. Margaret is also a U.S. citizen.
Leanne supports her mother financially, because Margaret has no taxable income. Nunzio does not
want to file jointly with Leanne, because he owns a successful business in Italy and he does not want
to pay U.S. income tax on his worldwide income, or have to file an FBAR for his Italian bank accounts.
Nonetheless, Leanne may choose to “disregard” her nonresident alien spouse, and file as head of
household, claiming her mother as a dependent.

Qualifying Surviving Spouse

Qualifying Surviving Spouse (QSS)39 is the least common filing status. A qualifying surviving spouse
receives the same standard deduction and uses the same tax brackets as married taxpayers who file
jointly. This filing status only applies if the surviving spouse remains unmarried and has a qualifying
dependent. In the year of the spouse’s death, a taxpayer can generally file a joint return. However, if

39The former filing status qualifying widow(er) (QW) name was changed to qualifying surviving spouse (QSS) starting in the 2022
tax year, but you may see either term on the IRS website and IRS publications.
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the surviving spouse remarries before the end of the year, the deceased spouse’s return must be filed
MFS (married filing separately).
Example: Daphne and her husband, Vince, have a 12-year-old son named Oscar. Vince dies on
February 1, 2024. A few months later, Daphne meets Adam, and she remarries on December 20, 2024.
Since Daphne remarried in the same year her late husband died, she no longer qualifies for the MFJ
status with her deceased husband. However, Daphne does qualify to file jointly with her new husband,
Adam. Therefore, Vince’s (the deceased) filing status for his final tax return must be MFS. The executor
of Vince’s estate would be responsible for filing his final tax return.
For each of the two years following the year of the spouse’s death, the surviving spouse can use the
qualifying surviving spouse (QSS) filing status if the survivor has a qualifying dependent and does not
remarry. After two years, the taxpayer’s filing status converts to single or head of household,
depending upon which status applies. For example, if a taxpayer’s spouse died in 2024 and the survivor
did not remarry, the taxpayer could file a joint return with their deceased spouse in 2024, then use the
qualifying surviving spouse (QSS) filing status for tax year 2025 and 2026 (two years following the
year of death). After this two-year period has ended, the surviving spouse may no longer file as QSS.

Filing Status After the Death of a Spouse (with Dependent Child)

Tax Year Filing Status

Year of death MFJ or MFS

1st year after death Qualifying surviving spouse*

2nd year after death Qualifying surviving spouse*

3rd and subsequent years after death Head of household or single

To be eligible for the “qualifying surviving spouse” filing status, the surviving spouse normally must:
• Not have remarried before the end of the year.
• Have been eligible to file a joint return in the year the spouse died; (it does not matter if a joint
return was actually filed or not).
• Have a qualifying child40 for the year. A qualifying child can be a child, adopted child, or a
stepchild, but does not include a foster child for the purposes of this filing status.
• Have furnished over half the cost of keeping up the child’s main home for the entire year.
Example: Sampson and Rosie are married and have always filed jointly. Rosie dies on July 3, 2024.
Sampson has one daughter, Angie, who is ten years old. Sampson did not remarry before the end of the
year. Therefore, Sampson’s filing status for 2024 is MFJ or MFS, since 2024 is the last year his wife was
alive. For 2025 and 2026, Sampson can claim Angie as his dependent and file as a “qualifying surviving
spouse,” which is a more favorable filing status than single or head of household. For 2027, Sampson
would file as HOH, assuming Angie is still his dependent child and he remains unmarried.

40While the taxpayer still needs a qualifying child that meets the qualifications listed above, the child does not have to be claimed
as a dependent on the tax return. The taxpayer must only provide the child’s name on the return.
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Example: Patrick and Janet are married and have always filed jointly. They have one 15-year-old foster
child named Ramona, who they claim as a dependent. They do not have any other children or
dependents. Patrick dies on June 10, 2024. Janet plans to file jointly with Patrick in 2024. Assuming
she does not remarry, Janet would qualify for Head of Household filing status in 2025 (the following
year). She would not qualify for the “qualifying surviving spouse” filing status, because Ramona is a
foster child, and that is not a qualifying relationship for the QSS filing status.
Example: Scott and Noelle are married. Scott has a 17-year-old son named Toby, from a prior
relationship. Scott dies suddenly on October 4, 2024. Toby continues to live with his stepmother and
Noelle supports her stepson financially. Noelle files jointly with her late husband Scott and claims Toby
as a dependent for 2024. If Noelle does not remarry, she can file as a “qualifying surviving spouse” in
2025 and 2026, as long as Toby continues to qualify as her dependent, because a stepchild is a
qualifying child for the QSS filing status.
Annulments
Annulment is a legal procedure for declaring a marriage null and void.41 If a taxpayer obtains a
court decree of annulment that holds no valid marriage ever existed, the couple is legally unmarried
even if they filed joint returns for earlier years. Unlike divorce, an annulment is retroactive. Taxpayers
who have annulled their marriage must file amended returns (Form 1040-X), claiming single (or head
of household status, if applicable) for all the tax years affected by the annulment that are not closed by
the statute of limitations.
Example: Norah and Remington were granted an annulment on October 31, 2024. They were married
for two years. Remington has sole custody of one son from a prior relationship. For 2024, Norah must
file as single and must amend the prior two years’ tax returns to “single” as well. Remington must also
amend his returns. If he otherwise qualifies, Remington can amend his returns to head of household
filing status, claiming his own son as a dependent.
Example: Howie and Cassie were married in Alaska three years ago. They do not have any children or
other dependents. Cassie discovers that Howie was already legally married in Canada to a different
woman and has been living a double life. Cassie files for an annulment on December 1, 2024, on the
grounds of bigamy. Their marriage is annulled on March 8, 2025. Howie and Cassie filed joint returns
for every year that they were married (prior to the annulment). Cassie must amend her prior-year tax
returns to “single” because her marriage has been legally annulled.

Determining Residency for Tax Purposes

To accurately file their taxes, a taxpayer must determine their residency status. For the IRS, an
“alien” refers to an individual who is not a U.S. citizen. Aliens are divided into two categories:
“nonresident alien” and “resident alien.” This classification is crucial because it determines how
these taxpayers are taxed.42

41 Fraud is the most common basis for annulment petitions, but depending on the jurisdiction, other legal reasons for an annulment

include bigamy, forced marriage, impotence, undisclosed infertility or sterility, and mental incompetence.
42 Nonresidents who are married to U.S. Citizens or U.S. resident aliens can make an election to file a joint return for tax purposes

and file as Married Filing Jointly.) If both married taxpayers are nonresident aliens, they CANNOT file as Married Filing Jointly, they
must file as Married Filing Separately.
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Residency status is important because these taxpayers are taxed in different ways:
• Resident aliens are typically taxed on all of their income worldwide, similar to U.S. citizens.
• Nonresident aliens are only taxed on income earned within the United States and certain
income related to conducting business in the country.43 A nonresident alien could be someone
who lives outside the U.S., and simply invests in U.S. property or stocks, and is therefore
required to file a tax return to correctly report their U.S. income.
• Dual-status aliens have both nonresident and resident alien statuses during the same tax year.
Different rules apply for the parts of the year when they were a U.S. resident and nonresident.
The most common dual-status years are the year of arrival and departure from the U.S.
Residency for IRS purposes is not the same as legal immigration status. Do not confuse residency
for federal tax purposes with:
• Immigration residency
• Residency requirements for college tuition or earning a degree, etc.
• Residency requirements for state income taxes
For tax purposes, an individual may be considered a U.S. resident based on the time spent in the
United States, regardless of their immigration status.
Tax Residency Tests
Certain rules exist for determining the tax residency of aliens. If a taxpayer is an alien (not a U.S.
citizen), they are considered a nonresident alien for tax purposes unless they meet one of two tests:
the green card test or the substantial presence test.
Green Card Test: An alien taxpayer is automatically considered a U.S. resident if they are “lawful
permanent residents” of the United States at any time during the tax year. A lawful immigrant who has
been issued an alien registration card, also known as a “green card” is a U.S. resident by default.
With a green card holder, their residency “start date” is the first day during the calendar year on
which the alien is physically present in the United States as a lawful permanent resident. However, an
alien who has been present in the U.S. any time during a calendar year as a lawful permanent resident
may opt to be treated as a resident alien for the entire calendar year.
Example: Hector is a citizen of Portugal. Hector meets and marries Theresa, an American citizen, while
she is visiting family on an extended visit in Portugal. They decide to live in the United States, rather
than Portugal. Two weeks after their marriage, Hector applies for a green card at a U.S. consulate in his
home country. On December 20, 2024, Hector is issued his permanent resident card (green card).
Hector and Theresa fly back to the U.S. together and land in New York City on January 10, 2025.
Hector’s official residency start date is January 10, 2025, his first date of physical presence in the
United States.

43 Nonresident aliens can earn what is called “Effectively Connected Income” or ECI. This is income that a foreign person earns
from
sources within the United States that is connected to a trade or business in the U.S. For example, if a foreign individual provides
services in the U.S., (such as a foreign athlete that makes a special appearance in the U.S. and earns money from that appearance)
the income from those services is ECI.
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Figure 1-Permanent Resident Card Sample, (courtesy of USCIS)

Substantial Presence Test: An alien without a green card is considered a U.S. resident for tax
purposes only if they meet the substantial presence test for the calendar year. To meet this test, they
must be physically present in the United States for at least:
• 31 days during the current tax year (2024), and
• 183 days during the three-year period, which includes the current year (2024) and the two
years immediately preceding the current year (2023 and 2022).
For purposes of the 183-day requirement, all the days present in the current year (2024) are
counted, along with:
• 1/3 of the days present in the previous year (i.e., 2023), and
• 1/6 of the days present in the second year before the current year (i.e., 2022).

Example: Juliana is a citizen of Brazil. Her brother, Felix, is a naturalized U.S. citizen living in the United
States and Juliana visits him frequently. She obtains a visitor’s visa and was physically present in the
U.S. for 120 days in each of the years 2022, 2023, and 2024. To determine if she meets the substantial
presence test for 2024, she must count the full 120 days of presence in 2024, 40 days in 2023 (1/3 of
120 days), and 20 days in 2022 (1/6 of 120 days). Since the total for the 3-year period is 180 days (and
therefore under the 183-day requirement for the substantial presence test), Juliana is not considered
a U.S. resident under the substantial presence test for 2024.

If an individual meets the requirements of the “substantial presence” test, the taxpayer is
considered for federal tax purposes a resident alien of the United States, even though they may not
have legal residency in the United States.
A taxpayer who does not meet either the green card test or the substantial presence test is
considered a nonresident alien for tax purposes and is subject to U.S. income tax only on their U.S.-
source income.

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Example: Romeo is a painter from Italy, famous worldwide for his expressive artwork. He lives and
works in Italy, but travels to New York twice a year on a special visa, to sell his paintings at prestigious
art galleries.44 Romeo earned $70,000 from selling his paintings in the United States. Romeo does not
spend enough time in the U.S. to meet the "substantial presence" test, and he does not have a green
card. Therefore, he is considered a nonresident alien for U.S. tax purposes. However, because he earned
income from U.S. sources (the sale of his paintings), he is required to file a tax return to report his U.S.-
source income and pay any applicable taxes on that income. Romeo hires a reputable accountant in the
U.S. who helps him file Form 1040-NR.
Example: Ayla is a French citizen and a professional translator who was physically present in the
United States for 19 days in each of the years 2022, 2023, and 2024. Ayla is not a green card holder or
a U.S. resident, but she has a special O-2 visa because she works for a famous tennis champion. In 2024,
Ayla earned $32,000 in the United States as a translator for this famous sports star, who traveled to
the U.S. to play in several international tennis matches. Since the total days Ayla was present in the U.S.
for the three-year period do not meet the substantial presence test, Ayla is not considered a U.S.
resident for tax purposes, and her earnings are taxed as a nonresident alien. Ayla is required to file
Form 1040-NR, U.S. Nonresident Alien Income Tax Return.

Exempt Individuals
Numerous exceptions are considered when counting days for the substantial presence test. The
following days within the United States are not counted if the alien:
• Regularly commutes to work in the U.S. from a residence in Canada or Mexico, generally more
than 75% of the workdays during the applicable working period (this is deemed a “closer
connection to home country”).
• Is present in the U.S. as a crew member of a foreign vessel.
• Is unable to leave because of a medical condition that arose while in the United States.
• Is a professional athlete in the U.S. to compete in a charitable sports event. These athletes
exclude only the days in which they competed in the sporting event, but do not exclude days
used for practice, travel, or to participate in promotional events.
• Is an exempt individual. Exempt individuals include aliens who are:
o Foreign government officials in the U.S. temporarily45 under an “A” or “G” visa (such as
foreign ambassadors and other important diplomats);
o Teachers on temporary visas; visiting scholars or researchers (scholars are exempt
from the substantial presence test for two years); and au pairs on a J-1 visa;
o Foreign students on temporary visas who do not intend to reside permanently in the
U.S. (foreign students are exempt from the substantial presence test for five years).

44 The most common visa options for famous artists and performers entering the US are the O-1 Visa for individuals with
extraordinary ability, and the P-1 Visa for international athletes or entertainers.
45 A foreign government-related individual is considered “temporarily” present in the United States regardless of the actual amount

of time present in the United States. An example would be an individual who had full-time diplomatic or consular status, such as a
foreign ambassador to the United States.
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Example: Amelia is a folk singer and a popular recording artist in her home country of Poland. Amelia
comes to the U.S. on tour, playing a variety of different venues for three weeks in May. After her tour
is over, she returns to her home country. Amelia is not a U.S. resident for tax purposes, but she entered
the U.S. legally on a P-2 Visa, and has the right to earn money from her musical performances in the
U.S. She is required to report her U.S. source income. Amelia hires a professional accountant to file a
Form 1040-NR to report the income that she earned while she was touring in the U.S. She will only
report and be taxed on her U.S. source income.
Example: Diego is a wealthy citizen of Panama. He entered the U.S. for the first time on August 29,
2022, on an E-2 investor visa, because he wanted to purchase a few rental properties. Since his initial
entry, Diego has returned to the U.S. several times to purchase more investment properties. He uses a
management company to manage the properties, which are profitable and trigger a filing requirement.
He remained physically present in the United States for 12 days in 2022, 90 days in 2023, and 175 days
in 2024. Diego meets the physical presence test in 2024, and must file a Form 1040 (not Form 1040-
NR) in that year. The substantial presence test for Diego is calculated as follows:
Current year (2024) days in the United States (175) × 1 = 175 days
Prior year (2023) days in the United States (90) × 1/3 = 30 days
Year before that (2022) days in the United States (12) × 1/6 = 2 days
Total for 2024 = 207 days (the physical presence test is met)
This means that in 2022 and 2023, Diego will file Form 1040-NR as a nonresident. But in 2024, Diego
will file Form 1040 as a U.S. resident.

International Students and Scholars

Most foreign students and scholars fall under the status of nonresident aliens. An international
student is anyone who is temporarily in the U.S. on an F, J, M, or Q visa. Immediate family members of
a student, including spouses and unmarried children under age twenty-one who reside with the
student, are also considered nonresidents for tax purposes.
International students holding specific visas are exempt from the substantial presence test for the
first five calendar years they are in the U.S.46 The five calendar years need not be consecutive. Any part
of a calendar year in which the student is present in the U.S. counts as a full year.
For example, if an international student’s very first F-1 or J-1 entry date to the U.S. was in 2019,
their five exempt years will be 2019-2023. The student will become a resident alien for tax purposes
in tax year 2024.
Nonresident Aliens who have F-1 or J-1 visas do not have to pay Social Security tax or Medicare
Tax on their earnings. However, once a person becomes a U.S. resident for tax purposes, they are
required to pay Social Security tax and Medicare tax on their earnings.

46In some circumstances a student may still be considered a nonresident alien and eligible for benefits under an income tax treaty
between the U.S. and their home country. Foreign tax treaties are outside the scope of the EA exam, but these exceptions do exist.
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Example: Woong, a citizen of South Korea, is in the U.S. as a graduate student on F-1 visa status,
enrolled in a doctoral degree program at Stanford University. She has resided in the U.S. since arriving
on February 15, 2019, going back to her home country only for short visits between semesters. She
was in the U.S. continuously all of 2024. Because international students are exempt from the
substantial presence test for five years, Woong became a U.S. resident alien for federal income tax
purposes in 2024. Woong is married to Quim, who lives in South Korea and is a nonresident alien.
Beginning in the 2024 tax year, Woong and Quim can both elect to be treated as U.S. residents for tax
purposes on a jointly-filed return. If they choose to make that election and file jointly, Woong and Quim
will be forced to report all their worldwide income and pay U.S. income tax on it, as well as report their
foreign bank accounts and other reportable foreign assets.
Example: Kalinda’s first visit to the United States was as a foreign student on an F-1 visa from India.
She attended Purdue University from 2017 until the end of 2019 and then returned to her home
country on December 31, 2019. She remained in India after that time. On January 5th, 2024 she re-
entered the U.S. on a J-1 visa to pursue her graduate studies. As a student under this visa, she is
permitted to work for the university as a part-time teaching assistant. Since she has been in the U.S.
for less than five years as a student, Kalinda is still considered a nonresident alien for federal income
tax purposes in 2024. She will need to file Form 1040-NR, not Form 1040, to report her earnings from
her on-campus job. This is true even if she stays in the U.S. for the entire year.
Remember, there are numerous exceptions that result in individuals who pass the substantial
presence test still being classified as nonresident aliens for tax purposes. For example, foreign
students, visiting scholars and diplomats, au pairs, and other types of exempt individuals are generally
considered nonresident aliens, even if they spend the entire taxable year in the United States. In
addition, noncitizens who pass the substantial presence test can still be deemed a nonresident alien if
they claim a “closer connection” to their home country.47 This is done by filing a special form, Form
8840, Closer Connection Exception Statement for Aliens.
Example: Liam is a retired Canadian teacher who lives in Vancouver, Canada. Laim has a visitor’s visa
to enter the United States, and usually spends several months each year in Florida to escape the harsh
Canadian winters. Based on the time he spends in Florida, he meets the substantial presence test, but
has a stronger connection to Canada where he owns a home and is involved in the community. By filing
Form 8840 and showing his closer ties to Canada, Liam may avoid being treated as a resident alien for
U.S. tax purposes.

Tax Residency through Marriage

A nonresident alien who does not meet the substantial presence test and does not have a green
card, may still elect to be treated as a resident for tax purposes if they are married to a U.S. citizen or
resident. This election can be made only if:
• At the end of the year, one spouse is a nonresident alien, and the other is a U.S. citizen or
resident, and

47 Nonresident aliens may use Form 8840, Closer Connection Exception Statement for Aliens (Form 1040-NR) to claim the “closer
connection to a foreign country” exception to the substantial presence test. This form is filed with the form 1040-NR. To establish
a closer connection, a taxpayer must have maintained more significant contacts with a foreign country other than the US.
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• Both spouses agree to file a joint return and treat the nonresident alien as a resident alien for
the entire tax year.
Example: Azalea and Sergio are married, and both are citizens of Costa Rica. They do not have any
dependents. Sergio is a cardiac physician who is legally present in the U.S. on an H-1B work
authorization visa. On February 1, 2024, Sergio obtains a green card and becomes a legal U.S. resident.
Azalea is not yet eligible for a Social Security number because her immigration paperwork is still being
processed. Sergio may choose to file a separate return and report only his income. Since Azalea is a
nonresident alien and has no U.S. source income, she does not have a filing requirement. Azalea does
not work and has no taxable income, but she may file jointly with her husband if she requests an ITIN.
If Azalea and Sergio may also choose to file jointly, they must attach an election statement to their joint
return.48

Example: Vanessa is a U.S. citizen living in Spain. She works online as a professional editor. In 2024,
she meets and marries Hugo, a citizen of Spain. Vanessa has a filing requirement, and she wants to file
jointly with Hugo, but Hugo refuses. Hugo owns a successful business in Spain, and has no desire to
report his worldwide income, or pay U.S. tax on his income. Vanessa does not have any dependents, so
she will be forced to file MFS. Since Hugo is a nonresident alien and does not have an SSN or ITIN,
Vanessa would enter “NRA” in the space for her husband’s identifying number on her Form 1040.

Example: Vladimir is a citizen of Serbia. He arrived in the United States on January 4, 2024, as a college
student on an F-1 visa. Vladimir meets Belinda, a U.S. citizen, in one of his college courses. After a
whirlwind romance, on March 2, 2024, Vladimir marries Belinda. Vladimir immediately petitions
USCIS for a change in immigration status to that of a lawful permanent resident based upon his
marriage to Belinda. USCIS approves Vladimir’s petition to become a lawful permanent resident of the
United States and issues him a green card on December 20, 2024. Vladimir passes the Green Card Test
on December 20, 2024. Although he is not required to do so, Vladimir could elect to be taxed as a U.S.
resident for the entire tax year by filing jointly with his U.S. citizen spouse, Belinda.
Dual Status Aliens: An alien is considered a “dual-status” alien when the person has been both a
resident alien and a nonresident alien in the same tax year. “Dual status” is only used for tax purposes,
and has no bearing on a person’s legal immigration status. The most common dual-status tax years are
the years of arrival and departure.
A taxpayer’s status on the last day of the year determines whether a person is a resident alien or a
nonresident alien for the tax year. For the part of each year the taxpayer is a nonresident alien, the
person is taxed only on their U.S.-source income.
Example: Humphrey is an unmarried citizen of England. Despite having a green card and a steady job
as a graphic designer, he always planned to permanently return to his home country after living in the
U.S. for several years. Humphrey seeks assistance from an immigration lawyer to officially renounce
his green card status. He officially relinquishes his green card and departs from the United States on
May 2, 2024, permanently returning to England. As a result, Humphrey will be classified as a dual-
status resident for the 2024 tax year.

48 The spouse who is a nonresident alien for U.S. income tax purposes can elect to be treated as a U.S. taxpayer and the married
couple can file a joint tax return. This is a Section 6013(g) election, and it is used when one spouse is a U.S. taxpayer and the other
is not. In the example, Sergio is a green card holder, so he is a U.S. resident by default.
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For the part of each year the taxpayer is a U.S. resident alien, they are taxed on their worldwide
income. This applies even if the income was earned earlier in the year while the taxpayer was a
nonresident alien but was received after they became a resident for tax purposes.
Example: Ismael applied for an adjustment of status and became a legal U.S. resident (a green card
holder) on December 25, 2024. A few weeks later, on February 16, 2024, he received $2,000 of income
for some online contract work he did during the previous tax year. Even though the income was earned
while he was a nonresident alien, it was received after he became a U.S. resident. This income must be
reported and taxed on Form 1040, not on Form 1040-NR.

Tax Treaties with Foreign Countries

The United States has income tax treaties with many foreign countries. Treaty provisions are
generally reciprocal, and are designed to avoid double taxation and prevent tax evasion. Tax treaties
may allow residents of foreign countries to be taxed at reduced rates or be exempt from U.S. income
taxes on certain types of income they receive from U.S. sources. The specific benefits and rates vary
depending on the country and the type of income.
Although knowledge of specific foreign tax treaties is not required for the EA exam, it is important
to have a general understanding of their existence and these key points:
• Reciprocal provisions: Tax treaty benefits generally apply to both countries involved in the
treaty.
• Types of income: Commonly covered income includes dividends, interest, royalties, and
pensions.
• Saving clause: Most tax treaties have a “saving clause.” This prevents U.S. citizens and U.S.
residents from using treaty provisions to avoid taxes on U.S. source income.
Example: Pierre is a Canadian citizen and wealthy investor who occasionally visits the United States.
He does not spend enough time in the U.S. to meet the substantial presence test, and he is considered
a nonresident alien for U.S. tax purposes. Because he is a savvy investor, he earns a substantial amount
of dividend income from U.S. investments. The United States has a tax treaty with Canada. Under this
treaty, a Canadian citizen receiving dividends from a U.S. company will be subject to U.S. withholding
at a reduced rate of 15% instead of the standard 30% that would normally apply. The treaty helps
maintain friendly relations between Canada and the United States, and encourages cross-border
investments between the two countries.
Note: For nonresident aliens, income or gains from U.S. sources is generally subject to automatic
backup withholding at 30%, unless a lower treaty rate applies. The normal backup withholding rate
for U.S. citizens and U.S. residents in 2024 is a flat 24% rate.

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Unit 3: Dependency Relationships

For additional information, read:
Publication 501, Dependents, Standard Deduction, and Filing Information
Publication 504, Divorced or Separated Individuals

Personal and dependency exemptions are suspended (reduced to $0) through tax year 2025.
However, the ability to claim a dependent can make taxpayers eligible for other tax benefits. For
example, the following tax benefits are all associated with a dependent:
• Child Tax Credit (CTC),
• Earned Income Tax Credit (EITC),
• Child and Dependent Care Credit,
• Head of household filing status (HOH),
• Credit for Other Dependents (ODC) and other tax benefits.

Although the Tax Cuts and Jobs Act eliminated the benefit of the dependency exemption itself, the
law remains unchanged on who qualifies as a dependent for tax purposes. For the 2024 tax year,
taxpayers can determine a dependent’s eligibility by using the “deemed exemption” amount of
$5,050.50 Dependents are either a “qualifying child” or a “qualifying relative” of the taxpayer. Examples
of dependents include a child, stepchild, brother, sister, or parent.

Primary Tests for Dependency

Identifying and determining the correct number of dependents is a critical component of
completing a taxpayer’s return. To determine if a taxpayer can claim a dependent, there are three
primary tests:
• Dependent taxpayer test
• Joint return test
• Citizenship or residency test
Test #1: Dependent Taxpayer Test
A person who may be claimed as a dependent by another taxpayer, may not claim anyone as a
dependent on their own tax return. In other words, the dependent taxpayer test specifies that any
taxpayer who can be claimed as a dependent cannot claim a dependent themselves.
Example: Evie is an 18-year-old single mother who has an infant son who is three months old. Evie
and her son live with her parents. Evie has a small part-time job, but she only earned $2,300. She does
not make enough money to support herself or her infant son. Evie agrees to be claimed as a dependent
by her parents, so she cannot claim her infant son as a dependent on her own tax return.
Sometimes, an individual meets the rules to be a qualifying dependent of more than one person.
Regardless, only one person can claim the same individual as a dependent.

50In 2024, the gross income limitation for a qualifying relative is $5,050. This amount is used for purposes of determining a
qualifying relative under IRC Sec. 152(d)(1)(B).
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Example: Pearce and Annika are an unmarried couple with one daughter, named Juliana, age 10. They
all live together in the same home. Juliana is a qualifying child for both Pearce and Annika, but only one
of them can claim her as a dependent. Although only one parent can claim Juliana as a dependent, the
two parents can agree on which parent should claim the child to achieve the best tax outcome, because
Juliana lived with both her parents the entire year.

Test #2: Joint Return Test

If a married person files a joint return, that individual normally cannot be claimed as a dependent
by another taxpayer. Even if the other dependency tests are met, a taxpayer is generally not allowed
to claim a dependent if that person files a joint return with their spouse.
Example: Irina is 19 years old and had no income for the year. Irina lived with her father for the whole
year. Irina got married on December 30, 2024, to Blaise, who is 25 years old. Irina’s new husband
earned $38,700 during the year. Irina and Blaise choose to file jointly. Irina’s father supported his
daughter the entire year and even paid for her wedding. However, her father cannot claim Irina as his
dependent because she is filing jointly with her new husband, Blaise.
There is only one narrow exception to this test. The joint return test does not apply if the joint
return is filed by the dependent only to claim a refund, and neither spouse would have a tax liability,
even if they filed separate returns.
Example: Robbie and Rosalie are both 18 years old and recently married. They both live with Rosalie’s
mother, Sylvia. In 2024, Robbie earned $4,950 from a part-time job. That was the only income that
Robbie and his wife earned all year. Neither Robbie nor Rosalie is required to file a tax return, but they
decide to file a joint return to obtain a refund of the small amount of income taxes that were withheld
from Robbie’s wages. Robbie and Rosalie correctly check the boxes next to “Someone can claim you as
a dependent” on their joint tax return. As the exception to the joint return test applies, Sylvia can claim
both Robbie and Rosalie on her tax return, if all the other tests for dependency are met.

Test #3: Citizenship or Residency Test

A dependent must be a citizen or resident of the United States, Canada, or Mexico. Exceptions exist
for foreign-born adopted children.51 If a taxpayer legally adopts a child who is not a U.S. citizen, U.S.
resident alien, or U.S. national,52 this test can be met if the child lives with the taxpayer as a member of
the household all year. If all other dependency tests are met, the child can be claimed as a dependent.
This also applies if the child was lawfully placed with the taxpayer for legal adoption.53
Dependency Relationships
A dependent may be either a “qualifying child” or a “qualifying relative.” Both types of
dependents have unique rules, but some requirements are the same for both. Remember, a person

51 Foreign exchange students generally are not U.S. residents and generally do not meet the citizen or resident test, so they cannot
be claimed as dependents, even if they live in the taxpayer’s home all year.
52 There is an exception for certain adopted children. A “U.S. national” is an individual who, although not a U.S. citizen, owes their

allegiance to the United States. U.S. nationals include American Samoans and Northern Mariana Islanders who chose to become
U.S. nationals instead of U.S. citizens.
53 When adopting a non-U.S. child, the taxpayer would need an Adoption Tax Identification Number for tax purposes. Federal law

requires a special immigration visa for foreign-born children in the process of adoption, which is completed in the child's native
country. Foreign adoptions can often take many years, depending on several factors.
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must meet the requirements of either a qualifying child or a qualifying relative to be claimed as a
dependent. There are very specific tests to identify the difference between the two.
Note: Both “qualifying children” and “qualifying relatives” must first meet all the primary
dependency requirements already specified: the dependent taxpayer, joint return, and citizenship or
residency tests. If these three tests are met, the person is a dependent.54

Rules for a Qualifying Child

The tests for a “qualifying child” are more stringent than the tests for a “qualifying relative.” Having
a qualifying child entitles a taxpayer to claim refundable tax credits, including the Earned Income Tax
Credit and the Additional Child Tax Credit. Having a qualifying relative, on the other hand, does not
qualify a taxpayer for these special credits. There are five tests for a qualifying child:
• Relationship Test
• Age Test
• Residency Test
• Support Test
• Tiebreaker Test (for a qualifying child of more than one person)
Test #1: The Relationship Test
The qualifying child must be related to the taxpayer by blood, marriage, or adoption. Qualifying
children include:
• A child, stepchild, or adopted child.55
• A sibling, half-sibling, or stepsibling (includes; half-brother, half-sister, stepbrother, etc.)
• A descendant of one of the above (such as a grandchild, niece, or nephew)
• A foster child
For the purposes of this test, an adopted child is always treated the same as a natural child.
Test #2: The Age Test
In order to be a qualifying child, the dependent must be:
• Under the age of 19 at the end of the tax year, or
• Under the age of 24 at the end of the tax year and a full-time student,56 or
• Permanently and totally disabled at any time during the year, regardless of age.
A child who is claimed as a dependent must be younger than the taxpayer who is claiming them,
except in the case of dependents who are disabled. For taxpayers filing jointly, the child must be
younger than one spouse listed on the return but does not have to be younger than both spouses.

54 A taxpayer’s spouse cannot be claimed as a dependent; however, a taxpayer’s registered domestic partner may qualify as a
dependent, assuming all the tests for dependency are met. A taxpayer cannot file as head of household if the taxpayer’s only
dependent is their registered domestic partner.
55 An adopted child also includes a child who was lawfully placed with a person for adoption, even if the adoption is not yet final.
56 To qualify as a “full-time” student, the child must be enrolled in the number of hours or courses the school considers full-time

during some part of at least five months of the year. See Publication 17 for additional details.
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Example: Gordon and Denise are both 21 years old, married, and file jointly. Denise’s 23-year-old
stepbrother, Cole, is a full-time student and lives with Gordon and Denise, who provide all of his
financial support while he is going to college. Cole is not disabled. Gordon and Denise are both younger
than Cole. Therefore, Cole is not their qualifying child, even though he is a full-time student.
Example: Stavros, age 30, and Audrey, age 21, are married and file jointly. Audrey’s 22-year-old
brother, Brayden, is a full-time college student, is single, and lives with Stavros and Audrey. They
provide all of Brayden’s support. In this case, Stavros and Audrey can claim Brayden as a qualifying
child on their joint tax return because he is a full-time student and is younger than Stavros.
Example: Jerrik is 55 years old and mentally disabled with Down’s syndrome. Jacie, his 38-year-old
sister, provides all of Jerrik’s support and cares for him in her home, where he lives with her full-time.
Despite Jerrik’s age, he is considered a qualifying child and a dependent for tax purposes because he is
disabled. Jacie can claim her brother Jerrik as her qualifying child. She may also file as head of
household.
Example: Elwin and Hortense file jointly. They have one daughter named Stacy, age 28. Stacy earned
$4,900 in wages before she was laid off in February and moved back in with her parents. Elwin and
Hortense provided most of Stacy’s financial support for the year. Stacy got a new job at the end of
December and moved out. She is not a qualifying child for federal tax purposes. Although Stacy meets
the support test and the residency test, she does not meet the age test to be claimed as a qualifying
child.

Test #3: The Residency Test

A qualifying child must live with the taxpayer for more than half the tax year (over six months).
The taxpayer’s home is any location where they regularly live; it does not need to be a traditional home.
For example, a child who lived with the taxpayer for over half the year in a homeless shelter would
meet the residency test.57
Example: Bruce and James are brothers. They have joint legal custody of their 17-year-old nephew,
Jonah, whose parents tragically passed away in a car accident three years ago. Bruce and James both
support Jonah financially, but Jonah lives full-time with his uncle Bruce, because Bruce’s home is closer
to Jonah’s high school. Since Jonah lives primarily with Bruce, then Jonah passes the residency test to
be Bruce’s qualifying child. Bruce may claim his nephew as his dependent, and file as head of
household.
In most cases, because of the residency test, a child is automatically the qualifying child of the
custodial parent. However, exceptions to the residency test apply to children of divorced parents,
kidnapped children, children who were born or died during the year,58 and temporary absences.
A “temporary absence” includes illness, college, vacation, military service, institutionalized care for
a child who is permanently and totally disabled, and incarceration in a juvenile facility. It must be
reasonable to assume that the child will return to the home after the temporary absence.

57 See IRS Publication 596, Earned Income Credit, for similar examples and scenarios.
58 A stillborn child cannot be claimed as a dependent. The child must be born alive, even if they lived only for a short period of time.
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Example: Martino is widowed and has one 10-year-old son named Davian. The child lives with his
father, and Martino provides all his son’s financial support. On January 10, Davian was diagnosed with
a rare form of pediatric cancer and was hospitalized continuously for ten months. Davian is still
considered Martino’s qualifying child because the hospitalization counts as a temporary absence from
home. Martino can claim Davian as his qualifying child, and he can also file as head of household.
Example: Jonathan, age 21, is a full-time college student and lived in the on-campus dorms at his
university for the entire year. Jonathan worked part-time and earned $4,100 in wages during the year.
He did not pay over one-half of his own support. Instead, his mother, Camille, supported him
financially, and paid his tuition and living expenses. Jonathan’s time spent in the dorms counts as a
“temporary absence.” Camille is unmarried, and therefore, she can file as “head of household” and claim
Jonathan on her tax return as her qualifying child, because he meets the relationship, age, residency,
and support tests.
Example: Denise is 18 years old and disabled. She is institutionalized at a long-term care facility for
severely disabled children. Denise cannot work and does not provide any of her own support. Denise’s
parents, Charlie and Cindy, both work full-time, and only see their daughter on weekends. However,
they can claim their daughter Denise as a qualifying child, even though she does not live with her
parents most of the time, because institutionalized care for a child who is permanently and totally
disabled is considered a temporary absence under the law.

Test #4: The Support Test

A qualifying child cannot provide more than one-half of their own support. This test is different
from the support test for a qualifying relative and should not be confused as such. State benefits
provided to a person in need, such as welfare, food stamps, or subsidized housing, are generally
considered support provided by the state. However, if a child receives Social Security benefits and uses
the benefits for their own support, the benefits are considered to be provided by the child, not by the
parents.
Example: Ernesto is 46 and unmarried. He has an 18-year-old daughter named Gladys, who is single.
Ernesto contributes $5,100 toward his daughter’s support for the year. Gladys is no longer in high
school, and she has a full-time job as a waitress, earning $19,500 for the year. Gladys spends all her
wages and tips on her own support. Since Gladys supplied over half of her own support for the year,
Gladys does not pass the support test, and consequently, she is not Ernesto’s qualifying child. Ernesto
cannot claim his daughter as a dependent. Gladys should file her own tax return as “single.”
A full-time student does not take scholarships (whether taxable or nontaxable) into account when
calculating the support test.
Example: Anton is 54, and a single parent with a 21-year-old daughter named Catia. Catia is a full-time
college student at the University of Nevada. Anton contributes $11,000 to his daughter’s support. Catia
receives a $10,900 scholarship during the year, and has no other income. The scholarship is not
counted for the support test for a qualifying child, so Catia can be claimed as Anton’s qualifying child.

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Note: The definition of “support” includes only income that is used for living expenses. A person’s own
funds are not “support” unless they are actually spent for support. For example, if a child earns income
that is saved in a bank account rather than spent on the child’s living expenses, the amounts saved are
not included for the purposes of the support test.
Example: Mikhail, age 12, had a small role in a television series. He earned $69,000 as a child actor,
but his parents put all the money in a trust fund for him. Mikhail lived at home with his parents all year.
Mikhail meets the support test since none of his earnings were used for his own support. He meets the
tests for a qualifying child, so he can be claimed as a dependent by his parents. Mikhail must file a tax
return to report his wages, but he is still treated as a “qualifying child” for tax purposes.
Foster parents may claim a foster child if the child is legally placed in their home by the courts or a
government agency. Payments received from a child placement agency for the support of a foster child
are considered support provided by the agency, rather than support provided by the child.
Example: Hilda is a single foster parent who provided $4,500 toward the support of Devon, her 8-
year-old foster son. The state of Nevada also provided $9,000 in foster care payments, which was
considered support provided by the state, not by the child. Devon did not provide more than half of his
own support for the year. Therefore, Hilda can claim her foster son as a qualifying child.

Test #5: Tie-breaker Test

Sometimes a child meets the rules to be a qualifying child of more than one person. Only one
taxpayer can claim a qualifying child. If more than one taxpayer attempts to claim the same child under
the dependency rules, the tie-breaker rules will apply in the following sequence:
• By the child’s parents, if they file a joint return.
• By the parent, if only one of the taxpayers is the child’s parent.
• By the parent with whom the child lived the longest during the year.
• By the parent with the highest AGI, if the child lived with each parent for the same length of
time during the tax year.
• By the taxpayer with the highest AGI, if neither of the child’s parents can claim the child as a
qualifying child.
• By a taxpayer with a higher AGI than either of the child’s parents who can also claim the child
as a qualifying child, but does not.
These rules ensure that only one taxpayer can claim the child and receive the associated tax
benefits.

Example: Isabel is a single mother who has a three-year-old son named Jeffrey. They live with Isabel’s
father, Robert (the child’s grandfather). Robert made $65,000 in wages during the year. Isabel made
$19,000 in wages during the year, and she has a filing requirement. Robert wants to claim his grandson
as a dependent, but Isabel plans to claim her son as a dependent on her own return. If Robert and Isabel
both attempt to claim Jeffrey, the IRS will apply the tie-breaker tests and disallow Robert’s claim,
because as the child’s mother, Isabel has the primary right to claim Jeffrey as her qualifying child.

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Note: The tiebreaker test only applies when two people attempt to claim the same child. If two or more
taxpayers have the same qualifying child, they can choose which of them will claim the credit using
that child. If more than one taxpayer actually attempts to claim the same child, only then will the IRS
apply the tie-breaker rules. In cases where the parents are in agreement, there is no tiebreaker test.
Example: Rosita and her sister, Evita, live together. Their seven-year-old nephew, Alex, lived with his
aunts all year while Alex’s mother was incarcerated in a maximum-security prison. Rosita’s AGI is
$18,600. Evita’s AGI is $29,000. Alex is a qualifying child of both Rosita and Evita because he meets the
relationship, age, residency, and support tests for both of his aunts. However, Evita has the primary
right to claim Alex as her qualifying child because her AGI is higher than Rosita’s.
The tie-breaker test applies when two taxpayers attempt to claim the same child, but all of the other
primary tests for dependency still apply. For tax purposes, the person with whom the child lives (i.e.,
the taxpayer with primary physical custody) generally has the decisive right to claim the child as a
dependent. Many times, these cases will go into audit, or even to litigation in the U.S. Tax Court.

Example: Carol Griffin claimed her nieces and nephews as her dependents. The children’s father,
Robbie, was a single father and disabled, and kept the children only two days a week. The IRS selected
Ms. Griffin’s tax return for audit, and disallowed the dependency exemptions for the children. Ms.
Griffin disagreed with the IRS examiner’s audit findings, and she subsequently petitioned the U.S. Tax
Court. At trial, Ms. Griffin provided evidence and credible testimony that the children lived with her
the majority of days during the year. The Tax Court awarded the three dependency exemptions to Ms.
Griffin because she had the children for the majority of the year. In this case, Ms. Griffin proved that
her nieces and nephews were her qualifying children by virtue of the residency test.59

Rules for a Qualifying Relative

A person who is not a qualifying child may still qualify as a dependent under the rules for qualifying
relatives. Unlike a qualifying child, even an individual of any age who is not a family member can be a
qualifying relative. The tests for a qualifying relative are applied only when the tests for a qualifying
child are not met. To be claimed as a qualifying relative, the following four tests must be met:
• Not a qualifying child test
• Member of household or relationship test
• Gross income test
• Support test
Test #1: “Not a Qualifying Child” Test
If a child is already a qualifying child for any taxpayer, the child cannot be a qualifying relative of
another taxpayer. In other words, a taxpayer cannot claim an individual who can be claimed as a
dependent on another tax return.

59Based on U.S. Tax Court case Griffin v. Comm’r. The Tax Court held that a child’s aunt was entitled to dependency exemption
based on the time spent living with her, which was determined by the court to be more than half the year.
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Example: Nigel lives with his girlfriend Madeline and her 3-year-old daughter, Ainsley. They all live
together in Nigel’s home. Nigel is not the father of the child. Nigel owns the home and pays all the costs
for keeping up the home, including the mortgage and property taxes. Nigel earned $56,000 in wages,
while Madeline earned only $16,500 in wages during the year. Madeline has a filing requirement, so
she files as single (not HOH) and claims her own daughter, Ainsley. Madeline also claims the Earned
Income Tax Credit and the Child Tax Credit on her return. Madeline’s daughter is her qualifying child,
so Nigel cannot claim Ainsley as his qualifying relative.
Under the tests for a qualifying relative, a child may qualify as the taxpayer’s dependent, even if
that child is the qualifying child of another taxpayer. This is allowed only when the child’s parent is not
required to file an income tax return and either does not file a return or only files to get a refund of
income tax withheld or estimated tax paid.

Example: For more than a year, Thorne has shared a home with his girlfriend, Daisy, and her two sons.
Daisy is unemployed and does not have any taxable income, so she is not obligated to file a tax return.
Thorne has a full-time job, and he provides all the support for the household. In this situation, Daisy
and her children meet the criteria to be considered Thorne’s “qualifying relatives.” Thorne can claim
Daisy and her two sons as “qualifying relative” dependents.

Test #2: “Member of Household” or “Relationship” Test

A dependent that is not related to the taxpayer must have lived with the taxpayer the entire tax
year in order to meet the “member of household” or “relationship” test. However, a family member
who is related to the taxpayer in any of the following ways does not have to live with the taxpayer to
meet this test:
• A child, stepchild, foster child, or descendant of any of them (for example, a grandchild)
• A sibling, stepsibling, or half-sibling
• A parent, grandparent, stepparent, or another direct ancestor (but not a foster parent)
• A niece or nephew, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law,
or sister-in-law
Example: Felton is 45 and single. Felton’s 12-year-old nephew, Raoul, lived with him for two months.
For the remainder of the year, Raoul lived with his mother, Inga, in a nearby town. Inga is Felton’s 32-
year-old sister. Inga receives welfare and food stamps, and she did not have a job during the year. She
does not have a filing requirement. Felton and Inga do not live together, but Felton still provides most
of Inga and Raoul’s financial support. Raoul is not Felton’s qualifying child because he did not live with
his uncle for more than half the year and therefore, does not meet the residency test. However, both
Raoul and Inga would meet the requirements to be Felton’s qualifying relatives.
For the relationship test, “family members” do not include cousins, who are treated as unrelated
persons for tax purposes. A cousin must live with the taxpayer for the entire year and also meet the
gross income test to qualify as a dependent, and even then, a cousin cannot be a qualifying child—only
a qualifying relative. Also, a taxpayer may not claim a housekeeper or other household employee as a
dependent, even if the employee lives with the taxpayer all year.

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Example: Faith works full-time and earned $55,000. She lived all year with her boyfriend, Oscar, and
his two children in her home. Faith is not the mother of Oscar’s children. Oscar was disabled for the
entire tax year and has no taxable income and no filing requirement. Oscar and his two children are
not related to Faith as family members, but they may be qualifying relatives if they meet all the other
tests. If Faith and Oscar were later to marry, then Faith would be able to claim Oscar’s children as her
stepchildren, and they would be qualifying children, instead of qualifying relatives.
Example: Ynez is unmarried and age 52. Ynez’s 23-year-old son, Ziyad, lives with her all year long. He
has a part-time job and earns $9,850 in wages during the year. He is not disabled or a college student,
so he does not meet the age test for a qualifying child. Since he made over the “deemed exemption”
amount, he is also not a qualifying relative. As a result, Ynez cannot file as head of household because
her son is not a dependent (he does not qualify under the rules for a “qualifying child” or for a
“qualifying relative”). Ynez is forced to file as single, and she cannot claim Ziyad as her dependent.
Example: Albert is 62 and single. Albert has lived with his first cousin, Elizabeth, the entire year.
Elizabeth is 54 and has no taxable income. She is not required to file a tax return. Albert provided all
the household support for Elizabeth. Therefore, Elizabeth passes the “not a qualifying child test” to be
Albert’s dependent. If Albert meets all other tests, Elizabeth may be claimed on Albert’s tax return as a
qualifying relative.
Example: Melanie is 21 years old and works as a live-in nanny for Vicente, a widowed taxpayer with
two small children. Melanie lives with Vicente all year and takes care of his two toddlers. Vicente pays
Melanie wages and properly reports her as his household employee on Schedule H, which he attaches
to his Form 1040. Regardless of how little or how much he pays his nanny, Vicente cannot claim
Melanie on his tax return as a dependent, because a household employee can never be claimed as a
dependent.
Any relationship that is established by marriage does not end as a result of death or divorce. 60 For
example, if a taxpayer supports his mother-in-law, he can continue to claim her as a dependent even if
he and his spouse divorce, or even if he later becomes widowed.
Example: Celeste and Carlos have always financially supported Celeste’s elderly mother, Rose, and
claimed her as their dependent on their jointly filed returns. In 2023, Celeste died, and Carlos became
a widower. Carlos remarries in 2024, but he has always continued to support his late wife’s mother.
Carlos can continue to claim his late wife’s mother, Rose, as a qualifying relative, even though he has
remarried.

Test #3: Gross Income Test

To meet the gross income test, the dependent’s gross income for the tax year must be less than the
threshold amount. A qualifying relative cannot earn more than the “deemed exemption” amount, which
is $5,050 in 2024. For the purposes of this test, “gross income” includes all income in the form of
money, property, and services that are not exempt from tax.61

60Treasury Regulation section 1.152-2(d) currently provides that "the relationship of affinity once existing will not terminate by
divorce or death of spouse."
61For purposes of this test, the gross income of an individual who is permanently disabled does not include income from a sheltered

workshop. Sheltered Workshops provide a supervised work environment for disabled individuals to learn job skills.
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Example: Beatrice is 56 and earned $67,000 in wages. She financially supported her nephew, Jacob,
who is 28 and a full-time college student, earning his Master’s degree. Jacob is not disabled. Jacob has
a small part-time job, and he earned $5,950 in 2024. Although Beatrice financially supported Jacob,
she cannot claim him as a dependent because Jacob does not meet the age test for a qualifying child.
Jacob also does not meet the test for a qualifying relative because his income exceeds the gross income
test.
Note: Remember that there is no “gross income test” for a qualifying child—only for a qualifying
relative! A person may be a qualifying child if they are permanently and totally disabled at any time
during the year, regardless of age.
Example: Keegan is 31 and has lived on his own for many years. He earns $14,000 in wages until
February 16, 2024, when he is involved in a horrible car accident, rendering him permanently disabled.
Keegan moves in with his mother, Annika, on April 3, 2024, after he gets out of the hospital. Keegan is
in a wheelchair now and needs nursing care. Keegan’s mother cares for him in her home and also hires
a home healthcare aide to care for Keegan when she is working. Keegan continues to live with his
mother until the end of the year, with his mother providing the majority of his financial support. Annika
earns $79,500 in wages during the year. Although Keegan was not a dependent in prior years, he is
now Annika’s qualifying child, because he lived with his mother for more than six months in 2024, he
does not provide his own support, and he is permanently disabled. He is Annika’s qualifying child in
2024.

Test #4: Support Test

To claim an individual as a qualifying relative, the taxpayer must provide more than one-half of the
dependent’s total support during the year. Support includes:
• The costs for necessities, such as food, housing, clothing, healthcare, education, and other
similar expenses. Support can include the fair market value of housing.
• It also includes amounts from Social Security and welfare payments, even if that support is
nontaxable.
Note that this “support test” is very different from the one for a qualifying child. The support test
for a qualifying relative considers all income, taxable and nontaxable.
Example: Alexi, 27, is a full-time graduate student who lives with his parents. He is not disabled. He
worked part-time, earning $4,200 in wages. He did not pay over half of his total support. Alexi meets
the relationship, residency, and support tests for a qualifying child, but he does not meet the age test,
because even though he is a full-time student, he is not under 24 years of age. Therefore, Alexi can only
be claimed as a qualifying relative, and not as a qualifying child, by his parents.
Example: Cherise, age 35, financially supports her father, Asmund, who lives with her. Cherise earns
$59,000 in wages during the year. Asmund is 62 and received $2,800 from Social Security during the
year. He spent only $700 for his own support and put the rest in a savings account. Cherise spent
$6,600 of her own income for Asmund’s support, so she has provided over half of her father’s support
for the year. Cherise can claim Asmund as her qualifying relative and file as head of household.

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Example: Angela’s son, Darwin, is 22 years old. Darwin does not go to college, so he is no longer a
student, and he is not disabled. Angela provides the majority of her son’s support. Darwin’s gross
income is $3,960 for the year from a small part-time job. Darwin is not Angela’s “qualifying child”
because he fails the age test (because he is not a full-time student). However, he is still Angela’s
dependent because he is a qualifying relative. Darwin meets the relationship test because he is Angela’s
child, and he meets the gross income test because his income is under the “deemed exemption” amount
for the year ($5,050 for 2024), and he meets the support test because Angela provides the majority of
his support.

Special Rules for Divorced and Separated Parents

Generally, to claim a child as a dependent, the child must live with the taxpayer for more than one-
half the year. However, special rules apply if the dependent is supported by parents who are divorced,
separated, or live apart. In most cases, the child is the qualifying child of the custodial parent.
Example: Johan and Penelope are legally divorced and live in separate homes. They share equal
custody of their 8-year-old son, Lucas. During the year, Lucas stayed with Johan for 195 nights and
with Penelope for 170 nights. Therefore, for federal tax purposes, Johan is considered the custodial
parent and has the primary right to claim Lucas as his qualifying child.
However, a custodial parent may permit the noncustodial parent to claim the child. The
noncustodial parent must attach Form 8332, Release/Revocation of Release of Claim to Exemption for
Child by Custodial Parent, to their tax return. A child may be treated as the qualifying child of the
noncustodial parent if all the following conditions apply:
• The parents are divorced or legally separated, or if they lived apart during the last six months
of the year.
• The child received over half of their support for the year from the parents.
• The child is in the custody of one (or both) parents.
• The custodial parent signs Form 8332 (or a similar statement), and the noncustodial parent
attaches this declaration to their return.
This rule is an exception to the normal residency test for a qualifying child. It does not apply to the
determination of head of household filing status or to eligibility for the Earned Income Tax Credit. The
EITC and HOH filing status can be claimed only by the custodial parent, even if the noncustodial parent
claims the child. If a divorce decree does not specify which parent is the custodial parent or which
parent is allowed to claim the child, the dependent should be claimed by the parent who has physical
custody for the majority of the year.
Example: Anders and Wilma are divorced and have one son, who is 10 years old. Wilma is the custodial
parent, but she allows Anders to claim the child by signing Form 8332. Anders correctly files as “single”
and claims his son as his dependent. Anders will receive the Child Tax Credit for claiming his son, which
will reduce his tax liability. Wilma may still file as head of household, even though she does not claim
her son as a dependent, because she maintained the home where the child lived for most of the year.

If the child lived with each parent for an equal number of nights during the year, the IRS will deem
the custodial parent to be the parent with the higher adjusted gross income.

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The custodial parent can also revoke the release by using Form 8332. A copy of the revocation must
be attached to the tax return for each year the child is claimed after the revocation. The custodial
parent must also give a copy of the revocation to the noncustodial parent (or make a reasonable effort
to do so).
The earliest the revocation will apply is the year following the year the revocation was provided to
the noncustodial parent. The custodial parent must keep a copy of the revocation and evidence of
delivery of the notice to the noncustodial parent, or of reasonable efforts to provide actual notice.
Example: Flora and Andre are divorced and share custody of their 10-year-old daughter, Emma. In
previous years, Flora, the custodial parent, agreed to let Andre claim Emma as a dependent on his tax
return by signing Form 8332. In 2024, Flora decides to revoke the release of the exemption for future
tax years. She wants to claim Emma as a dependent on her own tax return starting in 2025. Flora
revokes the release of her daughter’s dependency exemption by filling out Form 8332 and giving a
copy to Andre before the end of the year. She keeps a record for future reference. Starting in 2025,
Flora can claim Emma as a dependent on her taxes unless she chooses to release the exemption to
Andre again.

Multiple Support Agreements

A multiple support agreement is when two or more people jointly provide for a person’s support.
This happens commonly when adult children are taking care of their parents.
Under a multiple support agreement, family members together must pay more than half of the
person’s total support, but no one member individually may pay more than half.
Taxpayers use Form 2120, Multiple Support Declaration, to report a multiple support arrangement.
When taxpayers use this form, they acknowledge that they do not pay more than half the cost of
supporting a dependent, but that the other individuals who share the costs allow the taxpayer to claim
that person as a dependent.
In addition, the taxpayer who claims the dependent must provide more than 10% of the person’s
support. Only one family member can claim a dependent in a single year, but different qualifying family
members can agree to claim the dependent in other years.
Example: Betty and Elinor are sisters who help financially support their 66-year-old father, Grayson.
Each pays approximately 20% of his care in a residential facility for elderly people. The remaining 60%
is paid for by a wealthy friend of the family, who is not related to Grayson. Because more than half of
Grayson’s support is provided by someone unrelated to him, no one can claim Grayson as a dependent.
Example: Altair, Gerry, and Hettie support their disabled mother, Leanne. Leanne is 83 years old and
lives in a nursing home. Leanne receives 20% of her financial support from Social Security, 40% from
Gerry, 30% from Altair, and only 10% from Hettie. Under the IRS rules for multiple support
agreements, either Gerry or Altair can claim their mother as a dependent if the other signs a statement
agreeing not to do so. Hettie cannot claim her mother as a dependent, because she does not provide
more than 10% of the support for Leanne during the year.

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Unit 4: Taxable and Nontaxable Income

For additional information, read:
Publication 525, Taxable and Nontaxable Income
Publication 15-B, Employer’s Tax Guide to Fringe Benefits
Publication 3, Armed Forces Tax Guide

According to federal tax law, all income is taxable except for specific exclusions. Understanding the
difference between an exclusion and a deduction is important, as some deductions are phased out at
higher gross income levels. Excluded income, however, remains nontaxable regardless of the
taxpayer’s income level.
Most excluded income does not need to be reported on a tax return, although there are exceptions,
such as interest from municipal bonds, which is not taxable, but still must be reported on a taxpayer’s
return.62
Example: Javier is a software engineer who works for a tech company and earns a salary of $80,000 a
year. His salary is fully taxable. He also receives $15,500 in municipal bond interest, which is tax-
exempt at the federal level. Although he must report the municipal bond interest on his tax return, it
is not taxed.
Example: Marcus is a popular recording artist who earned more than $2 million of taxable income
during the year. Because of his high income, many deductions and credits are phased out for him.
However, on July 1, 2024, Marcus is involved in an auto accident and sustains major injuries. Marcus
sues the other driver and receives an insurance settlement of $900,000 related to his injuries resulting
from the accident. The settlement is excluded from his gross income because compensation for
physical injuries is not taxable to the recipient, regardless of his taxable income level. Marcus does not
even have to report the injury settlement on his tax return.

Calculating Taxable Income

In order for a taxpayer to calculate their tax owed, they must first determine their gross income.
Gross income includes all forms of taxable compensation such as wages, salaries, commissions, tips,
and self-employment income. It also encompasses non-monetary forms of compensation like goods,
property, services, and taxable fringe benefits such as interest, dividends, capital gains, and stock
options.
Next, the taxpayer calculates their adjusted gross income (AGI) by subtracting certain specific
deductions or adjustments from gross income. Examples of some of these “for AGI” (commonly
referred to as “above the line”) deductions include certain IRA contributions, certain expenses for self-
employed individuals, deductible student loan interest and penalties paid to banks on early
withdrawals of savings. The amount of a taxpayer’s AGI is important because it helps determine
eligibility for certain deductions and credits.

62 Municipal bonds are debt securities issued by state, city, and local governments. Municipal bond interest is tax-free at the federal

level but can be taxable at state or local income tax levels.

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Finally, the taxpayer calculates their taxable income by subtracting additional deductions
(standard or itemized) from AGI. The next table is a simplified example of how to calculate income tax.

How to Calculate Taxable Income and Tax Liability for Most Individuals
Start with gross income
Subtract adjustments to income (“above the line” deductions)
= Adjusted gross income (AGI)
Subtract the greater of itemized deductions or the standard deduction
= Taxable income
× Tax rate(s)
= Gross tax liability
Subtract credits
= Net tax liability or refund receivable (based on the amount of prepaid tax, if any)

Earned Income vs. Unearned Income

Earned income such as wages, salaries, tips, professional fees, or self-employment income is
received for services performed. Unearned income includes interest, dividends, retirement income,
taxable alimony, and disability benefits.
Earned income is generally subject to Social Security and Medicare taxes (also called FICA taxes).
Investment income and other unearned income are generally not subject to FICA taxes. The amount of
taxable income is used to determine the taxpayer’s gross income tax liability before applicable credits.
Constructive Receipt of Income
The doctrine of constructive receipt requires that cash-basis taxpayers be taxed on income when
it becomes available and is not subject to substantial limitations or restrictions, regardless of whether
it is in their physical possession.63 Income received by an agent for a taxpayer is constructively
received in the year the agent receives it.
Example: Logan is a landlord who owns several rental properties. On December 30, 2024, a tenant
delivers a $750 rent check to Logan’s payment lockbox. Logan does not collect the rental deposits in
the lockbox in December. Instead, he leaves town later that day to celebrate New Year’s Eve. Logan
does not actually take physical possession of the check until January 5, 2025. He deposits the check in
his bank account on the same day. He is considered to have constructive receipt in 2024, and must
include the $750 of gross income on his 2024 tax return because the check was available to Logan at
that time without any substantial limitations or restrictions.
If there are significant restrictions on the income, or if the income is not accessible to the taxpayer,
it is not considered to have been constructively received. According to the IRS, constructive receipt
requires that an amount credited to an individual’s account be subject to “unqualified demand.”

63Most individuals are cash-basis taxpayers who report income when it is actually or constructively received during the tax year.
This concept of constructive receipt would not apply to accrual basis taxpayers who recognize income when it is earned rather
than when it is received. We will cover accrual basis taxpayers in Book 2, Businesses.
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The doctrine of constructive receipt requires the actual receipt of property or the right to receive
property. Economic benefit applies when assets are unconditionally and irrevocably paid into a fund
or trust to be used for a taxpayer’s sole benefit.
Example: Raakel owns a large plot of land in Chicago, IL. On January 2, 2024, the county filed a
condemnation action to acquire Raakel’s land in order to build a public highway. Raakel does not want
to sell her land and decides to fight the condemnation. On April 1, 2024, the county deposited $800,000
as “probable compensation” for the property with the IL State Treasurer. Raakel could have withdrawn
the funds, but to do so would have jeopardized her ability to sue. She does not accept the funds, and
shortly thereafter, on June 3, 2024, Raakel files a lawsuit against the county, challenging the
government’s right to take her property. Raakel eventually settles the lawsuit, but not until the
following year, when she and the county eventually agree to a financial settlement. Raakel finally
accepts the condemnation award for her property on March 3, 2025 (the following year). Based on the
facts in this case, the IRS has determined that constructive receipt occurred in 2025.64
Income is also not considered to have been “constructively received” if a taxpayer declines to
accept an item, such as a prize or an award, or if the taxpayer does not receive the prize.
Example: Lucia won front-row concert tickets valued at $1,200 from a local radio station. The value of
the tickets is clearly printed on the tickets. Lucia would be required to pay taxes based on the fair
market value of the tickets. However, on the day of the concert, the radio station does not receive the
tickets in time from the promoter, and Lucia is not able to attend the concert. Since she never received
the tickets, the prize is not taxable to her because she never had constructive receipt of it.
Example: Wendy purchased a $1 ticket for a raffle conducted by her Methodist church, an exempt
organization. The drawing was held, and Wendy won $900. The church offered her a check for her
winnings, but Wendy declined the prize and did not accept the check. She preferred that her church
use the funds to help needy families. Since she never constructively received the funds, the prize is not
taxable to Wendy.
When determining the value of a prize or an award, the IRS defines fair market value (FMV) in this
way: the price at which a property would change hands between a buyer and a seller when both have
reasonable knowledge of all the necessary facts and neither is being forced to buy or sell. If parties
with adverse interests place a value on property in an arms-length transaction, that is strong evidence
of FMV. If there is a stated price for services, this price is treated as the FMV unless there is evidence
to the contrary.

The “Claim of Right” Doctrine

In the event that a taxpayer is required to pay back an amount over $3,000, which they had included
in their income in a previous year, they may be eligible for a deduction or a tax credit. 65 Under IRC

64 This example is based on Private Letter Ruling 200944012, where the IRS concluded that a taxpayer was not in constructive
receipt of condemnation proceeds that had been deposited with the state treasurer during the time the taxpayer was contesting
the condemnation in a legal action.
65 Per Publication 525, the repayment is deducted on the same form or schedule on which it was previously included. If it had been

included as self-employment income on Schedule C, Profit or Loss from Business, it is deducted on Schedule C. If it had been
included as capital gain on Schedule D, Capital Gains and Losses, it is deducted on Schedule D. If it was reported as wages, taxable
unemployment compensation, or other non-business ordinary income, it is deducted on Schedule A, Itemized Deductions (but only
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section 1341, if a taxpayer reports income in one year, but then has to repay that income in a future
tax year, and the repayment exceeds $3,000, the taxpayer may claim a tax credit on Schedule 3 (Form
1040) in the repayment year equal to the tax change caused by the income inclusion in the prior year
if it results in less tax.
If the repayment is $3,000 or less, section 1341 does not apply and the repayment is generally
deducted on the same form or schedule on which it was previously included. If the income had been
included as self-employment income on Schedule C, Profit or Loss from Business, it may be deducted
directly on Schedule C in the year the repayment occurs. A taxpayer should not amend their reported
gross income for the earlier year.
Example: Marilyn is a self-employed fine art dealer who owns her own art gallery. On November 3,
2024, Marilyn sells a painting in her art gallery for $28,000. She files her tax return in January, properly
includes $28,000 in her gross income, and pays taxes on the income. On February 28, 2025, the
customer discovers the painting is a forgery and returns the painting, demanding a full refund of
$28,000. Marilyn promptly refunds the customer. Since Marilyn pays back the $28,000 in 2025, she is
entitled to deduct the amount from her gross income in 2025 on her Schedule C. She does not amend
her prior-year tax return.
However, if the income was previously reported as wages, taxable unemployment compensation,
or other nonbusiness ordinary income, and the repayment is less than $3,000, the repayment cannot
be deducted.

Example: Webster is age 64. He retired from his teaching job several years ago and started receiving
pension payments. On February 3, 2024, Webster receives a letter from his pension administrator
informing him that the administrator made a mistake and overpaid his pension benefits by $2,300 in
2023 (the prior year). The administrator requests that Webster repay the overpayment by writing a
check back to the pension plan. Webster writes a check for the full amount and remits it to his pension
administrator on February 20, 2024. Since Webster repaid less than $3,000, he cannot deduct the
repayment.

Self-Employed Taxpayers
Self-employment income is earned by taxpayers who work for themselves. A taxpayer who earns
self-employment income of $400 or more in a year must file a tax return and report the earnings to
the IRS. Independent contractors usually receive Form 1099-NEC from their business customers
showing the income they were paid for the year (if $600 or more).
The amounts reported on Forms 1099-NEC, along with any other business income, are reported by
most self-employed individuals on Schedule C, Profit or Loss from Business, of Form 1040. Self-
employed farmers report their earnings on Schedule F, Profit or Loss from Farming, of Form 1040. Self-
employment income also includes:
• Income of ministers, priests, and rabbis for the performance of services such as baptisms and
marriages.

if the repayment is over $3,000). If the amount repaid was $3,000 or less, the Claim of Right under IRC Section 1341 does not apply.
See IRS Publication 525, under Repayments Under Claim of Right.
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• The distributive share of business income allocated by a partnership to its general partners or,
in certain circumstances, by a limited liability company (LLC) to its members. The income is
reported to the individual partners on Schedule K-1 (Form 1065).
Example: Carmen operates a popular taco truck with her brother, Orlando. They split profits and
losses equally and operate their business as a general partnership. They request a partnership EIN
from the IRS and correctly file Form 1065, U.S. Return of Partnership Income, to report the activity from
the taco stand. Carmen and Orlando both receive a Schedule K-1 from the partnership every year.
Carmen and Orlando must each report their distributive share of income from the taco stand on their
respective Forms 1040, Schedule E (Part 2). The income is considered self-employment income and is
subject to self-employment tax.

A taxpayer does not have to conduct regular full-time business activities to be considered self-
employed. A taxpayer may have a side business in addition to a regular job, and this is also considered
self-employment.
Example: Gavin earned $49,000 in wages as a full-time employee for Royal Roofing, Inc. He also
advertises general handyman services online and performs household repair services for various local
businesses. During the year, Gavin did several handyman side-jobs for private clients on the weekends.
Gavin received payments of $9,000 from several different individuals for his handyman work. He did
not receive Forms 1099-NEC for the $9,000 (because they were individuals who are not required to
issue Forms 1099-NEC), but he must report the payments as self-employment income on Schedule C.

FICA Tax (Payroll Taxes)

The Federal Insurance Contributions Act (FICA) tax includes two separate taxes: one is Social
Security tax, and the other is Medicare tax. The current rate for Social Security is 6.2% for the employer
and 6.2% for the employee, or 12.4% total. The current rate for Medicare is 1.45% for the employer
and 1.45% for the employee, or 2.9% total.
The combined FICA tax rate for 2024 is 15.3% and applies up to $168,600 of a taxpayer’s combined
earned income, including wages, tips, and 92.35% of net earnings from self-employment.66 If the
taxpayer’s combined earned income exceeds this threshold, a rate of 2.9%, representing only the
Medicare portion, applies to any excess earnings over the earned income threshold.
Note: The 7.65% FICA tax rate is the combined rate for Social Security and Medicare. The Social
Security portion (also called “OASDI”) is 6.2% on earnings up to the applicable taxable maximum
amount ($168,600 in 2024). Remember: the Medicare portion is 1.45% on all earned income: there is
no yearly maximum for Medicare tax.
For certain high-income individuals, an additional Medicare surtax of 0.9% is applied to wages and
self-employment income above certain thresholds.67

66 A 7.65% deduction is taken from the total amount of net self-employment income before applying the applicable Social Security
and Medicare tax rates for self-employment tax purposes.
67 The Additional Medicare Tax applies to wages, railroad retirement (RRTA) compensation, and self-employment income over

certain thresholds. This tax will be covered in more detail later.

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Example: Bernadette is a registered nurse who works for a medical office. To calculate her FICA tax
contribution as an employee, her payroll department multiplies Bernadette’s gross pay by the current
Social Security and Medicare tax rates. Bernadette’s taxable wages are $80,000 in 2024, so all her
wages would be subject to FICA tax. Bernadette’s social security contribution would be: $80,000 ×
6.2%, or $4,960, which is credited to her Social Security account. Her Medicare contribution would be:
$80,000 × 1.45%, or $1,160. These are also the amounts her employer would pay.
Note: If a taxpayer works for more than one employer and their total compensation is over the
$168,600 Social Security base limit for 2024, too much Social Security tax may have been withheld. A
taxpayer will have excess Social Security withholdings if the sum of multiple employers’ withholdings
exceeds the annual maximum. This usually occurs when a person changes jobs mid-year, or works
multiple jobs. In this case, the taxpayer can claim the excess as a credit against his income tax. This is
officially called the “Credit for Excess Social Security and RRTA Tax Withheld” and is fully
refundable on a taxpayer’s individual return.
Example: Kiyoshi is a civil engineer working for Surety Engineering. Kiyoshi earns $98,000 in wages
working for his employer until August 5, 2024, when he gets a better job offer from another company.
Kiyoshi gives notice and begins working at the new engineering firm on August 25, earning $75,000 in
wages from September to the end of December. He has earned a total of $173,000 in wages for the year
($98,000 + $75,000). Both employers withheld Social Security and Medicare taxes because employers
are required by law to withhold payroll taxes from each employee’s wages. As a result of having two
jobs, Kiyoshi has “excess” Social Security withholdings. When Kiyoshi files his individual tax return, he
will receive a credit for the over-withheld amounts on Schedule 3 (Form 1040).

Self-Employment Tax
Self-employment tax (SE tax) is imposed on self-employed individuals in a manner similar to the
Social Security and Medicare taxes that apply to wage earners. Self-employed individuals are
responsible for paying the entire amount of Social Security and Medicare taxes applicable to their net
earnings from self-employment.
Self-employment tax is calculated on Schedule SE, Self-Employment Tax. If a taxpayer has wages in
addition to self-employment earnings, the Social Security tax on the wages is paid first. Two
adjustments related to the self-employment tax reduce overall taxes for a taxpayer with self-
employment income.
• First, the taxpayer’s net earnings from self-employment are reduced by 7.65%. Just as the
employer’s share of Social Security tax is not considered wages to the employee, this reduction
removes a corresponding amount from the net earnings before the SE tax is calculated.
• Second, the taxpayer can deduct the employer-equivalent portion of their self-employment tax
to determine their adjusted gross income for income tax purposes.
More Than One Business: If a taxpayer owns more than one business, they must net the profit or
loss from each business to determine the total earnings subject to SE tax. However, married taxpayers
cannot combine their income or loss from self-employment to determine their individual earnings
subject to SE tax.

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Example: Kamran is a sole proprietor who owns a popular barbershop. He has $49,000 of net income
from the business in 2024. His wife, Naira, has a candle-making business with overall losses of
($12,000) for the year. Kamran must pay self-employment tax on $49,000, regardless of how he and
Naira choose to file. That is because married couples cannot offset each other’s income from self-
employment, even if they file jointly, for self-employment tax purposes. The income of each business
is allocated to each individual.
Example: Kangiten is a married taxpayer who is a sole proprietor of two small businesses, a computer
repair shop and a car wash business. Kangiten’s wife, Akemi, is a homemaker and does not work in
either business. Kangiten’s computer business has net income of $50,000, while the car wash has a net
loss of ($23,000) for the year. Kangiten must pay self-employment tax on only $27,000 ($50,000 -
$23,000) of income because he may “net” the income and losses from both his businesses.

Employee Compensation and Worker Classification

Wages, salaries, bonuses, tips, and commissions are compensation received by employees for
services performed. Employee compensation is taxable income to the employee and a deductible
expense for the employer. For federal tax purposes, the IRS classifies “workers” in two broad
categories: employees and independent contractors.
These workers are taxed in different ways, and businesses must identify the correct classification
for each individual to whom it makes payments for services.
In general, a business must withhold and remit income taxes, Social Security and Medicare taxes
(payroll taxes), and pay unemployment tax on salaries and wages paid to an employee. Employers are
required by January 31 to issue Forms W-2, which shows the amounts of wages paid to employees for
the previous year.
A business generally does not have to withhold or pay taxes on payments to independent
contractors, because Independent contractors are considered self-employed and are responsible for
their own taxes, including self-employment tax.
Note: The general rule is that an individual is an independent contractor if the payor has the right to
control or direct only the result of the work, not what will be done and how it will be done. In other
words, the key distinction between an independent contractor and an employee lies in the level of
control the payor has over the work performed. Worker classification is considered a “hot-button”
issue for the IRS, and is covered in more detail in Book 2, Businesses.
If a worker receives a Form 1099-NEC, but believes that they are an employee and should have
received a Form W-2 instead, the worker can file Form SS-8, Determination of Worker Status for
Purposes of Federal Employment Taxes and Income Tax Withholding with the IRS, and if a determination
is made that they are an employee, they will file Form 8919, Uncollected Social Security and Medicare
Tax on Wages, with their tax return. Wages from Form 8919 are also reported on a special line on Form
1040 (line 1g).

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Example: Stella was hired to work as a file clerk for a small car wash company in 2024. The business
classified Stella as an independent contractor in order to avoid having to pay payroll taxes. Stella
worked in the office every day from 9-5, under the full control of the company, and was clearly an
employee. The business issued Stella a 1099-NEC at the end of the year. Stella disagrees with her
classification, so she fills out Form SS-8 and files it with the IRS. The IRS will investigate the
classification issue, and if they determine that she was an employee, they will make sure that her
employer pays the payroll taxes that were their responsibility, and Stella will be liable for the income
tax on the amount that she earned, just as she would have been, had she been classified correctly. She
would file Form 8919 with her tax return to account and pay for her share of Social Security and
Medicare taxes on her wages.
Example: Terrence works for a company as a full-time delivery driver. At the end of the year,
Terrence’s employer issues him a Form 1099-NEC instead of a Form W-2. Terrence believes he was
misclassified as an independent contractor. While he completed and filed Form SS-8 with the IRS, he
has not yet received a response from the IRS by the tax return due date. Therefore, he files Form 8919,
Uncollected Social Security and Medicare Tax on Wages with his tax return. Terrence lists the
employer's name, provides the employer’s Federal Employer Identification Number, the reason he is
filing, and his alleged wages with unreported Social Security and Medicare taxes.
Advance Wages: If an employee receives advance wages, commissions, or other earnings, the
employee must recognize the income in the year it is actually or constructively received. If the
employee is later required to pay back a portion of the earnings, the amount would be deducted from
their taxable wages at that time.
Example: Damian requests a modest salary advance of $1,300 on December 1, 2024, so he can take a
two-week Christmas vacation. His employer agrees, and gives Damian the salary advance in the form
of a check before Christmas, on December 20, 2024. Damian must recognize the income on his 2024
tax return, even though he will not actually “earn” the money until 2025, when he returns from his
vacation.

Supplemental Wages
“Supplemental wages” are a type of compensation paid to an employee in addition to their regular
pay. These amounts are listed on the employee’s Form W-2 and are taxable, just like regular wages,
even if the pay is not actually for work performed. Vacation pay and sick pay are common examples of
supplemental wages that are taxable just like any other wage income, even though the employee has
not technically “worked” for the income. Supplemental wages may also include:
• Bonuses and commissions
• Taxable prizes and awards
• Severance pay, back pay, and holiday pay, accrued leave
• Payment for nondeductible moving expenses
The employer is responsible for tracking and reporting supplemental wages, and is also required to
withhold taxes from them.

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Example: Ayesha is a sales associate working for a retail jewelry store. She was absent for three days
in January due to illness and received sick pay. The total amount of sick pay she received was $445,
which was added to her earnings statement and taxed as regular wages. Also, in recognition of
exceeding her monthly sales targets, Ayesha received a $200 pre-paid Visa gift card. The gift card is
taxable as well. So, in addition to her regular salary, Ayesha received supplemental wages of $645 in
January. These amounts are taxable and subject to the same tax withholding as her regular salary.

Garnished Wages
Employees may have their wages garnished for various reasons, such as when they owe child
support, back taxes, or other debts. State and federal law require employers to comply with various
income-withholding orders for child support and other court-mandated obligations. Regardless of the
amounts garnished from the employee’s paycheck, the full amount of gross wages must be included in
his taxable wages at year-end.
Example: Jonas is a customer service representative working for a telecommunications company.
Jonas has a court order for child support, which requires his employer to garnish $300 from his
monthly wages. Despite the garnishment, the full amount of his gross wages, determined before the
garnishment, must be included on his Form W-2 at year-end.

Property or Services “in Lieu” of Wages

Wages paid in any form other than cash are measured by their fair market value. An employee who
receives property for services performed must generally recognize the fair market value of the
property when it is received as taxable income. However, if an employee receives restricted stock or
other property that is restricted, the property is not included in income until it is available to the
employee without restriction.
Example: Leonard’s company gives him 500 shares of restricted stock, valued at $9,000. He cannot
sell or otherwise use the shares for five years. If Leonard quits his job, he forfeits the shares. He does
not have to recognize the restricted stock as income in the year he receives it, because the stock is
subject to substantial restrictions. Leonard will report it as taxable income when the restrictions lapse,
and he gains complete control over the stock.
Another common arrangement is when colleges offer tuition reduction and/or free on-campus
housing in lieu of wages to student teachers. Any portion of a grant or scholarship that is compensation
for services is taxable as wages.
Example: Violet is a doctoral student attending Boston University. Violet received a grant of $32,500
to pay her tuition and on-campus housing. As a condition for receiving the scholarship, Violet must
serve as a part-time teaching assistant. Of the $32,500 scholarship, $11,000 represents payment for
teaching. The University gives Violet a Form W-2 showing $11,000 as wages. All the money was used
to offset her tuition and course-related expenses. Assuming that all other conditions are met, $21,500
of her grant is tax-free. However, the $11,000 Violet received for teaching is taxable as wages, because
it was for services that she performed.

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Tip Income
Tips received by food servers, baggage handlers, hairdressers, and others for performing services
are taxable income. An individual who receives $20 or more per month in tips must report the tip
income to their employer. An employee who receives less than $20 per month in tips while working
one job does not have to report the tip income to his employer. Tips of less than $20 per month are
exempt from Social Security and Medicare taxes, but are still subject to federal income tax. 68
In situations where an employee works more than one job, the $20 tip reporting threshold applies
on a per job basis, and not on an overall basis for the employee. An employee who does not report all
their tips to their employer generally must report the tips and related Social Security and Medicare
taxes on Form 1040. Form 4137, Social Security and Medicare Tax on Unreported Tip Income, is used to
compute the additional tax.
Example: Sherrie works two jobs: as an administrative assistant during the week and as a part-time
bartender on the weekends. She reports $3,000 in tip income from the bartending job to her employer.
Her W-2 Forms show wage income of $31,000 (administrative assistant) and $8,250 (bartender).
Sherrie must report $39,250, the total amount earned at both jobs, on her Form 1040. Since she
reported the tip income to her employer, her bartending tips are already included on her Form W-2
for that job.
Taxpayers who are self-employed and receive tips must include their tip income in gross receipts
on Schedule C.
Example: Baltazar is a licensed hairdresser who works for a popular salon franchise, Classic Cuts. He
is an employee of the franchise and receives minimum wage as well as tips. He must report these tips
to his employer. Baltazar also cuts hair in the evenings in his garage, offering his barbering services to
friends and family. All the income he earns cutting hair at home (including tips) is treated as self-
employment income and must be reported on Schedule C.
Non-cash tips (for example, concert tickets, or other items) do not have to be reported to the
employer, but they must be reported and included in the taxpayer’s gross income at their fair market
value.
Example: Benita is a waitress at the Denton Diner, a popular restaurant. One of Benita’s regular
customers left Benita an expensive piece of jewelry as an additional tip. Benita accepts the jewelry and
plans to wear it. Benita does not have to report the noncash tip to her employer, but she must include
the fair market value of the noncash tip (the jewelry) in her gross income. This amount will be subject
to income taxes, but not Social Security and Medicare taxes.
Note: All tips, whether given in cash or non-cash form, are considered taxable income and are subject
to federal income taxes. However, per IRC Section 3121(a)(12)(A), tips paid in any means “other than
cash” are exempt from FICA taxes.

Taxable Fringe Benefits for Employees

While the tax law does not have a specific definition for fringe benefits, the IRS considers them to be
any additional cash, property, or service given to employees on top of their regular taxable wages.

68 IRC section 3121(a)(12)(A) and Rev. Rul. 2012-18 (Q&A #2), 2012-26 IRB 1032
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Employers often offer fringe benefits as part of a compensation package, with common examples being
health insurance, retirement plans, and parking passes .
While most fringe benefits are not subject to taxes, there are some exceptions. These include
certain entertainment expenses, which are no longer deductible for employers. This means that any
entertainment provided to employees, such as tickets to sporting events, must now be included in their
taxable income.69 Some other examples of taxable fringe benefits include:
• Off-site athletic facilities and health club memberships,
• Concert and athletic event tickets,
• The value of employer-provided life insurance over $50,000,
• Any cash benefit in the form of a credit card or gift card (an exception applies for occasional
meal money or transportation fare to allow an employee to work beyond normal hours),
• Transportation benefits exceeding the monthly maximum ($315 per month in 2024),
• Employer-provided vehicles, if they are used for personal purposes. There is an exception for
qualified nonpersonal use vehicles (i.e., police cars, school buses, transit buses, etc.).
Example: Smithville Pharmaceuticals, Inc. pays for country club memberships for all its top sales
executives. Membership costs $8,000 a year per person. The executives use the country club to
entertain prospective clients and investors. Even though the club membership is used frequently for
business purposes, this type of fringe benefit is taxable compensation to the employees. Smithville
Pharmaceuticals, Inc. must include the full amount of the club membership ($8,000) in the employee’s
wages, subject to income tax and payroll taxes.

Nontaxable Fringe Benefits for Employees

Many fringe benefits are not taxable and may be excluded from an employee’s income. For example,
the value of accident or health plan coverage provided by an employer is not included in an employee’s
income. The following sections cover the rules for some common types of nontaxable employee fringe
benefits.
Retirement Plans
Employer contributions on behalf of their employees’ qualified retirement plans are not taxable to
the employees when they are made. However, when an employee receives distributions from a
retirement plan, the amounts received are taxable income.
Retirement plans may also allow employees to contribute part of their pre-tax compensation to the
plan. This type of contribution is called an elective deferral and is excluded from taxable compensation
for income tax purposes but is subject to Social Security and Medicare taxes.70
Cafeteria Plans
A cafeteria plan allows employees to receive certain benefits before taxes are taken out. Employees
must be given the option to choose at least one taxable benefit (like cash) and one qualified benefit
(nontaxable). Some examples of qualified benefits that can be offered in a cafeteria plan include
accident, dental, vision, and medical insurance (excluding Archer medical savings accounts and long-

69 There is a narrow exception for entertainment expenses that are directly for the benefit of employees, other than highly
compensated employees, (i.e., office parties or company picnics that include all company staff).
70 The tax provisions of retirement plans are covered in more detail later.

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term care insurance), flexible spending accounts71 for health and dependent care, as well as adoption
assistance and dependent care assistance.
Employee contributions are typically deducted through salary reduction agreements, meaning the
money is taken directly from their paychecks and deposited into an account. These contributions do
not count as taxable income and are not subject to employment taxes. Employers may also extend these
benefits to employees’ spouses and dependents.
Flexible Spending Arrangements (FSAs)
An FSA is a form of cafeteria plan benefit that reimburses employees for expenses incurred for
certain qualified benefits, such as health care and daycare expenses. The two most common types of
FSA accounts are: Healthcare FSAs (HCFSA), and Dependent Care FSAs (DCFSA). In 2024, employee
salary reduction contributions to a Healthcare FSA are capped at $3,200. Both employer and employee
may contribute to an employee’s Healthcare FSA, but contributions from all sources combined must
not exceed the annual maximum.
FSA benefits are subject to annual maximums and are typically subject to an annual “use-it-or-lose-
it” rule, with a short (two-and-a-half-months) grace period after year-end to claim subsequent year
qualifying expenses against the prior plan year remaining balance. Typically, Healthcare FSA funds that
are not spent by the employee within the plan year are forfeited back to the employer.
Example: Johann, a marketing coordinator at a technology company, contributes $3,200 to his
Healthcare FSA for the 2024 plan year. He uses $3,000 of the funds throughout the year, leaving a
remaining balance of $200 at the end of December. Johann’s employer offers a short grace period for
employees to use their FSA funds at the end of the year. This means that Johann must spend $200 on
qualifying medical expenses by March 15, 2025 or the amounts will be forfeited back to his employer
per the "use-it-or-lose-it" policy. Johann schedules an appointment with his eye doctor in January to
order an additional pair of prescription reading glasses to use up his remaining balance.
Cafeteria plans may offer employees a two-and-a-half-month grace period after the end of the year
to spend down any remaining FSA funds. Employer plans can also offer a “carryover” option, with the
maximum amount that can be carried forward into the following year (if allowed by the employer)
being 20% of the maximum available salary reduction for the year (so the maximum amount of
contributions from the 2024 year that can be carried forward into 2025 is $640 ($3,200 × 20%). 72
The Dependent Care FSA (also known as a Dependent Care Assistance Plan) is separate from the
Health Care FSA, which is used to pay for dependent care. For unmarried taxpayers and married
couples filing jointly, the annual limit is $5,000. For married couples filing separately, the limit is
$2,500. The funds in a DCFSA can be used to pay for eligible daycare services, before or after school
programs, and adult daycare for disabled dependents.

71 An FSA is not the same thing as an HSA. A health savings account (HSA) is always paired with a high deductible health plan, and
it is an account that a taxpayer may establish and fund on his own. An FSA, on the other hand, is always offered by an employer as
part of a cafeteria plan.
72 It is the employer’s decision whether or not to offer a carryover or a grace period. Healthcare FSAs, specifically, have an additional

option of allowing participants to carryover a portion of unused funds. Healthcare FSA plans can elect either the carryover or grace
period option but not both. The specific deadline also depends on the employer’s cafeteria plan year end, and how the employer
decides to set up their plan.
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Example: Ariana works for TechMedia, Inc. She has two small children, ages 4 and 6, that are in
daycare. TechMedia sponsors an FSA plan for its employees. Ariana opts out of the health care FSA but
elects to fund her DCFSA $5,000 for the 2024 plan year. Ariana spends $6,900 in daycare during the
year. She may request a reimbursement of $5,000, the annual maximum. TechMedia, Inc. will properly
reset the DCFSA limit to $5,000 for the next year.
Example: Jace is 45, unmarried and has no children, but he has a dependent parent. He works full-time
and cares for his elderly mother, Ursula, who is 79 years old and has mild dementia. While Jace is at
work, Ursula needs a caretaker to watch over her. Jace hires a caretaker through a caregiver support
service. He pays $13,000 in 2024 for adult daycare so he can work. Jace’s employer offers a DCFSA, and
Jace contributes the maximum of $5,000 in 2024. Jace may request a reimbursement of $5,000, which
is the maximum for the year. These amounts are pre-tax, thus reducing the amount of Jace’s income
that is subject to taxes.
DCFSA accounts may only reimburse up to the amount the account is actually funded. In other
words, if an employee makes only $2,900 in pre-tax contributions to their dependent care FSA, and
then later attempts to submit a claim for $3,000 in daycare expenses, the employee will only be
reimbursed for $2,900.
Example: Noura has a six-year-old son and participates in her employer's Dependent Care FSA. Each
month, $400 is set aside from her paycheck and deposited into her FSA. At the end of each month, her
daycare provider gives Noura a receipt, which she submits to her employer for reimbursement.
Noura’s employer then reimburses the funds directly from her FSA account. The money she
contributes to her Dependent Care FSA is not subject to payroll tax or income tax, so she will end up
paying less in taxes when she files her tax return.

Adoption Assistance in a Cafeteria Plan: Although uncommon, adoption assistance benefits may
be offered under a cafeteria plan and paid for entirely with pre-tax salary reductions. An employee can
exclude amounts paid or reimbursed by an employer under a qualified adoption assistance program
(up to a maximum of $16,810 for 2024).
Highly Compensated Employees (HCEs) and Key Employees
A cafeteria plan cannot have rules that favor eligibility for highly compensated employees to
participate, contribute, or benefit from a cafeteria plan. If a benefit plan favors HCEs, the value of their
benefits may become taxable.
This is to discourage companies from offering excellent tax-free benefits to their top executives
while ignoring the needs of lower-paid employees. Per Publication 15-B, a “highly compensated
employee” for 2024 is defined as:
• A company officer (i.e., company president, vice-president, treasurer).
• A 5% (or greater) shareholder in the current or prior year;
• An employee paid $150,000 or more for the preceding year (2023),
• A spouse or dependent of a person described above, regardless of salary level.
The IRS uses a process called “family attribution” in order to determine who qualifies as an HCE,
which means that an employee can be determined to be an HCE merely by familial relationship. An

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individual is attributed to interests owned by their spouse, siblings, and ancestors. For example, the
family attribution rules will treat the child of an owner as having the same ownership percentage.
Example: Jasper is the 100% employee-shareholder of Silica Corporation. Jasper’s wife and son both
work for Silica corporation, but they are not stockholders. However, because family attribution rules
apply, Jasper’s stock is attributed to both his wife and his child, meaning they are all considered 100%
owners for HCE determination purposes.
Employees that are hired in the middle of the year will not receive HCE status until the start of the
following year, when they are eligible to collect the entirety of their salary. For example, an employee
hired on June 1, 2024 would not be classified as an HCE until January 1, 2025, (regardless of their salary
level).73
“Highly compensated employees” and “key employees” have similar-sounding names, but the rules
for defining Key Employees are slightly different. Employer-provided benefits also cannot favor “key
employees.” Publication 15-B defines “key employees” as any of the following:
• A company officer having annual pay of more than $220,000 in 2024 (in this case, the officer
does not have to be an owner of the company).
• An employee who is either of the following:
o A 5% owner of the business, or;
o A 1% owner of the business whose annual pay is more than $150,000 in 2024.
Although the compensation threshold is lower for HCEs than Key Employees, an employee can be
classified as a key employee without having any ownership in the company.
Example: Brody is a vice-president of Grainger Plastics, Inc., a manufacturing firm. Brody is not an
owner of the company, and he is not related to any of the owners. His salary is $290,000 in 2024, and
was $225,000 in the previous year. Brody is classified as a key employee, even though he does not have
an ownership stake in the company, by virtue of his high salary and his position as a company officer.
Most businesses that offer cafeteria plans are subject to mandatory non-discrimination testing. If
a cafeteria plan or a retirement plan fails to pass IRS non-discrimination testing, highly compensated
employees and key employees may lose the tax benefits of participating in the plan.
A plan is considered to have improperly “favored” HCEs and key employees if more than 25% of all
the benefits are given to those employees. If this happens, then the plans can lose their tax-favored
status, and the HCEs or key employees must include the value of these benefits as taxable
compensation.74 These types of “corrections” often take the form of taxable distributions to plan
participants.

73 Corporate executives often receive extraordinary fringe benefits that are not provided to other employees. Any property or
service that an executive receives in lieu of or in addition to regular taxable wages is a fringe benefit that may be subject to taxation.
This is such an important issue to the IRS that they have developed an Audit Technique Guide about the subject (Executive
Compensation-Fringe Benefits Audit Techniques Guide).
74 Non-discrimination testing is a set of rules and tests required by the IRS to ensure that employee benefit plans, like cafeteria

plans and retirement plans, are fair to all employees. These tests make sure that the plans do not favor highly compensated
employees (HCEs) or key employees over regular employees. If a plan fails these tests, the tax benefits for HCEs and key employees
may be lost. We cover this topic in greater detail from the employer’s perspective in Part 2, Businesses.
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Example: Dixie Motorsports, Inc. is a small corporation with fifty-five employees. The sole shareholder
of the company, Randall, sets up a cafeteria plan as well as a 401(k) retirement plan. However, he only
allows his wife and his two sons to participate in the plans. The rest of the employees are not offered
any type of benefits, and in fact, are never told about the plans. Later, Dixie Motorsports goes through
a retirement plan audit, and the company fails discrimination testing. Randall is forced to recognize
the value of his pretax benefits as taxable income. Randall’s spouse and his two sons are also
considered HCEs because they are Randall’s family members, so they are also forced to recognize their
benefits as taxable income, as well. They will be required to amend the business’ tax returns as well as
their individual returns to include the additional compensation.
Example: McGovern Energy, Inc. is a C corporation with 300 employees, twenty-five of whom are
considered highly compensated employees. McGovern Energy’s cafeteria plan and its benefits are
available to all full-time employees, and the benefits offered are the same for everyone, regardless of
the employee’s level of pay. Everyone is treated equally under the plan. Therefore, the discrimination
rules do not apply, and the employees’ benefits are not taxable, and fully deductible by the employer
as a business expense.

Other Types of Employee Fringe Benefits

Educational Assistance: An employer can offer employees educational assistance for the cost of
tuition, fees, books, supplies, and equipment. The payments may be for either undergraduate or
graduate-level courses, and do not have to be work-related.
In 2024, up to $5,250 in educational assistance may be excluded per year per employee. If an
employer pays more than $5,250, the excess is generally taxed as wages to the employee. 75 An
employer may contribute this amount annually toward educational expenses, student loans, or a
combination of both.76 The cost of courses involving sports, games, or hobbies is not covered unless
they are related to the business or are required as part of a degree program. The cost of lodging, meals,
and transportation is also not included.
Tuition Reduction Benefits: A college or other educational institution can exclude the value of a
qualified undergraduate tuition reduction to an employee, his spouse, or a dependent child. A tuition
reduction is “qualified” only if the taxpayer receives it from, and uses it at, an eligible educational
institution. Graduate education only qualifies if it is for the education of a graduate student who
performs teaching or research activities for the educational organization.
Example: Mayra is a graduate teaching assistant at Louisiana State University. As part of her
employment agreement with the college, Mayra is offered a 50% tuition waiver, reducing the cost of
her own graduate tuition at the school. The normal graduate tuition cost is $14,800 per year. Because
of the tuition waiver, Mayra only pays $7,400. The tuition reduction is not taxable to Mayra, but any
wages that she receives as compensation for student teaching would be taxable.

75 There is an exception for job-related education. If the education is directly job related, amounts in excess of the $5,250 limit may

qualify for exclusion as a working condition fringe benefit. For instance, an accounting firm can cover the cost of courses for a staff
accountant preparing business tax returns without taxing the employee, regardless of the amount.
76 The Consolidated Appropriations Act of 2021 extended this provision through tax year 2025.

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Employer-Provided Meals and Lodging: An employer may exclude the value of meals and
lodging provided to employees if they are provided:

• On the employer’s business premises, and

• For the employer’s convenience.
For lodging, there is an additional rule: it must be required as a “condition of employment.” Lodging
can be provided for the taxpayer, the taxpayer’s spouse, and the taxpayer’s dependents and still not be
taxable to the employee. However, the exclusion from taxation does not apply if the employee can
choose to receive additional pay instead of lodging.
Example: Sullivan is a project supervisor for Birchwood Construction. He is provided free lodging at
remote job sites in an RV, where he is required to stay on-site for several months while the timber is
cleared and the grounds are prepared for various construction projects. Sullivan’s presence at the job
site helps deter theft and vandalism. The value of the lodging and his meals are excluded from
Sullivan’s income, because it is primarily for the employer’s security and convenience.
Meals may be provided to employees for the convenience of the employer on the employer’s
business premises for several reasons, such as when:
• Police officers and firefighters need to be on call for emergencies during the meal period.
• The nature of the business requires short meal periods.
• Eating facilities are not available in areas near the workplace, such as in the case of remote or
dangerous locations.
• Meals are furnished immediately after working hours because the employee’s duties prevented
him from obtaining a meal during working hours.
Meals furnished to restaurant employees before, during, or after work hours are also considered
furnished for the employer’s convenience and are not taxable to the employee.
Example: Paramedic Transport, Inc. regularly provides meals to employees during working hours so
that paramedics are available for emergency calls during the meal. The employees are not permitted
to take regular lunches or eat off-site because of the nature of their employment. The value of the free
meals is therefore excludable from the employees’ wages, and the employer is allowed to deduct the
cost of the meals as a business expense, subject to the 50% limit.

Transportation Fringe Benefits

Employers have the option to provide transportation benefits to their employees, such as transit
passes, paid parking, or commuter passes (bus passes). These benefits are non-taxable for employees
up to a certain amount.
However, under the Tax Cuts and Jobs Act (TCJA), employers can no longer deduct these expenses.
This does not affect the tax-exempt status of transportation benefits for employees (with the notable
exception of bicycle commuting benefits, which became taxable to the employee under the TCJA). Any
expenses exceeding $315 per month in 2024 for transit and parking benefits will be added to the
employee’s taxable income as wages. It is possible for an employee to receive both parking and transit
benefits in the same month.

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The use of a company car for commuting purposes or other personal use is generally a taxable
benefit. Thus, the value of using the vehicle for these reasons will be included in their taxable wages.
Example: Sienna was offered a lucrative new job in New York City as a computer programmer. As part
of her employment contract, she negotiates a reserved parking space for her car. Her new employer
agrees to pay the cost of the space at the garage across the street from her work. Monthly parking is
quite expensive in New York City, and the monthly parking fee at the garage is $700. Since this amount
exceeds the allowable limit for parking fringe benefits, a portion of the parking costs will be taxable to
Sienna as wages. In 2024, the allowable transportation benefit for parking is $315. Therefore, an
additional $385 ($700-$315 limit) would be taxable to Sienna each month as wages and must be added
to her Form W-2.
Example: Bowie is employed by Eagle Hardwood, a lumber company. He drives an employer-provided
pickup truck, hauling equipment on job sites and delivering lumber to customers. He also gets to take
the truck home in the evenings. In 2024, Bowie drives the truck 20,000 miles, of which 4,000, or 20%,
are personal miles (4,000/20,000 = 20%). The truck has an annual lease value of $4,100. Personal use
is therefore valued at $820 and is included in Bowie’s taxable wages, subject to all payroll taxes.
There is an exception in IRS regulations that exempts the personal use of certain types of vehicles.
Qualified “nonpersonal use” vehicles, such as police or fire vehicles, school buses, and ambulances, are
exempt from fringe benefit reporting, even if the vehicles are used for commuting purposes, as long as
the employer requires their use for the employees to do their jobs.
Example: Martina works as a school bus driver for Garden City Elementary School. She drives a school
bus, and her primary job is to transport students to and from the school during the week. She also
occasionally drives longer distances for field trips. Since she is responsible for the bus and cannot leave
it unattended, Martina uses the bus to drive to a local sandwich shop to buy lunch on her break. This
small amount of personal use is not taxable to Martina, because a school bus is a qualified nonpersonal
use vehicle, and an employee’s use of a qualified nonpersonal-use vehicle is considered a nontaxable
working condition benefit.
Cell Phones: Employer-provided cell phones can be excluded from an employee’s income. The
employer must have valid business-related reasons for providing the phone, such as the need to
contact the employee during work emergencies or to communicate with clients while away from the
office. However, if the phone is given solely for the purpose of creating goodwill, boosting employee
morale, or attracting potential employees, its value must be added to the employee’s wages.
Group-Term Life Insurance Coverage: Up to $50,000 of life insurance coverage may be provided
as a nontaxable benefit to an employee. The cost of insurance coverage on policies that exceed $50,000
is a taxable benefit. If an employer provides more than $50,000 of coverage, the amount included in
the taxpayer’s income is reported as part of their taxable wages on their Form W-2. The taxable amount
is shown separately with a “code C” in box 12 of their Form W-2.
Work-Related Moving Expense Reimbursements: Moving expenses are no longer deductible for
most taxpayers, except for certain members of the armed forces. Therefore, moving expenses that are
reimbursed or paid by an employer must be included in the employee’s taxable income as wages.

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Example: Margaret was offered a new job in another state on November 5, 2024. Her new employer
offered to reimburse her moving expenses as a condition of her employment. She accepted the position
and moved on December 17, 2024. Margaret submits the paperwork, and her employer reimburses all
her moving expenses on December 30, 2024. Even though she submitted receipts for reimbursement,
the amounts would be taxable to Margaret as wages. The employer may deduct the amounts as
employee compensation, and all the normal payroll taxes that are applicable to wages would apply.
No-Additional-Cost Services: Nontaxable fringe benefits also include services provided to
employees that do not impose any substantial additional cost to the employer because the employer
already offers those services in the ordinary course of doing business. Employees do not need to
include these no-additional-cost services in their income. Typically, no-additional-cost services are
excess capacity services, such as unused airline seat tickets for airline employees or open hotel rooms
for hotel employees.
Example: Momentum Airlines is an airline company that offers both domestic and international
flights. Donahue is a pilot for this airline. When Donahue is not on duty, the airline allows him to fly as
a passenger on their flights free of charge, as long as there are seats available. This is an example of an
excess capacity service. In this case, the airline is already offering flights as part of its business, and
Donahue occupying an otherwise empty seat does not incur any significant extra cost. Therefore, it
qualifies as a no-additional-cost service and is a nontaxable fringe benefit for Donahue.
If an employee is provided with free or low-cost use of a health club on the employer’s premises,
the value is not included in the employee’s compensation. The gym must be used primarily by
employees, their spouses, and their dependent children. However, if the employer pays for a fitness
program or use of a facility at an off-site location, the value of the program is included in the employee’s
compensation.
Example: Orion is employed at a software company located in downtown Los Angeles. His employer
provides an optional subsidized gym membership at Iron Fitness Club, a local gym, as part of a fitness
reimbursement program to promote employee health and wellbeing. Orion happily takes advantage of
this benefit. However, the monthly fee for the off-site gym membership ($38) is taxable as wages, and
will be reported on Orion’s Form W-2. An off-site gym membership is a taxable fringe benefit.
Employee Achievement Awards: Employers may generally exclude from an employee’s taxable
wages the value of awards given for length-of-service or safety achievement. The tax-free amount is
limited to the following:
• $400 for awards that are not qualified plan awards.
• $1,600 for qualified plan awards. A qualified plan award is one that does not discriminate in
favor of highly compensated employees, and that is established under a written plan.
Example: Wallace has worked for Telegraph Corp. for ten years. Telegraph Corp. makes a qualifying
length-of-service award to Wallace in the form of an engraved silver watch. The cost of the watch was
$575. The watch was presented to Wallace during a meaningful presentation. All the company
employees are eligible to receive length-of-service awards based on their tenure with the company.
The watch is deductible to Telegraph Corp. as a business expense, and the value of the watch is not
taxable to Wallace.

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The exclusion for employee awards does not apply to awards of cash, gift cards, lodging, stocks,
bonds, or tickets to sporting events.
De Minimis (Minimal) Benefits: This is a property or service an employer provides that has so
little value that accounting for it would be impractical. Examples of de minimis benefits include the
following:
• Occasional personal use of a company copying machine.
• Holiday gifts with a low fair market value (such as a holiday turkey or a gift basket)
• Flowers, fruit, books or similar property provided to employees under special circumstances,
such as an employee’s birthday
• Beverages and snacks, such as coffee or doughnuts for employees
• Cash is not excludable as de minimis benefits unless they are for occasional meal money or
transportation fare, and they are not given out on the basis of hours worked (for example, $1.50
per hour for each hour over 8 hours). In order to be non-taxable, the benefit must also be
provided so that an employee can work an unusual, extended schedule.
Example: Wayne works for Dogwood Dairy Farms as a farmhand. One day, there was an emergency
on the farm where several dairy cows accidentally ingested tainted feed. The cows began to have
seizures, and all the employees were forced to work overtime to stabilize the livestock and administer
medicine. Dogwood Dairy Farms gives Wayne $20 in cash to purchase a meal during this unusual
overtime shift. The cash can be excluded as a de minimis benefit because Wayne is working overtime
for the benefit of his employer, and it is an unusual and infrequent situation.
Example: Bennett owns Greenhaven Farms. He has 10 employees. One day, severe storms struck the
area, and all of the company’s crops were at risk. Bennett asks all his employees to work overtime in
order to bring in crops and secure the farm buildings and fencing. During this emergency situation,
Bennett gives his employees $25 in cash to purchase their lunch and dinner at a nearby deli. The
amounts would be excluded from the employees’ wages as a de minimis benefit, because the storm is
an unusual and infrequent occurrence.
Employee Discounts: Employers may exclude the value of employee discounts from wages up to
the following limits:
• For services, a 20% discount of the price charged to non-employee customers.
• For merchandise, the company’s gross profit percentage multiplied by the price non-employee
customers pay.

Accountable Plan Reimbursement of Employee-Business Expenses

When a company reimburses its workers for specific business-related costs, such as work travel
and meals, the reimbursements are not considered taxable income if the employees meet all of the
following requirements under an accountable plan:
• Have incurred the expenses while performing their duties as employees.
• Provide proper documentation for travel, meals, and lodging expenses.
• Supply evidence of their employee business expenditures, such as receipts or records.
• Return any surplus reimbursements within a reasonable timeframe.

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The decision to create an accountable plan is ultimately up to the employer, not the employee. An
employer is not obligated to establish an accountable plan for reimbursing employee business
expenses. Furthermore, the employer has the freedom to choose which expenses will be covered under
this plan.
Under an accountable plan, a company may give cash advances to employees. These advances must
reasonably align with anticipated expenses and must be given within a reasonable timeframe. If any
expenses reimbursed through this arrangement cannot be substantiated, they will be considered
taxable income for the employee.
Qualifying expenses for travel are excludable from an employee’s income if they are incurred for
temporary travel on business away from the area of the employee’s tax home. Travel expenses paid in
connection with an indefinite work assignment cannot be excluded from income. Any work assignment
more than one year is considered “indefinite.” Reimbursement for travel expenses may cover:
expenses incurred while traveling to and from the designated business location (such as airfare and
mileage reimbursements), transportation costs during the trip (such as taxi fares), hotels, meals, and
other related costs, and dry cleaning, laundry, and any other miscellaneous expenses during the period
spent away from home on assignment.
Example: Cohen works full-time for a software company in Seattle. He flies to San Francisco for a
business conference that lasts an entire week. His employer reimburses the cost of the $400 round trip
flight to San Francisco as well as lodging and meals while he is attending the conference. The
reimbursements for travel expenses are excluded from Cohen’s income, and deductible by his
employer as a business expense.
Example: Miriam runs a tax preparation business as a sole proprietor. Nasser, her employee, wants to
become a notary, and Miriam agrees that a notary license would add value to her practice. Nasser isn’t
sure how much the notary class will cost, so Miriam gives Nasser a reasonable sum of $250 so Nasser
can pay for the required course and the exam fees, with the requirement that any unused amounts are
repaid to Miriam. A week later, Nasser spends $90 on a live notary seminar, and then another $100 to
take the notary exam. Nasser didn’t use the entire advance, so he returns the unused funds ($60) to his
employer. He also gives copies of his receipts to Miriam. The expenses are qualified expenses under an
accountable plan, so the amounts paid are not taxable income for Nasser and are still deductible as
business expenses by Miriam.

Taxation of Clergy Members

There are special rules regarding the taxation of clergy members, defined as individuals who are
ordained, commissioned, or licensed by a religious body or church denomination. A clergy member’s
salary is reported on Form W-2 and is taxable. 77
For services in the exercise of the ministry, members of the clergy receive a Form W-2 but do not
have social security or Medicare taxes withheld. Offerings and fees received for performing marriages,
baptisms, and funerals must be reported as self-employment income on Schedule C.

77 A minister’s housing allowance is exempt from income tax under IRC §107, but it is still subject to self-employment tax. If a
congregation provides housing in-kind instead of a housing allowance, the fair market rental value of the housing is also included
in net earnings from self-employment.
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Example: Reverend Milton is an ordained minister working for a local church. His annual salary is
$52,000, which is reported on Form W-2. This salary is subject to federal income tax and state income
taxes, just like any other employee's salary. However, because Reverend Milton is a member of the
clergy, his Form W-2 does not have Social Security or Medicare taxes withheld. Instead, he is
responsible for paying these taxes himself, and will be computed on Schedule SE, Self-Employment Tax.
Reverend Milton also earned an additional $5,600 during the year for performing marriages for
various couples. He must report that income on Schedule C.
Housing Allowance for Clergy: A clergy member who receives a housing allowance may exclude
the allowance from gross income to the extent it is used to pay the expenses of providing a home. Only
taxpayers who are serving as clergy (ministers, priests, etc.) are eligible for a housing allowance. The
exclusion is limited to the lesser of the following amounts:
• The amount officially designated as a housing allowance.
• The amount actually used to provide or rent a home.
• The fair market rental value of the home (including utilities, property taxes, insurance, etc.)
The housing allowance cannot exceed reasonable pay and must be used for housing in the year it
is received. Salary, other fees, and housing allowances must be included in income for purposes of
determining self-employment tax.
Example: Garrison is an ordained pastor for the First Baptist Church. His church allows him to use a
cottage that has a rental value of $8,000. He is paid an additional $22,000, and his church does not
withhold Social Security or Medicare taxes. Garrison’s income for income tax purposes is $22,000, but
for self-employment tax purposes is $30,000 ($22,000 + $8,000 housing). Any amount of housing
allowance excluded from gross income is still subject to Social Security and Medicare tax.
Example: Emanuel is an ordained minister who receives $32,000 in salary from his church. He
receives an additional $4,000 for performing private marriage and baptism ceremonies. His housing
allowance is $500 per month, for a total of $6,000 per year, and is excluded from his gross income.
Emanuel must report the $32,000 as salary and $4,000 as self-employment income. The $6,000
housing allowance is subject to self-employment tax, but not income tax.
A clergy member may apply for an exemption from self-employment tax if he is conscientiously
opposed to public insurance because of religious principles. For a clergy member or a minister to claim
an exemption from SE tax, the minister must file IRS Form 4029, Application for Exemption from Social
Security and Medicare Taxes and Waiver of Benefits. The sect or religious order must also complete part
of the form. Generally, this exemption is irrevocable.
Example: Pastor Frieda is a minister working for a small church. She is conscientiously opposed to
public insurance due to her religious principles. To claim an exemption from self-employment tax,
Pastor Frieda files IRS Form 4029. Her religious order also completes the necessary part of the form
to support her application. Once the exemption is granted, Pastor Frieda will not pay Social Security or
Medicare taxes on her earnings from the church. However, she will still be subject to federal income
tax on her salary. Since this action is irrevocable, Pastor Frieda will not receive Social Security or
Medicare benefits in retirement.

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This exception does not cover federal income tax, only self-employment tax. If granted, the clergy
member will not be responsible for Social Security or Medicare taxes on their earnings and will not be
eligible for these benefits in retirement. If a member of a religious order has taken a vow of poverty,
they are exempt from paying self-employment tax on their earnings for qualified services. The earnings
are tax-free because they are considered the income of the religious order, rather than of the individual
clergy member.78
Combat Pay and Veterans Benefits
Typically, military personnel’s regular wages are subject to taxes. However, there are specific
exceptions and rules for military personnel regarding taxable income. For instance, combat zone
wages or “combat pay” is not considered taxable income. Hazardous duty pay is also excludable for
military personnel. Enlisted personnel who serve in a combat zone for any part of a month may exclude
their pay from tax. For officers, the pay is excluded up to a certain amount, depending on the branch of
service.
Example: Ashton is an Air Force pilot who served in a combat zone from January 1, 2024, to November
3, 2024. He is only required to report his income for December, because all of the other income is
excluded from taxation as combat-zone pay. Even though Ashton only served three days in November
in a combat zone, his income for the entire month of November is excluded.
Similarly, veterans’ benefits paid by the Department of Veterans Affairs to a veteran or his family
are not taxable if they are for education (the GI Bill), training, disability compensation, work therapy,
dependent care assistance, or other benefits or pension payments given to the veteran because of
disability.
Example: Colton is a Navy Veteran who has recently enrolled in his local junior college’s Automotive
Technology Program. Colton can receive up to $3,500 annually as a GI education benefit. Colton’s
tuition is $4,000. His $3,500 GI benefit payment is made directly to his college, directly reducing his
college tuition. The GI benefit is not taxable to Colton.

Medicare/Medicaid Waiver Payments

“Difficulty-of-care” payments, also known as Medicare waiver payments, or Medicaid waiver
payments, can be excluded from a taxpayer’s gross income.79 These payments are nontaxable to the
caregiver if they are for in-home-care services provided to a disabled individual who resides in the
same home.
Note: Starting in 2024, Form W-2, Wage and Tax Statement, now includes a new Box 12 code for
Medicaid waiver payments that are excluded from income under Notice 2014-7.
The exemption applies to anyone providing care in their own home, regardless of who owns the
home. It is also not necessary for the caregiver to be related to the disabled individual, although this is
often the case. Qualified Medicare waiver payments may be excluded from income only when the care
provider and the care recipient reside in the same home. When the care provider and the care

78 Poverty vows only exempt priests and ministers from federal income tax if they give their earnings from third parties to the
church. Payments received directly from the church are not exempt.
79 According to IRS Notice 2014-7, payments through state Medicaid and Medicare Personal Care programs for in-home supportive

care are considered "difficulty of care payments" and can be excluded from a provider's gross income. FAQs on this topic can be
found at: https://www.irs.gov/individuals/certain-medicaid-waiver-payments-may-be-excludable-from-income.
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recipient do not live together in the same home, the Medicare waiver payments may not be excluded
from gross income.
Example: Brooke moved into her elderly mother’s home to care for her. Brooke begins to receive $575
monthly payments under a state Medicare Home and Community-Based Services waiver program for
supportive home care. The payments are not taxable to Brooke because she lives in the home with her
mother while providing care. This is true even if she receives a Form W-2 or a Form 1099 for the
income.
Example: Timothy cares for his elderly uncle five days a week. Timothy eats all his meals at his uncle’s
home and sleeps there occasionally. Most evenings and weekends, Timothy leaves his uncle’s home at
6:00 p.m. and goes home to his wife and family in their separate home. Timothy receives monthly
Medicare waiver payments for his uncle’s care. Since Timothy has a separate home, the Medicare
waiver payments are taxable to Timothy.
Taxpayers who receive Medicare waiver payments may choose to include them in their income for
purposes of the earned income credit (EITC) or the additional child tax credit (ACTC). 80 A taxpayer
may not choose to include or exclude only a portion of qualified Medicaid waiver payments. They must
either include all or none of the qualified Medicaid waiver payments for the taxable year in their earned
income. However, a taxpayer and their spouse are permitted to each make separate elections to include
or not include their respective Medicaid waiver payments in earned income.
Example: Cecilia and Miguel, a married couple, both receive Medicaid waiver payments—Cecilia for
caring for her disabled mother, Rosario, and Miguel for his disabled brother, Paulo. They all live
together in the same household, so Cecilia and Miguel can each choose to exclude their Medicaid waiver
payments from their gross income. Cecilia and Miguel file a joint return. Cecilia chooses to include her
Medicaid payments as earned income to qualify for the Earned Income Tax Credit (EITC). In contrast,
Miguel chooses to exclude all his Medicaid waiver payments to reduce their taxable income. Cecilia's
inclusion of her payments boosts their EITC, while Miguel's choice lowers their overall taxable income.
In addition, under the SECURE Act, taxpayers can use this income to fund an IRA, but since the
contributions come from amounts excluded from tax, they are treated as nondeductible contributions.
Disability Payments
There are several types of disability payments, and the taxability of the income depends on several
factors. Some types of disability-related payments are given to workers that are not taxable at all.
Worker’s compensation is one such example. Worker’s compensation should not be confused with
disability insurance, sick pay, or unemployment compensation; it is a type of benefit that only pays
workers who are injured on the job.81
Worker’s compensation is a type of mandatory business insurance, meaning most large and mid-
sized employers are required to have coverage for their employees. Worker’s compensation coverage
can include wage replacement as well as rehabilitation services that help injured employees return to
work when they are medically able to do so. Worker’s compensation is always exempt from tax.

80See Q&A #9 at: https://www.irs.gov/individuals/certain-medicaid-waiver-payments-may-be-excludable-from-income.

81Under worker’s compensation law, an injury or illness is covered, without regard to fault, if it was sustained in the course and
scope of employment, this would also include injuries sustained during work-related travel, but would not cover injuries incurred
by an employee’s willful criminal acts or self-injury, or intoxication from drugs or alcohol.
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Example: Kieran is a construction worker. During the year, he is struck by falling concrete on a
construction site. The concrete crushes his pelvis, causing catastrophic injuries and a long hospital
stay. His employer’s worker’s compensation policy covers Kieran’s medical costs as well as a portion
of his lost wages while he is recovering from his injury. The amounts are not taxable to Kieran and do
not need to be reported on his tax return.

Disability Retirement Benefits

Disability retirement benefits are unique. These benefits are taxable as wages if a taxpayer retired
on disability before reaching the minimum retirement age. The benefit is usually based on the
employee’s final average earnings and their years of actual service. Once the taxpayer reaches
retirement age (usually, this is age 62), the payments are no longer taxable as wages, they are taxable
as pension income.
This type of disability retirement benefit is offered to most Federal government workers and U.S.
Postal Service employees and is often called “FERS disability” because the disability retirement
benefits are offered under the Federal Employees Retirement System (FERS).82 To apply for this
benefit, the employee’s disability generally must have caused them to discontinue working.
Example: Sloane is a U.S. Postal Service employee. She is 50 years old and has worked for the postal
service for over sixteen years, but she is still many years away from official retirement age. On January
29, 2024, Sloane sustains a life-altering spinal injury and becomes permanently disabled. She
immediately applies for disability retirement under the Federal Employees Retirement System, or
FERS, and is awarded disability retirement benefits. Her disability retirement benefits will be taxable
as wages until she reaches retirement age (usually 62 years of age). After she reaches retirement age,
the benefits will be taxable as pension income instead of wages.

Disability Insurance Benefits

A taxpayer may receive long-term disability insurance payments because of an insurance policy.
Generally, long-term disability payments from an insurance policy are excluded from income if the
taxpayer pays the premiums for the policy. If an employer pays the insurance premiums, the employee
must report the payments as taxable income.

Disability Insurance Premiums Taxability of Benefits

The employer pays 100% 100% taxable
The employer pays a portion, and the employee Partially taxable; the taxable percentage is
pays the balance with post-tax dollars based on the premiums paid by the employer
The employer pays a portion, and the employee 100% taxable
pays the balance with pretax dollars
The employee pays 100% with post-tax dollars Not taxable

The employee pays 100% with pre-tax dollars 100% taxable

82Social Security Disability Insurance (SSDI) benefits is a separate benefit from disability retirement benefits that are offered to
federal and postal service employees. Supplemental Security Income (SSI) is also different from SSDI. SSI is a non-taxable needs-
based federal benefit.
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If both an employee and the employer have paid premiums for a disability policy, only the
employer’s portion of the disability payments would be reported as taxable income.
Example: Robyn became disabled in 2024 and began to receive a long-term disability benefit of $4,200
a month. The original insurance policy was paid for by both her employer and herself. Before Robyn
became disabled, her employer paid 80% of the disability insurance premiums. Robyn paid the
remaining premium amount (20%) with post-tax dollars. In this case, because the employer paid 80%
of the policy premiums, 80% of the benefits received would be taxable to Robyn. This means that
$3,360 ($4,200 × 80%) would be taxable. The remaining benefits of $840 (20% × $4,200) would not
be taxable since Robyn paid that portion of the insurance premium with her own post-tax dollars.

Veterans Disability Benefits

Veterans’ disability benefits (also called VA Disability Compensation) are a type of disability benefit
paid specifically to a veteran for disabilities that are service-connected, which means the injury or
disease is linked to their military service.
Veterans’ disability benefits are exempt from taxation if the veteran was terminated through
separation or discharged under honorable conditions. The Department of Veterans Affairs (VA)
typically does not issue Form W-2, Form 1099-R, or any other tax-related document for veterans’
disability benefits.
Example: Phoebe is a Navy veteran who was medically discharged after she sustained a serious injury
in Iraq. She lost vision in one eye and the use of one hand due to an explosion. Since Phoebe’s discharge
from the Armed Forces, she has received $1,950 per month in Veterans’ disability benefits. She now
has a civilian job working in a factory, where she earns regular wages as an employee. Her wages are
taxable, but the disability compensation remains non-taxable to Phoebe. Her veterans’ disability
benefits do not need to be reported on her tax return.
Note: Do not confuse “sick pay” with disability pay or disability benefits. Sick pay, or sick leave, is
always taxable as wages, just like vacation pay and holiday pay.

Life Insurance Payments

Life insurance payouts generally are not taxable to a beneficiary. This is true even if the proceeds
were paid under an accident or health insurance policy. However, interest income received on life
insurance proceeds is usually taxable. Further, if a taxpayer surrenders a life insurance policy for cash,
they must generally include in income any proceeds that are more than the cost of the policy.
However, an exception exists for when a terminally ill person receives a viatical settlement. 83 In
this case, the funds are tax-free. Sometimes, a taxpayer will choose to receive life insurance proceeds
in installments rather than as a lump sum. In this case, part of the installment generally includes
interest income.
If a taxpayer receives life insurance proceeds in installments (also called a life insurance annuity),
they can exclude part of each installment from their income. To determine the excluded part, the

83 A “viatical settlement” when the policyholder is deemed to be terminally or chronically ill and executes a “deemed sale” of their
life insurance policy. As long as the taxpayer has proof from a physician that they have a life expectancy of 24 months or less, the
sale of their life insurance policy is treated as a viatical settlement and is tax-free.
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amount held by the insurance company (generally the total lump sum payable at the death of the
insured person) is divided by the number of installments to be paid. The taxpayer would include any
amount over this excluded portion as taxable interest income.
Example: Molly’s brother died in 2024, and she is the sole beneficiary of his life insurance. The face
amount of the policy is $75,000. Rather than take a lump sum payment, Molly chooses to receive 120
monthly installments of $1,000 each. The excluded part of each installment is $625 ($75,000 ÷ 120),
or $7,500 for an entire year. The rest of each payment, $375 a month (or $4,500 for an entire year), is
taxable as interest income to Molly.

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Unit 5: Investment Income and Expenses

For additional information, read:
Publication 550, Investment Income and Expenses
Instructions for Schedule B

This unit covers investment income, such as interest and dividend income. Taxpayers who deposit
cash or invest in securities such as stocks, bonds, and mutual funds may earn income from interest,
dividends, and capital appreciation. Other types of income from investments, such as capital gains
resulting from sales, are covered later.
Interest Income
Interest is a form of income that may be earned from deposits, such as bank and money market
accounts, notes receivable, and investments in instruments such as bonds. Some interest income is
taxable, and some is not. Certain distributions, commonly called dividends, are reported as taxable
interest. These include “dividends” on deposits or share accounts in cooperative banks, credit unions,
domestic savings and loan associations, and mutual savings banks. A taxpayer can also have taxable
interest from certificates of deposits (CDs) and other deferred interest accounts.
Interest income is generally reported to the taxpayer on Form 1099-INT by the financial institution
or another payor if the amount of interest is $10 or more for the year. Even if a taxpayer does not
receive Form 1099-INT from a payor, all taxable interest income must be reported. If taxable interest
income exceeds $1,500, the taxpayer must report the interest on Schedule B, Interest and Ordinary
Dividends.
Example: Trixie has three savings accounts in different banks, earning a total of $1,950 in interest. She
will receive three Forms 1099-INT. On Schedule B, she must list each payor and the amount of interest
she receives from each bank and file it with her tax return.

Example: Zebadiah loaned his best friend Rufus $20,000 for one year at 3% interest. Rufus paid
Zebadiah $600 in interest in 2024 ($20,000 × .03 = $600). Since this is a personal loan, the payor is not
required to file a 1099-INT. Even if Zebadiah does not receive a Form 1099-INT from Rufus, he must
report the interest he earned on the loan as taxable income on his Form 1040.

Gift for Opening a Bank Account: When a taxpayer receives noncash gifts for making deposits or
opening an account in a savings institution, they may need to report the value of the gift as interest. If
the deposit is less than $5,000, any gifts or services valued at more than $10 must be reported. For
deposits of $5,000 or more, gifts or services valued over $20 must be reported as interest. The financial
institution determines the value of the gift based on its cost.
Receiving a cash bonus for opening a new checking or credit card account is also considered taxable
interest. However, rewards earned from credit and debit card purchases are typically not deemed as
taxable income. For example, many major airlines have frequent flyer programs that allow passengers
to accumulate miles with each flight. The IRS considers these rewards “rebates” and not taxable
income.

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Example: Florent applies for a new credit card through Inspire Airlines Visa. The card company offers
20,000 frequent flyer miles for spending $10,000 in the first six months. Florent makes over $10,000
in purchases between February and May and receives 20,000 of not taxable bonus miles.
The same is true for customer loyalty programs like grocery store discount cards, punch cards that
provide a price reduction after a number of purchases, and discounts for opening a store credit card. 84
Example: Kiana earns $26,000 in wages during the year. She also earns some interest from her two
savings accounts in different banks. Kiana earns $9 in interest from the first savings account and $8 in
interest from the second account. Because the amounts are below the reporting threshold, she does
not receive a Form 1099-INT from either bank. However, the interest is still taxable and must be
reported on her tax return. She can report the interest directly on her Form 1040. She does not have
to file a Schedule B, since the amount of interest is less than $1,500.
Interest Earned on a Certificate of Deposit
Interest earned on a certificate of deposit (CD) is generally taxable when the taxpayer receives it
or is entitled to receive it without incurring a penalty. The interest a taxpayer pays on funds borrowed
from a financial institution to meet the minimum deposit required for a CD, and the interest a taxpayer
earns on the CD are two separate items. The taxpayer must include the total interest earned on the CD
in income. If the taxpayer chooses to itemize deductions, they can deduct the interest paid as
investment interest, as long as it does not exceed their net investment income, by using Form 4952,
Investment Interest Expense Deduction.85
Example: Tiffany wants to invest in a $50,000 six-month CD. She deposited $40,000 of her own money
in a CD with a bank and borrowed an additional $10,000 from the same bank to make up the minimum
deposit required to buy the six-month CD. The certificate of deposit earned $575 at maturity in 2024,
but Tiffany received a net amount of $265 for the year after taking into account the $310 of interest
paid to the bank. This represented the $575 Tiffany earned on the CD, minus $310 interest charged on
the $10,000 loan. The bank issued Tiffany a Form 1099-INT showing the $575 interest she earned. The
bank also issued Tiffany a statement showing that she paid $310 in investment interest during the
year. Tiffany must include the total interest amount that she earned, $575, in her gross income for the
year. She can deduct the interest expense of $310 only if she itemizes deductions on Schedule A.

Tax-Exempt Interest
Interest earned on debt obligations of state and local governments (also commonly called muni
bonds or municipal bonds) is generally exempt from federal income tax but may be subject to income
taxes by state and local governments. Also, even if the interest on an obligation is nontaxable, the
taxpayer may need to report a capital gain or loss when the investment is sold. The taxpayer’s Form(s)
1099-INT may include both taxable and tax-exempt interest. Tax-exempt interest must be reported on
Form 1040, even though it is not taxable.

84IRS Announcement 2002-18 addresses frequent flyer miles and promotional card benefits.
85 The TCJA temporarily suspends miscellaneous itemized deductions subject to 2%-of-AGI until 2026. This temporary
disallowance includes the deduction for most investment expenses. Other examples include: safe deposit fees, trustee fees, and
investment advisor fees. However, the TCJA did not repeal the deduction for investment interest expense. Investment interest
expense is any interest incurred on loans used to purchase taxable investments.
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Example: Travis is a software programmer who earns $109,000 in wages during the year. He also
receives $2,950 in municipal bond interest. The muni bond interest was reported to him on Form
1099-INT. Travis must report his wages as well as the full amount of the muni bond interest on his tax
return, but the municipal bond interest is not taxable.
If a taxpayer borrows money to buy investments that generate tax-free income, the interest is not
deductible as investment interest.

Example: Antoinette borrowed $60,000 from a bank to invest in municipal bonds. Antoinette
purchased the bonds and received tax-exempt interest of $1,250. She also paid $950 in interest on the
loan. Since Antoinette does not have to pay tax on the municipal bond income, she cannot take the
investment interest expense deduction for the interest that she paid.

Interest on U.S. Treasury Bills, Notes, and Bonds

Interest on U.S. obligations, such as U.S. Treasury bills, notes, or bonds issued by any agency of the
United States, is normally taxable for federal income tax purposes and exempt from state and local
income taxes. The Series EE bond is issued at a discount, and the difference between the purchase
price and the amount received when the bonds are later redeemed (or “cashed in”) is interest income.
Series I bonds are issued at face value with a maturity period of thirty years. The face value and
accrued interest are payable at maturity. Individual taxpayers can generally report interest income
from a Series EE or Series I savings bond either:
• When the bond matures or is redeemed (whichever occurs first), or
• Each year as the bond’s redemption value increases (if the taxpayer makes an election).
However, taxpayers must use the same reporting method for all the Series EE and Series I bonds
they own. When taxpayers redeem savings bonds, they should receive a Form 1099-INT from a bank
or another payor.
The Education Savings Bond Program
Series EE and I savings bonds are also called “educational savings bonds.” A special rule permits
qualified taxpayers to exempt the interest earned upon redemption of eligible savings bonds, if they
are used to pay higher education expenses in the same year. The educational expenses must be for the
taxpayer, a spouse, or dependents. This exclusion is known as the Education Savings Bond Program.
Interest earned on these bonds is usually exempt from state taxes as well.
The taxpayer must use both the principal and interest to pay for qualified education expenses. If
more savings bonds are cashed than educational expenses paid, the excludable interest is reduced.
Example: Sonya is 28 and a full-time college student. She redeemed several education savings bonds
to pay for her college expenses. She cashed in the bonds during the year, receiving total bond proceeds
of $10,000 ($8,000 principal and $2,000 in bond interest). Sonya’s qualified educational expenses were
only $8,000. She used the remaining $2,000 to make a down payment on a new car. Therefore, since
Sonya used only 80% of the bond proceeds for qualified expenses, she can only exclude 80% of the
bond interest. The excludable portion would equal $1,600 (80% × $2,000 bond interest = $1,600). She
would pay tax on the remaining $400 of bond interest.

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These rules must be followed for a taxpayer to claim the Educational Savings Bond Exclusion:
• Eligible Bonds: Only Series EE and I bonds issued after 1989 will qualify.
• Ownership: The bonds must be registered in the taxpayer’s name or their spouse's name. The
bonds cannot be registered in the name of the child under age 24, even if the amounts are used
for the dependent child.
• Age requirement: The taxpayer and owner of the bonds must be at least 24 years old before
the bond's issue date.
• Qualified expenses: The interest exclusion applies to tuition and fees required for enrollment
or attendance at an eligible educational institution.
• Timing: The bonds must be redeemed in the same year that the qualified expenses are paid.
• Filing Status: Taxpayers filing as married filing separately are ineligible.
• Phaseout Ranges for 2024:
o Single or Head of Household: The exclusion begins to phase out at a modified adjusted
gross income (MAGI) of $96,800 and is completely phased out at $111,800.
o Married Filing Jointly: The exclusion begins to phase out at a MAGI of $145,200 and is
completely phased out at $175,200.
Taxpayers who meet these requirements can claim the exclusion by filling out IRS Form 8815,
Exclusion of Interest from Series EE and I U.S. Savings Bonds Issued After 1989. and attaching it to their
tax return.
Remember, married taxpayers who file separately (MFS) do not qualify for the education savings
bond interest exclusion. If a taxpayer cashes an education savings bond during the year and then files
MFS, all the interest would be taxable, regardless of whether the taxpayer had qualifying education
expenses.
Example: Gunther is married and usually files jointly with his wife, Tilda. In 2024, Gunther cashed out
qualified Series EE U.S. savings bonds. He received proceeds of $7,520, representing a principal of
$5,000 and interest income of $2,520. Gunther paid $11,000 of college tuition for his graduate program
using the bond proceeds. Normally, Gunther would be able to exclude all the bond interest from his
taxable income, but Tilda gets angry with Gunther and refuses to file jointly with him in 2024. Gunther
will be forced to file a separate tax return. Unfortunately for Gunther, since he is filing MFS, all the bond
interest is now taxable, even though he has qualifying educational expenses to offset.
The amount of qualified expenses must be further reduced by the amount of any scholarships,
fellowships, employer-provided educational assistance, and other forms of tuition reduction.
Note: In general, only tuition and fees are considered qualified expenses for the purposes of the
savings bond exclusion. The costs of room and board, as well as required textbooks, are not eligible
expenses. However, the cost of required textbooks is a qualified educational expense for the purposes
of the Lifetime Learning Credit and the American Opportunity Credit.

Dividend Income
A dividend is a distribution of cash, stock, or other property from a corporation or a mutual fund.
Most large corporations pay dividends in cash. The payor will generally use Form 1099-DIV to report
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dividend income to its shareholders. If a taxpayer does not receive Form 1099-DIV from a payor, the
taxpayer must still report all taxable dividend income. Generally, if a taxpayer’s total dividend income
is more than $1,500, it must be reported on Schedule B, Interest and Ordinary Dividends. Otherwise, the
dividend income can be reported directly on Form 1040. In 2024, the top rate on long-term capital
gains and qualified dividends is 20%.86
This means that the maximum tax rate for qualified dividends is 20%, regardless of the taxpayer’s
individual tax bracket. However, many higher-income taxpayers may also be subject to the Net
Investment Income Tax (NIIT) on long-term capital gains and qualified dividends (the NIIT is covered
in detail later).
Example: Aiden is unmarried and earned $790,000 in wages in 2024. This puts him in the highest
marginal tax bracket, at 37%. Aiden also earned $120,000 in qualified dividends from various
investments. His dividend income will be taxed at 20%, a much lower rate than his marginal ordinary
tax rate. Also, unlike his wages, the dividends are not subject to employment taxes. However, Aiden
will be subject to the Net Investment Income Tax (NIIT) on the qualified dividends because his adjusted
gross income is over the threshold amount for the NIIT.
Ordinary Dividends: Ordinary dividends are corporate distributions in cash (as opposed to
property or stock shares) that are paid to shareholders out of earnings and profits. Unless they are
qualified dividends, they are taxed at ordinary income tax rates rather than at lower long-term capital
gain rates. Ordinary dividends are reported in Box 1a of Form 1099-DIV.
Qualified Dividends: Whereas ordinary dividends are taxable as ordinary income, qualified
dividends that meet certain requirements are taxed at lower capital gain rates if specific criteria are
met. Short-term capital gains and ordinary dividends are taxed at ordinary income rates. The top rates
for qualified dividends and long-term capital gains are as follows:

Long-Term Capital Gains & Qualified Dividends Tax Rates for 2024
Rate Single MFJ MFS HOH
0% $0 – $47,025 $0 – $94,050 $0 – $47,025 $0 – $63,000
15% $47,026 – $518,900 $94,051 – $583,750 $47,026 – $291,850 $63,001– $551,350
20% $518,901+ $583,751+ $291,851+ $551,351+

Other long-term gains rates

Gain on sale of collectibles Examples: artwork, antiques, stamps, etc. Maximum 28%
Unrecaptured Sec. 1250 Maximum 25%
gain Applies to depreciable real estate property.

Qualified dividends are reported to the taxpayer in Box 1b of Form 1099-DIV. In order for the
dividends to qualify for these preferred tax rates, the following are the two most common
requirements that must be met:

86 Note that short-term capital gains, which are generated by the sale of investments normally held for one year or less, are taxed
at the individual taxpayer’s ordinary income rate. This is why the holding period is so important. We will discuss the holding period
in more detail later.
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• The dividends must be paid by a U.S. corporation or qualified foreign corporation,87 and
• The taxpayer generally must have held the stock for more than sixty days during the 121-day
period that begins sixty days before the ex-dividend date.
When figuring the holding period for qualified dividends, the taxpayer may count the number of
days the stock was held, with the first day being the day after the stock was acquired (the date the
taxpayer acquires the stock is not included in the holding period), and include the day the stock was
sold. A longer holding period may apply for dividends paid on preferred stock. The “ex-dividend date”
is the date a shareholder will no longer be entitled to receive the most recently declared dividend
(typically the day following the record date). 88
Nondividend Distributions: Distributions that are not paid out of a corporation’s earnings and
profits are called nondividend distributions. They are considered a recovery or return of capital and
therefore are generally not taxable.
However, these distributions reduce the taxpayer’s basis in the corporation's stock. Once the basis
is reduced to zero, any additional distributions are capital gains and are taxed as such. Nondividend
distributions are reported in Box 3 of Form 1099-DIV.
Money market funds: Money market funds pay dividends and are offered by nonbank financial
institutions, such as mutual funds and stock brokerage houses. Generally, amounts received from
money market funds should be reported as dividends, not as interest.
Stock Dividends and Stock Distributions
A stock dividend is a distribution of stock, rather than money, by a corporation to its own
shareholders. A stock dividend is generally not a taxable event and does not affect the shareholder’s
income in the year of distribution because the shareholder is not actually receiving any money, and all
shareholders increase their total number of shares pro-rata. When a stock dividend is granted, the total
basis of the shareholder’s stock is not affected, but the basis of individual shares is adjusted by the
inclusion of the newly issued shares.
Example: AeroSystems Corporation declares a year-end stock dividend. Sharon is a shareholder in
AeroSystems, and prior to the stock dividend, she owns 100 shares. Her basis in the shares is $5,000,
or $50 per share. Sharon receives a stock dividend of 100 additional shares. After the dividend, Sharon
owns 200 shares. Her overall basis in the shares does not change (it is still $5,000), but her new basis
in each individual share is $25 per share ($5,000 ÷ 200 = $25 per share). Sharon does not have any
taxable income as a result of the stock dividend.
If a shareholder has the option to receive cash instead of stock, the stock dividend is taxable in the
year it is distributed. The recipient of the stock must include the FMV of the newly issued stock in his
gross income; that same amount is the basis of the shares received.

87 A “qualified foreign corporation” for the purposes of this rule is generally a foreign corporation whose stock is traded on a U.S.
stock exchange or if a tax treaty between the U.S. and the corporation’s foreign country allows for qualified dividend treatment.
88 The “ex-dividend date” is the day on which a corporation’s shares that are bought and sold no longer come attached with the

right to receive the most recently declared dividend. This is important, because if a taxpayer purchases stock after its ex-dividend
date, the taxpayer who bought the shares will not receive the next dividend payment. Instead, the seller of the stock receives the
dividend.
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Example: Superjet Corporation declares a year-end stock dividend and gives its shareholders the
option of receiving cash instead of stock. Therefore, the stock dividend becomes a taxable event. Before
the dividend, Danton owns 1,000 shares in Superjet Corp., and his basis in the shares is $10,000, or
$10 per share. Danton decides to take the stock instead of cash and receives an additional 100 shares.
The FMV of the stock at the time of the distribution is $15 per share. Danton must recognize $1,500 of
income ($15 FMV × 100 shares = $1,500), which also is his basis in the new shares.
Dividend Reinvestment Plans (DRIP)
A dividend reinvestment plan allows a taxpayer to use their dividends to purchase more shares of
stock in a corporation instead of receiving dividends in cash. If the taxpayer uses their dividends to
buy more stock at a price equal to its fair market value, the taxpayer must still report the dividends as
income, as illustrated in the example below.
Example: Francesco owns 100 shares of Applied Plastics, Inc., which is currently trading at $50 a share
on the open market. Through the company’s dividend reinvestment plan (DRIP), Francesco buys 50
additional shares at $40 per share. He must report $500 as dividend income ($10 per share difference
between FMV and purchase price multiplied by 50 shares).
Some plans also allow taxpayers to invest cash to buy shares of stock at a price less than fair market
value. In this case, taxpayers must report as dividend income the difference between the cash they
invest and the FMV of the stock they purchase.
Mutual Fund Distributions
A mutual fund is an investment vehicle that allows investors to pool their money to invest in stocks,
bonds, and other securities. The combined holdings of stocks, bonds, or other assets the fund owns are
known as its “portfolio.” Mutual funds are professionally managed by a portfolio manager. Mutual
funds generally distribute all of their ordinary income to shareholders by the end of the year to obtain
favorable tax treatment.
A taxpayer who receives mutual fund distributions during the year will also receive Form 1099-
DIV, identifying the types of distributions received. Mutual fund distributions are reported based on
the character of the income source and may include ordinary dividends, qualified dividends, capital
gain distributions, exempt-interest dividends, and nondividend distributions. Ordinary dividends are
the most common type of distribution from a mutual fund; these dividends are taxable as ordinary
income.
Capital gain distributions from a mutual fund are always treated as long-term, regardless of the
actual period the mutual fund investment is held. Distributions from a mutual fund investing in tax-
exempt securities are tax-exempt interest and retain their tax-exempt character for the payee. Even
so, the taxpayer must report them on his tax return.
If a mutual fund or Real Estate Investment Trust (REIT) declares a dividend payable to
shareholders in October, November, or December, but actually pays the dividend during January of the
following year, the shareholder is considered to have received the dividend on December 31 of the
prior tax year and must report the dividend in the year it was declared.

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Example: Alessandro has money invested in the Great Shares Mutual Fund. The fund declared a $230
dividend on December 27, 2024. Alessandro actually received the dividend the following year, on
January 9, 2025. Alessandro must report the dividend in 2024 and not in 2025. The dividend is taxable
in the year declared, regardless of whether Alessandro withdraws the dividends or reinvests them.

Constructive Distributions and Constructive Dividends

Certain transactions between a corporation and its shareholders may be considered constructive
distributions. In general, constructive distributions (also called “constructive dividends”) are assessed
under audit, and they can have very negative consequences for the company as well as to the
shareholder. They may be considered dividends and, therefore, taxable to the shareholders and non-
deductible to the corporation. Examples of constructive distributions include:
• Payment of personal expenses: If a corporation pays personal expenses on behalf of an
employee-shareholder, the amounts should be classified as a distribution, rather than expenses
of the corporation.
• Unreasonable compensation: If a corporation pays an employee-shareholder an
unreasonably high salary considering the services actually performed, the excessive part of the
salary may be treated as a distribution.
• Unreasonable rents: If a corporation rents property from a shareholder, any rent charged that
is considerably higher than what the shareholder would charge an outside party for the same
use of the property may be considered a taxable distribution to the shareholder. Conversely, if
a corporation rents property to a shareholder and the rent is unreasonably low, the discounted
portion of the rent could be treated as a distribution.
• Cancellation of a shareholder’s debt: If a corporation cancels a shareholder’s debt without
repayment by the shareholder, the amount canceled may be treated as a distribution.
• Property transfers for less than FMV: If a corporation transfers or sells property to a
shareholder for less than its FMV, the excess may be treated as a distribution.
• Below-market or interest-free loans: If a corporation gives a loan to a shareholder on an
interest-free basis or at a rate below the applicable federal rate, the uncharged interest may be
treated as a distribution.
Example: Erika’s father owns 95% of Spitfire Motorsports, Inc., and she and her siblings own the
remaining 5%. Erika performs administrative assistant duties part-time for the corporation and is paid
a salary of $700,000 yearly. The corporation also pays for various personal expenses Erika incurs, such
as monthly lease payments on her personal vehicle. The IRS would likely consider Erika’s salary as
unreasonably high based on the nature of her duties, meaning that a portion of the salary and the
personal expenses would be reclassified as constructive distributions. If that happens, then the
constructive distribution becomes taxable to Erika as a taxable dividend, and the amounts are no
longer deductible by the corporation as a business expense.

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Unit 6: Calculating the Basis of Assets

For additional information, read:
Publication 551, Basis of Assets
Publication 544, Sales and Other Dispositions of Assets

A large portion of tax law revolves around taxing assets. In order to accurately calculate gains and
losses from selling or disposing of an asset, it is necessary to classify the asset first. Assets can generally
be categorized into two main types: real property and personal property.
“Real property” refers to real estate, which includes land and anything permanently attached to
it. Examples of real property include: buildings, farmland, residential homes, commercial properties,
rental properties, and subsurface mineral rights.
“Personal property” encompasses all assets that are not classified as real estate. This includes
items such as furniture, equipment, vehicles, household goods, collectibles, and livestock. It also covers
intangible assets like stocks, trademarks, cryptocurrency, and copyrights. The tax treatment of an asset
may differ depending on whether it is intended for personal use, business purposes, or investment.
Note: It is important not to confuse the term “personal property” with “personal-use property.” While
“personal property” is a legal and accounting term used to describe any movable asset whether or not
it is used for business purposes, “personal-use” property specifically refers to assets that are used
personally by the taxpayer and not for trade, business, or investment.

Basis in General
In order to accurately determine profits and deficits, it is important to grasp the idea of “basis.” The
original basis of an asset is typically its purchase price. However, there may be cases where the basis
is calculated based on the fair market value at the time of acquisition, rather than the cost, such as
when property is inherited or gifted. The cost basis of an asset may include:
• Sales taxes charged during the purchase
• Freight-in charges and shipping fees
• Installation costs and testing fees
• Delinquent real estate taxes that are paid by the buyer of a property
• The cost of any major improvements to the property
• Legal and accounting fees for transferring an asset
Example: Ambrosio purchases a new vehicle for $15,000. The sales tax on the vehicle is $1,200. He
also pays a delivery charge to have the car shipped to his home from a dealership in another state. The
delivery charge is $210. Therefore, Ambrosio’s basis in the vehicle is $16,410 ($15,000 + $1,200 +
$210).
Example: Cassandra is a self-employed copywriter who reports her income on Schedule C. She
purchases a powerful new laptop for her home office. The laptop costs $3,540 with an additional $194
for sales tax. Cassandra’s basis in the computer is $3,734 ($3,540 + $194). This is also her basis for
depreciation.

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Certain post-acquisition costs can also increase the basis of an asset, including:
• The cost of extending utility service lines to the property and impact fees90
• Legal fees or court costs perfecting title to a property
• Legal fees for obtaining a decrease in an assessment levied against property to pay for local
improvements; and/or zoning costs and the capitalized value of a redeemable ground rent.
Example: Titus spent $45,000 to purchase a piece of farmland. However, he is soon faced with a title
dispute initiated by the former owner’s ex-wife, claiming that the sale was invalid. To defend his
ownership, Titus hires an attorney for $7,800. After successfully proving his rights to the land and
having the lawsuit deemed frivolous, Titus’s adjusted basis for the property increases to $52,800
(original cost of $45,000 plus legal fees of $7,800). It should be noted that while these legal fees are
not currently tax deductible, they do contribute to the basis of the property.
Example: Calix buys a house for $120,000, which he plans to use as a personal residence. Four months
after he closes the sale, he paves the driveway, which costs $9,000. Calix’s adjusted basis in the home
is now $129,000 ($120,000 original cost + $9,000 for major improvements).

Study Note: Understanding basis and how it is applied to various types of property is critical to your
success in passing Part 1 and Part 2 of the EA exam. You may be expected to calculate basis in multiple
scenarios.

Depreciation Deduction
Depreciation is a tax deduction that allows businesses to gradually recoup the cost of assets they
use over time. This process decreases the basis of an asset over the course of several years.
The annual amount allowed for depreciation is meant to account for natural wear and tear,
deterioration, or obsolescence of assets. Eventually, the asset will no longer be depreciable once its
basis has been fully recovered or if it is sold or retired from service. Some types of property, such as
land, cannot be depreciated, but most tangible assets like buildings, machinery, vehicles, furniture, and
equipment can be depreciated.
Study Note: Depreciation is an important accounting concept, so it is tested most often on Part 2:
Businesses of the EA exam. For Part 1 of the EA exam, test-takers must understand depreciation
primarily in the context of residential rental property. Most residential rental property is depreciated
over 27.5 years. Only the value of the building can be depreciated, never the land.

Dispositions and Holding Period

The length of time an asset is held determines whether any gain or loss from its sale will be
considered long-term or short-term. The holding period for an asset begins the day after it is acquired
and ends on the day it is sold. If an asset is sold, the difference between its initial cost and selling price
may result in a taxable gain or loss. In some cases, a gain or loss may not be recognized until a later
date after an asset has been disposed of or sold.

90An “impact fee” is a one-time capital charge imposed on property developers by municipalities to help fund the capital cost of
the additional public services. Impact fees are added to a property’s basis.
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To accurately report any taxable gain or loss from the sale or disposal of an asset, a taxpayer must
identify:
• Whether the asset is personal-use or used for business or investment;
• The asset’s basis or adjusted basis:
o As described above, the initial basis of an asset is usually its purchase cost, including certain
ancillary charges.
o “Adjusted basis” includes the original basis plus any increases or decreases (such as
subsequent improvements, depreciation deductions, casualty losses, rebates, and
insurance reimbursements).
• The asset’s holding period:
o Short-term property is held for one year or less.
o Long-term property is held for more than one year (at least a year, plus a day).91
• The proceeds from the sale.
Example: Kenji purchased 75 silver coins as an investment on January 1, 2024. The coins cost $23
each, plus an additional sales tax of $67. Kenji’s basis in the silver coins is $1,792 ([$23 × 75 coins] +
$67). On November 5, 2024, Kenji sold all the coins to a collector for $1,900. His net gain is $108
($1,900 - $1,792 basis). Kenji has a $108 short-term capital gain, because he held the coins for less than
a year. The short-term gain will be taxed at his ordinary income tax rate.
Example: Denise bought 500 shares of Aberdeen Inc. stock on January 1, 2024. If Denise sells the stock
the following year, right on January 1, 2025, the capital gain or loss will be short-term. If she sells the
property on January 2, 2025, (one year plus one additional day) her holding period will have been over
one year, and her capital gain or loss will be long-term.

Basis of Real Property (Real Estate)

The basis of real estate usually includes a number of costs in addition to the purchase price. If a
taxpayer purchases real property (such as land or a building), certain fees and other expenses are
automatically included in the cost basis. The transaction might include real estate taxes the seller owed
at the time of the purchase. If delinquent real estate taxes are paid by the buyer, those amounts must
be added to the property’s basis.
Example: Millie sells Anthony her home for $125,000. She had fallen behind on her property tax
payments, so Anthony agrees to pay $3,500 of delinquent real estate taxes as a condition of the sale.
Because a taxpayer is not allowed to deduct property taxes that are not his legal responsibility,
Anthony must add the property taxes paid to his basis. Anthony’s basis in the home is $128,500.
If a property is constructed rather than purchased, the property's basis includes all the
construction expenses. This includes payments to contractors, building materials, and fees for
inspections. Any expenses related to preparing the land, such as demolition costs, must be included in
the basis of the land itself, not the buildings constructed on it at a later date. If raw land is purchased
on its own, the basis includes the purchase price plus any legal and recording fees, abstract fees, and
land survey costs.

91Long-term capital gains are given more favorable tax treatment. Although most assets have to be held for over one year in order
to be treated as “long term” an exception applies to assets acquired through inheritance, which we will cover later.
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Example: Dianne pays $50,000 for an empty lot where she plans to build her dream home. She also
pays $2,800 to remove ten old tree stumps and $6,700 to demolish an existing concrete foundation on
the lot. These costs must be added to the basis of the land, not to the basis of the future house.
Therefore, Dianne’s basis in the land is $59,500 ($50,000 + $2,800 + $6,700).
Settlement Costs: Generally, a taxpayer must include settlement costs for the purchase of property
in his basis. The following fees are some of the closing costs that can be included in a property’s basis:
• Abstract fees
• Charges for installing utilities
• Legal fees (including title search and preparation of the deed)
• Recording fees and land surveys
• Transfer taxes
• Owner’s title insurance
Also included in a property’s basis are any other amounts the seller legally owes that the buyer
agrees to pay, such as recording or mortgage fees, charges for improvements or repairs, and sales
commissions. However, a taxpayer cannot include fees incidental to getting a loan in the basis of the
property financed with proceeds from the loan. Settlement costs do not include any amounts placed in
escrow for the future payment of items, such as taxes and insurance.
Basis Other Than Cost
The following are examples of situations in which an asset’s basis is determined by something other
than the purchase cost.
Property in Exchange for Services: When a taxpayer receives property in exchange for services,
they are required to report the property’s fair market value as income. This value then becomes their
basis for the property. In situations where two individuals have agreed on a price for services
beforehand, this agreed-upon cost can be used to determine both the amount of income and the asset’s
basis.
Example: Jeremy is a licensed CPA who prepares a tax return for his client, Maryanne. Maryanne loses
her job and cannot pay Jeremy’s bill, which totals $400. Maryanne offers Jeremy an antique vase
instead of paying her invoice. The fair market value of the vase is approximately $525. Jeremy agrees
to accept the vase as full payment on Maryanne’s delinquent invoice. Jeremy’s basis in the vase is $400,
the amount of the invoice that was agreed upon beforehand by both parties.
Basis After Casualty Loss: If a taxpayer has a deductible casualty loss, the taxpayer should
increase the basis in the property by the amount spent on repairs that restore the property to its pre-
casualty condition. However, a taxpayer must decrease the basis of the property by any related
insurance proceeds.
Example: Giovanni paid $5,000 for a used truck several years ago. His truck was damaged in a severe
hailstorm, so he spends $3,000 to repair it. He does not have insurance on the vehicle to cover storm
damage, so he pays for all the repairs himself, out-of-pocket. Therefore, his new basis in the truck is
$8,000 ($5,000 original cost + $3,000 restoration repairs).

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Basis After Mortgage Assumption: If a taxpayer buys a property and assumes an existing
mortgage on it, the taxpayer’s basis includes the amount paid for the property plus the amount owed
on the mortgage.92 The basis also includes the settlement fees and closing costs paid to buy the
property. However, fees and costs for obtaining a loan on the property (points) are not included in a
property’s basis.
Example: Sabrina’s cousin, Pablo, is selling his office building because he can no longer afford the
mortgage payments. Sabrina agrees to purchase the office building for $220,000 cash, and she also
assumes Pablo’s existing mortgage of $800,000 on the property. Therefore, Sabrina’s basis in the
building is $1,020,000 ($220,000 cash + $800,000 mortgage assumption).

Basis of Securities
When a taxpayer purchases securities, their basis is usually the cost, plus any additional fees, such
as brokers’ commissions. When these securities are later sold, the broker should provide the taxpayer
with Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, which shows the proceeds
from the transaction.93 The IRS also receives a copy of this form. In cases where Form 1099-B does not
include information about the taxpayer’s basis in the sold securities, the taxpayer must provide it
themselves using their personal records.94 Failure to provide evidence of basis may result in the IRS
assuming it is zero.
A taxpayer may own more than one block of shares in a particular company’s stock. Each block may
differ from the others in its holding period (long-term or short-term), its basis, or both. When
instructing a broker to sell shares, the taxpayer can specify which set, or portion of a set, they wish to
sell; this is known as “specific identification.” Keeping accurate records is essential for using this
method. However, it makes calculating the holding period and starting value of sold stock easier, and
it allows the taxpayer greater control over identifying profits and/or losses when selling a portion of
their investment. If the taxpayer cannot identify a specific set at the time of sale, the shares sold are
considered to be from the earliest set purchased. This technique is referred to as First In, First Out
(FIFO). The IRS requires stockbrokers and mutual fund companies to report the basis for most stock
sold on Form 1099-B, Proceeds From Broker and Barter Exchange Transactions. The form also includes
any federal income tax that has been withheld (if any). The reporting is made to investors and to the
IRS.
Example: Sharleen buys two blocks of 400 shares of stock (800 shares total). She bought the first 400
shares on May 1, 2022, for $11,200 and an additional 400 shares on June 1, 2022 for $12,000. On June
20, 2024, she sells 400 shares for $11,500 without specifying which block of shares she was selling.
The sold shares are therefore treated as coming from the earliest block purchased (those purchased
on May 1, 2022). Since the basis and holding period defaults to the original block of shares, Sharleen
realizes a long-term capital gain of $300 ($11,500 - $11,200).

92 An "assumable" mortgage allows a buyer to take over the seller's existing home loan. This can be appealing if interest rates have
risen since the seller's purchase, offering the buyer a potentially lower rate.
93 Form 1099-DA, introduced by the IRS, will report digital asset transactions like cryptocurrencies and NFTs, starting January 1,

2025. Please note that digital assets are not considered securities for federal tax purposes.
94 “Noncovered” securities are exempt from broker cost basis reporting due to several factors. For example, cost basis may be

missing when the shares are acquired by gift or inheritance, or if the shares were purchased long ago, when investment firms were
not required to track this information. In that case, the taxpayer is responsible for knowing their own stock basis.
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Note: You must understand how to calculate the basis of securities and other assets, because this
subject is frequently tested on Part 1 of the exam.
After purchasing stock, subsequent events may result in changes to the basis per individual share.
These adjustments can either increase or decrease the original basis. Examples of such events include
stock dividends and stock splits. While these events are typically not taxable, a stock dividend may be
subject to taxes if shareholders have the choice to receive cash or other assets instead of additional
stock.
• Stock dividends are additional shares a company grants to its shareholders in lieu of paying
cash dividends and are often nontaxable. When nontaxable, these additional shares increase
the number of shares owned by an individual shareholder, so their original basis is spread over
more shares, which decreases the basis per individual share. The total basis of all the shares
remains the same.
• A stock split is similar to a stock dividend and occurs when a company issues additional shares
of stock for every existing share an investor holds. Stock splits are a way for a company to lower
the market price of its stock. The stock’s market capitalization, however, remains the same.
For example, in a 2-for-1 stock split, a corporation issues one share of stock for every share
outstanding. This decreases a shareholder’s basis per individual share by half. An original basis of $200
for 100 shares becomes $200 for 200 shares in a 2-for-1 stock split. However, the total basis in the
stock remains the same even though the basis per share decreases.

Example: Leticia pays a total of $1,050 for 100 shares of Azure Cola, Inc., plus an additional broker’s
commission of $50. This means her initial cost for the 100 shares is $1,100 ($1,050 original cost + $50
broker’s commission). This equals $11 per share ($1,100 ÷ 100 shares). At a later point in time, Leticia
receives a stock dividend of 10 shares without any tax implications. However, her original basis of
$1,100 must now be divided over 110 shares (the initial 100 shares plus the additional ten-share
dividend). Her basis per share decreases to $10 ($1,100 ÷ 110).
Example: Irwin buys 100 shares of Cortex Technology, Inc. for $50 per share. His cost basis is $50 ×
100 shares or $5,000. Six months later, Cortex Technology, Inc. declares a 2-for-1 stock split, and Irwin
receives 100 additional shares of stock. Therefore, his new basis in each individual stock is $25 =
($5,000 ÷ [100 + 100]). His total basis in the shares remains $5,000.

Stock Options
A taxpayer may purchase options to buy or sell securities (such as stocks or commodities) through
an exchange or in the open market. With a stock option, an investor can choose to buy or sell a stock
at a predetermined price. There may be a gain or loss from trading just the option itself, or the investor
can exercise the option and buy or sell the underlying securities, which could result in a gain or loss
from those securities.
Example: Peter is a casual investor. He purchases a call option in Wellstone Manufacturing Inc., which
allows him to buy company stock at $5 per share. Two weeks later, the stock’s price climbs to $10 a
share. Peter can use his option contract to buy that stock at a discount, or he could sell the option itself
for a profit.

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Companies may also offer stock options to their employees as a form of equity-based
compensation. This is typically done to motivate employees, increase loyalty, and decrease employee
turnover.
Example: Zidan works for Worthington Corporation. On January 1, 2024, Zidan is granted 30,000
shares of incentive stock options (ISOs) with a grant price of $20 per share. These options would vest
(become exercisable) over a four-year period, meaning that he would have to stay at the company for
at least four years in order to exercise them all. Zidan is pleased to get the options. In this way, the
stock options motivate employees and lower employee turnover.

Generally, there are two types of stock options:

• Options granted under an employee stock purchase plan (ESPP) or an incentive stock option
(ISO) plan are statutory stock options. When exercising ISOs, no taxes are due until the
eventual sale of the shares. Although incentive stock options come with favorable tax
treatment, they may be subject to alternative minimum tax (AMT) in the year of exercise.
• Stock options that are not granted under an employee stock purchase plan or an ISO plan are
called nonstatutory stock options.95 Generally, a taxpayer recognizes taxable wage income
upon the exercise of a nonstatutory stock option. The taxable wage income is the difference
between the fair market value of the stock on the exercise date and the option price and will be
reflected on the employee’s Form W-2.
The nature, timing, and amount of income that needs to be reported by the taxpayer depends on
whether the options are statutory or nonstatutory options.
The tax advantage of a statutory stock option is that income is not reported when the option is
granted or when it is exercised. Income is only reported once the stock is ultimately sold.

Note: For Part 1 of the EA Exam, you must understand the concept of stock options from the
perspective of the individual taxpayer receiving the options. For Part 2 of the EA Exam, you must
understand stock options from the point of view of the corporation issuing the stock options.
Example: Muscle Fitness, Inc. has an employee stock purchase plan (ESPP). The plan allows employees
to purchase company stock at a discounted price. The “option price” is the lower of the stock price at
the time the option is granted, or at the time the option is exercised. Annamaria is an employee of
Muscle Fitness, and she decides to take advantage of the ESPP that her employer provides. Muscle
Fitness deducts $5 from Annamaria’s pay every week for 48 weeks (total = $240 [$5 × 48]). The value
of the stock when the option was granted was $25. When Annamaria exercises her options, the FMV of
the stock is $20. Annamaria receives 12 shares of Muscle Fitness stock ($240 ÷ $20). Her holding
period for all 12 shares begins the day after the option is exercised, even though the money used to
purchase the shares was deducted from her pay on many different days. Annamaria holds onto all the
shares and does not plan to sell them. Her basis in each share is $20 (based on an example in
Publication 525).

95Refer to Publication 525, Taxable and Nontaxable Income for more information on the treatment of statutory or nonstatutory
stock options.
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Property Transfers Incident to Divorce

When property is transferred from one spouse to another, the recipient’s adjusted basis remains
the same as the original owner’s. Typically, there will be no tax implications for this transfer, regardless
of whether it was due to divorce or not.
For property transfers related to a divorce, the transfer generally must occur within one year after
the date the marriage ends. This nonrecognition rule applies even if the transfer was in exchange for
cash, the release of marital rights, the assumption of liabilities, or other financial considerations.96
Example: Quinton and Adrienne finalized their divorce on January 23, 2024. Quinton owns a vacation
home in Hawaii with a current adjusted basis of $285,000 and a fair market value of $550,000.
Pursuant to their divorce agreement, Quinton agrees to transfer his ownership in the home to
Adrienne. He transferred the property to Adrienne on June 1, 2024. Since the transfer was made within
a year after their divorce was made final, there is no gain or loss recognized by either spouse, and no
tax reporting is required. Adrienne’s basis in the property is the same as Quinton’s basis before the
transfer: $285,000.
Example: Adelynn and Graham jointly co-owned an antique collector Porsche that had a basis of
$50,000 and an FMV of $150,000. When they divorced in 2024, Adelynn transferred her entire interest
in the automobile to Graham as part of their property settlement. Graham’s basis in the vehicle is the
same as their original joint basis of $50,000.

The Basis of Gifted Property

The basis of property received as a gift is determined differently than property that is purchased
or inherited. The taxpayer must know the donor’s adjusted basis in the property when it was gifted, its
fair market value on the date of the gift, and the amount of gift tax the donor paid on it (if any). The
concept of “fair market value” is important when calculating any capital gains tax liability on a gift, so
it is important to know how the basis and the FMV is determined.
Generally, the basis of gifted property for the donee is equal to the donor’s adjusted basis. This is
called a “transferred basis.” For example, if a father gives his son a car and the father’s basis in the car
is $4,000, the basis of the vehicle remains $4,000 for the son. The holding period of the gift would also
transfer to the donee.
Example: Matteo purchases a valuable collectible stamp on February 2, 2024 for $1,000. Matteo gives
the stamp to his daughter, Anne, on April 2, 2024, for her 25th birthday. Anne lists the stamp online and
sells it on May 2, 2024 for $1,500. Since Matteo only held the stamp for two months before giving it to
Anne, and Anne only held the stamp for a month, their combined holding period is less than a year.
Anne has a short-term capital gain on the stamp ($1,500 sale price - $1,000 transferred basis). Anne’s
gain will be taxed at ordinary income rates. She will be required to report the sale on Schedule D and
Form 8949.

96 A divorce, for this purpose, also includes the end of a marriage by annulment or due to violations of state laws, such as bigamy.
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Example: Madden is a casual investor. He decided to sell 600 shares of Centrex, Inc. on September 25,
2024 for a net sales price of $1,600. When Madden receives his Form 1099-B, it shows the sales price,
but not the basis, because his father had gifted the shares to him many years ago, and his brokerage
firm does not track the basis of gifted stock. However, Madden knows that his father originally paid
$1,455 for the stock, so $1,455 will be used as Madden’s basis to calculate his gain or loss on the sale.
As a result, Madden will report a long-term capital gain of $145 on Schedule D.
Example: Shira’s father, Logan, gives her 50 shares of IBM stock he purchased ten years ago. Logan
originally purchased the stock for $1,800. Shira’s basis in the stock, for purposes of determining gain
on any future sale, is also $1,800 (this is a transferred basis). Shira is also considered to have “held”
the stock for ten years, the same amount of time that her father held the stock.
However, in situations where the fair market value of the property on the date of the gift is less
than the transferred basis, the donee’s basis for gain is the transferred basis. However, if the donee
reports a loss on the sale of gifted property where the fair market value of the property on the date of
the gift is less than the transferred basis, the basis is the FMV of gifted property on the date of the gift.
The sale of gifted property can also result in no gain or loss. This happens when the sale proceeds
are greater than the gift’s FMV but less than the transferred basis in situations where the fair market
value of the property on the date of the gift is less than the transferred basis. The extended example,
next, explains this scenario.
Extended Example: Noah’s aunt, Fatima, bought 100 shares of Fairway Airlines Inc. stock when it was
at $92 per share. Fatima’s basis for the 100 shares is $9,200. Fatima gives Noah the stock when it is
selling at $70 and has an FMV of $7,000 (it has lowered in value). In this case, Noah has a “dual basis”
in the stock. He has one basis for determining gain and a different basis for determining a loss. Here
are three separate scenarios that help illustrate how the gain or loss would be calculated when Noah
sells his gifted stock:

Scenario #1: If Noah sells the stock for more than his aunt’s basis, he will use her basis to determine
his amount of gain. For example, if he sells the stock for $11,000, he will report a gain of $1,800
($11,000 - $9,200).
Scenario #2: If Noah sells the stock for less than the FMV of the stock at the time of the gift ($7,000 in
the example), he will use as his basis the FMV at the time of the gift to determine the amount of his loss.
For example, if the stock continues to decline, and Noah eventually sells it for $4,500, he can report a
loss of $2,500 ($7,000 - $4,500).
Scenario #3: If Noah sells the stock for an amount in between the FMV and the donor’s basis, no gain
or loss will be recognized. For example, if Noah sells the stock for $8,000, there will be no gain or loss
on the transaction (his basis will be deemed to be $8,000, the same as his sales price).

The Basis of Inherited Property

The basis of inherited property is treated very differently for tax purposes as compared to gifts. In
most cases, the basis of inherited property is the fair market value of the property on the date of the
decedent’s death, regardless of what the deceased person paid for the property or the adjusted basis

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of the property right before death. In addition, when a beneficiary sells inherited property, it is deemed
to have a long-term holding period, regardless of how long the beneficiary held it.
When inherited property is sold by a beneficiary, the gain will be calculated based on the change
in value from the date of death. This usually results in a beneficial tax situation for anyone who inherits
property because the taxpayer generally gets an increased or “stepped-up” basis.
Example: When Libby’s uncle, Jonathan, passed away, she inherited 300 shares of stock that he had
purchased for $850 twenty years ago. At the time of his death, the shares were valued at $19,000, so
that is now her basis. This is known as a “stepped up” basis. Three months after inheriting the stock,
Libby sells all the shares for $21,000, resulting in a long-term capital gain of $2,000 ($21,000 -
$19,000). Although Libby held the stock for less than a year, it is inherited property and therefore
qualifies for beneficial tax treatment.
However, there are cases in which this rule can work against taxpayers. Although the value of most
property, such as stock, collectibles, and bonds, generally increases over time, there are also instances
in which a property’s value drops. This creates a “stepped-down” basis.
Example: Norbert purchased a home with cash in Connecticut for $240,000. His neighborhood
becomes riddled with crime, and Norbert’s home declines in value. On February 3, 2024, Norbert died.
On the date of his death, the home’s FMV was only $198,000. Norbert’s daughter, Nikki, inherits the
home. Nikki’s basis in the home is $198,000. This is a “stepped-down” basis situation.

Example: Anson bought 100 shares of stock many years ago for $10,000. In 2024, Anson dies, and his
daughter, Haley, inherits her father’s stock. On the date of Anson’s death, the value of the stock had
plummeted to $5,000, meaning Haley’s basis in the stock is “stepped down” for tax purposes to $5,000.
The stock continued to decline, so six months later, she sold the stock for $4,000. Haley has a long-term
capital loss of $1,000 ($5,000 -$4,000), the difference between her inherited basis and the selling price.
Although the basis of an estate for estate tax purposes is usually determined on the date of death,
a special rule allows the estate’s personal representative to elect a different valuation date of six
months after the date of death. This is known as the alternate valuation date. To elect the alternate
valuation date, the estate’s value and related estate tax must be less than they would have been on the
date of the taxpayer’s death.
If the alternate valuation date has been elected for the estate, the basis for inherited assets is
normally the fair market value of the assets six months after the date of death. However, if any assets
are received from the estate less than six months after the date of death, the basis in these inherited
assets is the fair market value as of the date the asset was distributed to the heir. If a federal estate tax
return (Form 706) is not filed for the deceased taxpayer, the basis in the beneficiary’s inherited
property is the FMV value at the date of death, and the alternate valuation date does not apply.

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Unit 7: Capital Gains and Losses

For additional information, read:
Publication 550, Investment Income and Expenses
Publication 523, Selling Your Home
Publication 544, Sales and Other Dispositions of Assets
Capital Assets
In the previous chapter, we covered assets in a general sense. This chapter will delve into capital
gains and losses, which occur when a taxpayer sells or disposes of their capital assets. Personal or
investment items are often considered “capital assets,” meaning that any net gains from their sale may
be subject to more favorable tax rates for capital gains.
The specific rate depends on factors such as how long the asset was held, what type of asset it is,
and the taxpayer’s income bracket. Some examples of common individual-owned capital assets include
a primary residence or vacation home, furniture, vehicles, boats, antiques and collectibles,97 stocks,
bonds, mutual funds (excluding those held by professional securities dealers), and digital assets (e.g.,
cryptocurrency or virtual currency). 98
Losses from the sale of personal-use property, such as a main home, a vacation home, personal-use
furniture, or jewelry, are not deductible and cannot be used to offset capital gains. However, gains from
the sale of personal-use assets usually are taxable, subject to certain exclusions.
Example: Judith collects antique coins as a hobby. She is not a professional coin dealer. Ten years ago,
Judith purchased an antique Roman coin at an estate sale for $50. In 2024, she was offered $6,000 for
the coin, and she promptly sells it for the offered price. Judith has a taxable capital gain of $5,950 that
she must report on her tax return. Since she held the coin for more than one year, she may be eligible
for favorable capital gains rates if her applicable tax rate on ordinary income happens to be greater
than 28% as this was a sale of a collectible.
Example: Ismail owns a station wagon that he uses to commute to work and run errands. He
purchased the station wagon four years ago for $24,000. He decides to buy a new vehicle this year, so
he sells his station wagon to a private party for $13,000 in cash. Ismail does not have to report the sale,
and he cannot claim a loss from the sale since it is his personal-use vehicle.

How to Report the Sale of Capital Assets

Most people possess multiple assets, such as investments (stocks and bonds) and other valuable
items like collectibles, primary residences, or vacation homes. The profit or loss for each asset is
calculated individually, and the tax consequences vary depending on the type of asset sold. For capital
assets, gains and losses are typically reported using two forms: Schedule D, Capital Gains and Losses,
and Form 8949, Sales and Other Dispositions of Capital Assets.99

97 Antiques and collectibles (such as artwork and coin collections), while normally capital assets for nondealers, have special tax
rates applicable if they are sold at a gain and held greater than a year prior to sale. The tax rate on long-term capital gains on
antiques and collectibles is taxed at the individual’s ordinary tax rate, but at a maximum rate of 28%.
98 IRS Notice 2014-21 states that, for federal tax purposes, virtual currency is treated as property.
99 Capital assets include homes (such as personal residences and vacation homes), stocks, vehicles, coins, artwork, and other

collectibles. In the case of individuals, a “capital asset” is typically anything the taxpayer owns for personal or investment purposes.
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Schedule D is used to report gain or loss on the sale of investment property and most capital gain
(or loss) transactions. The taxpayer may also have to complete Form 8949, Sales and Other Dispositions
of Capital Assets. Form 8949 reports specific details about each sale the taxpayer makes during the
year. Form 8949 is used to report the following:
• The sale or exchange of capital assets, including digital assets, like cryptocurrency
• Gains from involuntary conversions (other than from casualty or theft)
• Nonbusiness bad debts and
• Worthless securities
• The election to defer capital gain invested in a qualified opportunity fund (QOF) and the
disposition of interests in QOFs.
There are two parts to Form 8949. The first part is for short-term assets, and the second part is for
long-term assets. This form must be filed along with Schedule D, which contains the summary of all
capital gains and losses.
Example: Carmen received both a Form 1099-S and a Form 1099-B in 2024. The 1099-S was for the
sale of farmland, and the 1099-B was for the sale of stock. Carmen also sold some cryptocurrency in
2024, but she did not receive an information statement for the sale. Carmen should report all these
transactions on Form 8949. The totals from Form 8949 will then be transferred to Schedule D, where
all her capital transactions will be summarized and “netted” for the year.
Example: On August 1, 2024, Guadalupe received a collectible model train as a gift from her uncle. Her
uncle originally purchased the train for $1,300 on January 1, 2024. Two months later, a collector offers
Guadalupe $1,500 for the train, and Guadalupe decides to sell it. On her tax return, she reports $200 of
short-term capital gain from the sale ($1,500 - $1,300) on Form 8949 and Schedule D. Since the train
was held less than a year (adding up the time her uncle owned it and Guadalupe owned it), the gain
will be short-term and taxed at ordinary income tax rates.
Some sales and dispositions can be reported on Schedule D without also reporting them on Form
8949. This is only possible if the taxpayer received a Form 1099-B that reports the basis to the IRS and
does not include any nondeductible wash sale losses. Additionally, no adjustments need to be made to
the basis or type of gain or loss reported on Form 1099-B, or to their overall gain or loss.
Noncapital Assets
Assets held for business-use or created by a taxpayer for purposes of earning revenue (copyrights,
inventory, etc.) are considered noncapital assets. The following assets are common noncapital assets:
• Inventory held for sale to customers
• Depreciable property used in a business, even if it is fully depreciated
• Real property used in a trade or business, such as a commercial building or a rental
• Self-produced copyrights, transcripts, manuscripts, photographs, or artistic compositions
• Accounts receivable or notes receivable acquired by a business
• Stocks and bonds held by stockbrokers and professional securities dealers
• Business supplies
• Commodities and derivative financial instruments

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Gains and losses from the sale of business assets are typically reported on Form 4797, Sales of
Business Property, and in the case of individual taxpayers, the amounts flow through to Form 1040,
Schedule D, Capital Gains and Losses. However, the sale of the inventory is reported as ordinary income
on Schedule C (or Schedule F) and not as an asset sale on Form 4797.
Example: Nolan is the sole proprietor of Powerhouse Gym, a popular fitness club. He reports his
income and loss on Schedule C. In 2024, he sells several used treadmills in order to make room for new
gym equipment. Since the used equipment was business property, and not capital assets, Nolan would
report the sale of the equipment on Form 4797. Also, during the year, Nolan sells some stock at a
substantial profit. He is a casual investor and not a professional stockbroker, so he must report his
capital gains from the sale of stock on Schedule D and Form 8949.
Example: Lester is a farmer who reports his earnings and expenses on Schedule F. In 2024, he sells a
used farm tractor at a loss. The tractor is a noncapital asset, and the sale must be reported on Form
4797, Sales of Business Property. In addition, Lester also sells 7,000 bushels of wheat that he grew on
his farm. Since the wheat is considered a farm product, it is classified as inventory. Any income from
the sale of farm products grown and sold by a farmer must be reported as business income on Schedule
F. This income will be subject to both income tax and self-employment tax.
Example: Gerald is a self-employed author who has written several popular children’s books. During
the year, he sells one of his copyrights to a large publisher. Since Gerald is the creator of the copyright,
it is a noncapital asset in his hands. The copyright is not eligible for capital gains treatment, and Gerald
will owe ordinary income tax on the sale. He must use Form 4797 to report the sale of the copyright.
Also, during the year, Gerald sells his vacation home at a substantial loss. Gerald never rented the home
and it was only used for family vacations. His vacation home is a capital asset, but since it is also
personal-use property, he cannot deduct the loss.

Unlike capital assets, the costs of many noncapital assets may be deducted as business expenses
when they are sold, and losses are generally fully deductible. Depending on the circumstances, a gain
or loss on a sale or trade of property used in a trade or business may be treated as either capital or
ordinary (this topic is covered in more detail in Book 2, Businesses).
Holding Period (Short-Term or Long-Term)
When a taxpayer disposes of investment property, such as stocks and bonds, the holding period
affects the tax treatment. This is important because long-term capital gains are taxed at lower rates
than short-term gains. If a taxpayer holds investment property for more than one year, any capital gain
or loss is long-term capital gain or loss. If a taxpayer holds investment property for one year or less,
any capital gain or loss is short-term capital gain or loss.
Long-term = more than one year (at least a year and a day)
Short-term = one year or less
To calculate the holding period of investment property, one must start counting on the day after
they acquire the property and end on the day they sell it. The date of the sale is included in the holding
period.

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Example: Leesa bought 50 shares of XYZ stock on February 2, 2024, for $10,000. She sells all the shares
on February 2, 2025, for $20,500. She held the stock for exactly one year. Since Leesa’s holding period
is not more than one year, she has a short-term capital gain of $10,500. The short-term gain is taxed at
ordinary income tax rates. If Leesa had waited just a few more days to sell the stock, she would have
received long-term capital gain treatment, and the gain would have been taxed at a lower rate.
Example: Zoran bought 100 shares of Momentum Pharmaceuticals, Inc. stock on January 1, 2024, for
$1,200. He sells all the stock on January 5, 2025, for $2,850. Zoran’s holding period exceeds one year,
and therefore, he will recognize a long-term capital gain of $1,650 in 2025, the year in which he actually
sold the stock ($2,850 - $1,200).
Stock shares acquired because of a nontaxable stock dividend or stock-split100 have the same
holding period as the original shares owned.
Example: Five years ago, Cagney bought 500 shares of Stellar Biotechnology, Inc. stock for $1,500. On
June 6, 2024, Stellar Biotechnology distributes a 2% nontaxable stock dividend (10 additional shares).
Three days later, Cagney sells all his stock for $2,300. Although Cagney owned the 10 shares he
received as a nontaxable stock dividend for only three days, a long-term holding period applies to all
of his shares. Because he bought the stock for $1,500 and then sold it for $2,300 more than a year later,
Cagney has a long-term capital gain of $800 on the sale of the 510 shares.
The holding period for a gift is treated differently than the holding period for purchased property.
If a taxpayer receives a gift of property, their holding period normally includes the donor’s holding
period. This concept is known as “tacking on” the holding period.
Example: Sophia gives her favorite nephew, Dustin, an acre of land. At the time of the gift, the land had
an FMV of $13,000. Sophia’s adjusted basis in the land was $12,000, which she originally paid for the
property. Sophia only held the land for six months prior to making the gift. Dustin holds the land for
another seven months and then sells it for $14,200. Neither held the property for over a year.
Regardless, Dustin may “tack on” his holding period to his aunt’s holding period. Jointly, they held the
property for 13 months, which is more than one year. Therefore, Dustin has a long-term capital gain of
$2,200 ($14,200 - $12,000), which will be taxed at beneficial tax rates.
When a taxpayer acquires property through inheritance, it is automatically classified as long-term
property. This means that even if a person sells their inherited property shortly after receiving it, the
holding period for tax purposes will still be considered long-term. This rule applies regardless of the
actual length of time the beneficiary or the decedent held the asset.
Example: Nella inherited a vacation home from her father, who died on February 10, 2024. The fair
market value of the house was $210,000 on the date of her father’s death. Nella immediately puts the
house up for sale. On August 30, 2024, the house is sold for $215,000. Nella has a long-term capital
gain of $5,000 on the sale. All the gain is treated as long-term, even though she held the property for
only a few months, because inherited property is always treated as long-term.

100A stock split is when a corporation increases the number of its outstanding shares, generally to boost a stock’s liquidity. A stock
split revalues the price per share and increases the total number of shares by the issuance of additional shares to existing
shareholders.
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Example: Madeline purchased gold bars as an investment on January 3, 2024, paying $11,000. Six
months later, on July 3, 2024, Madeline dies, and her only son, Ezra, inherits her entire estate. On the
date of Madeline’s death, the gold bars were valued at $10,500 (they had dropped in value). Ezra holds
the gold bars for one more month, and the bars continue to drop in value. Ezra decides to sell them to
a pawn shop for $9,500. Ezra has a $1,000 long-term capital loss. The loss is treated as long-term,
because inherited property is always treated as long-term, even if the decedent or the beneficiary does
not hold the property for a year.

Determining Capital Gain or Loss

A taxpayer determines gain or loss on a sale or trade of stock or property by comparing the amount
realized with the adjusted basis of the property. A disposition of stock and the related income or loss
must always be reported in the year of the sale, regardless of when the taxpayer actually receives the
proceeds.
Capital losses are netted against any capital gains that may be generated in the same year. A
taxpayer can deduct up to $3,000 ($1,500 for MFS) of net capital losses against ordinary income in a
tax year. Unused losses above this limit are carried over to subsequent years.
Example: Lucas purchased 100 shares of stock three years ago for $16,000. His stock declines in value,
and he sells all the shares in 2024 for $9,000, generating a $7,000 long-term capital loss on the sale. He
also earned $60,000 of wages during the year. He can claim $3,000 of his long-term capital loss against
his ordinary income, thereby lowering his gross income to $57,000 ($60,000 - $3,000). The remainder
of the long-term capital loss ($4,000) must be carried forward to the following year.
Carryover losses are combined with gains and losses that occur in the next year. A taxpayer first
nets short-term capital gains and losses (including carryover losses) against each other, and then long-
term capital gains and losses (including carryover losses) against each other. The results are then
netted against each other, if applicable.
Any net capital losses carried over retain their character as either long-term or short-term and are
reported on Schedule D. Thus, a long-term capital loss carried over to the next tax year will reduce that
year’s long-term capital gains before it reduces that year’s short-term capital gains.
A net capital loss can be carried over indefinitely during the taxpayer’s life. However, once a
taxpayer dies, the capital losses not used on the final return cannot be carried over to a beneficiary or
an heir. Capital losses always belong to the decedent. Any capital loss carryovers that are not used on
the taxpayer’s final return are lost forever.

Example: Ethan has $13,000 of capital losses from the sale of cryptocurrency in 2024. On December
20, 2024, Ethan dies. His executor may claim the capital losses on Ethan’s final individual tax return,
up to the allowable limit. However, any unused capital losses cannot be carried over to a future year,
because Ethan is dead. The losses do not transfer to Ethan’s estate or to his heirs.
Digital assets, such as cryptocurrencies and nonfungible tokens (NFTs), are typically treated as
property and their sale or disposition generally results in capital gain or loss. Exchanging one digital
asset for another is generally treated as a disposition and is a fully taxable event.

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Example: On April 30, 2024, Kaito exchanged $63,000 of Bitcoin for $63,000 of Ethereum. The Bitcoin
was purchased in 2018 for $7,800. Kaito has a long-term capital gain of $55,200 on the exchange. Also,
on May 10, 2024, Kaito sells Litecoin for $3,820. Kaito had purchased Litecoin (another type of
cryptocurrency) on February 10, 2024, for $9,660 cash (purchased and sold in the same year). Kaito,
therefore, has a $5,840 short-term capital loss on the sale of Litecoin. His losses and gains are “netted”
for the year. Kaito will report a net long-term capital gain of $49,360.
Digital Asset Basis Sale or Exchange Gain or (Loss)
Price
Bitcoin $7,800 $63,000 Long-term gain: $55,200
Litecoin $9,660 $3,820 Short-term loss: ($5,840)
Kaito’s Net Capital Gain: $49,360

Special rules apply to married couples. Married taxpayers are at a disadvantage when deducting
capital losses. On a joint return, the net capital loss deduction limit is still $3,000, which is the same
limit for unmarried taxpayers. And MFS filers only get half of that limit (a $1,500 capital loss limit can
be offset against other income).
Example: Ariana purchased 100 shares of BMC, Inc. stock two years ago for $6,800. The stock declines
in value, and she sells all her BMC shares on December 20, 2024, for $4,000, resulting in a $2,800
capital loss. She is married, but always files separately from her husband. Ariana has $52,000 in wages
for the year. Since she is filing MFS, Ariana can only claim $1,500 of her long-term capital loss against
her ordinary income, thereby lowering her gross income to $50,500 ($52,000 - $1,500). The remainder
of the long-term capital loss ($1,300) must be carried forward to the following tax year.
Example: Monique and Jerrod are married and live in Florida, a non-community property state. They
keep their income separate and plan to file separate returns (MFS). In 2024, Monique sells some stock
that she owns and incurs a ($5,000) capital loss. Jerrod also sells some stock and has a $12,500 capital
gain. Monique can only claim ($1,500) of her loss on her tax return because she is filing MFS. Jerrod
cannot use any of Monique’s losses on his return, because they are filing separate returns. Jerrod must
pay tax on his entire capital gain on his separate tax return. If they had instead chosen to file jointly,
then their capital losses would have “offset” each other, which would have reduced the amount of their
taxable gain to $7,500 ($12,500 Jerrod’s capital gain - $5,000 Monique’s capital loss).

Capital Gains from Mutual Funds

A mutual fund is a regulated investment company generally created by pooling funds of investors
to allow them to take advantage of a diversity of investments and professional management. Two
different types of transactions may result in taxable capital gains reporting by a taxpayer who invests
in mutual funds. First, profits resulting from investments made by the fund itself are reported to its
own shareholders as capital gain distributions on Form 1099-DIV. The capital gain distributions are
always taxed at long-term capital gains tax rates, without regard to how long a taxpayer has owned
shares in the mutual fund.
If a taxpayer disposes of shares that represent all or a portion of his investment in the mutual fund
itself, a Form 1099-B will be issued. The taxable gain or loss that results from the sale or exchange of

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the taxpayer’s shares in the mutual fund is reported on Form 1040, Schedule D. Brokers are now
required to include the basis of mutual funds on Form 1099-B.
Wash Sales
A “wash sale” occurs when an investor sells a security to claim a capital loss, only to repurchase it
again very soon thereafter. A taxpayer cannot deduct a loss on the sale of an investment if a
substantially identical investment is purchased within 30 days before or after the sale.101 A wash sale
is considered to have occurred when a taxpayer sells a security at a loss and, within 30 days:
• Buys the identical security,
• Acquires a “substantially identical” security in a taxable trade, or
• Acquires a contract or option to buy the identical security.
If a taxpayer’s loss is disallowed because of the wash sale rules, he must add the disallowed loss to
the basis of the new stock or securities. The result is an increase in the taxpayer’s basis in the new
stock or securities.
This adjustment postpones the loss deduction until the later disposition of the new stock or
securities. These rules apply only to stocks and securities. 102 It is considered a wash sale if a taxpayer
sells stock and the taxpayer’s spouse then repurchases identical stock within 30 days, even if the
couple chooses to file separate tax returns.
Example: Malcolm sells 800 shares of Quanta Corporation stock on December 1, 2024, resulting in a
loss of $3,200. He immediately regrets selling the stock, so on December 31, 2024, (less than a month
later) he repurchases 800 shares of Quanta stock through his online trading account. Because of the
wash sale rules, the entire $3,200 loss is disallowed. He must add the disallowed loss to the basis of
the newly-purchased shares. He cannot take the disallowed loss until he finally sells the repurchased
shares at some later time.
In situations where only a portion of the stock is repurchased during the applicable wash sale
period, only the percentage of the shares repurchased will be used to determine the amount of the
disallowed loss.
Example: Ayami sells 1,000 shares of Hampstead Corporation stock on July 4, 2024, resulting in a loss
of $5,000. She regrets selling all of her stock, and less than a month later, on August 1, 2024, she
repurchases only 200 shares of Hampstead stock on the open market. Because of the IRS wash sale
rules, 20% of the $5,000 realized loss, $1,000, is disallowed, but the remaining $4,000 loss may be
recognized.
The wash sale rules do not apply to professional securities dealers or stockbrokers.103 A full-time
securities dealer is someone who regularly buys and sells securities to customers in the ordinary
course of their trade or business.

101 The “wash sale” period is technically 61 days long, starting 30 days before the date of the sale and running 30 days afterwards.
102 Wash sales are governed by §1091 of the Internal Revenue Code. At the time of this book’s printing, the wash sale rules in §1091

do not apply to cryptocurrency or any other type of digital asset. Bitcoin and other cryptocurrencies are currently classifie d as
property, and not as securities, by the IRS. The wash sale rules also do not apply to commodity futures contracts and foreign
currency trading.
103 Professional securities dealers report their business expenses on Schedule C (Form 1040). Per IRS Revenue Procedure 99-17,

in order to claim ordinary gains and loss treatment on the sale of securities, a professional securities dealer must make the “mark-
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Example: Melville is a full-time securities dealer with professional trader status. His sole business
consists of trading in securities. He properly made a mark-to-market election (Sec. 475 election)
several years ago. Melville trades stocks and bonds all year, for himself as well as his clients. He
manages dozens of investment accounts. His trades are not subject to the wash sale rules. Melville’s
losses from the sales of stocks and other securities are treated as ordinary losses, and his gains are
treated as ordinary income, as well. He will report his business activity on Schedule C.
For purposes of the wash sale rules, securities of one corporation are not considered identical to
securities of another corporation. This means that a person can sell shares in one corporation and then
purchase shares in a different corporation, and this will not trigger a wash sale. Similarly, preferred
stock of a corporation is not considered identical to the common stock of the same corporation.
Example: Oswald is not a professional securities dealer, but he owns stock in many different
companies. On February 1, 2024, Oswald sells 200 shares of common stock in Frontline Manufacturing,
Inc. for a $2,300 loss. A month later, on March 1, Oswald purchases 200 shares of preferred stock in
the same company. Common stock and preferred stock are not considered “substantially identical”
securities, so these transactions are not subject to the wash sale rules. Oswald is permitted to recognize
the $2,300 capital loss in 2024.

Home Sale Gain or Loss

The rules for selling a primary residence are beneficial for taxpayers. Typically, selling a home does
not result in a taxable gain. However, there are specific guidelines for when a taxpayer sells their main
residence. We will discuss these rules in more detail in the chapter on nonrecognition property
transactions. For now, we will focus on how to calculate a home’s basis. The following are used to
determine the basis and the gain (or loss) on a home sale:
• Selling price
• Amount realized
• Basis
• Adjusted basis
Selling Price: The total selling price for a main home includes all forms of payment received by the
taxpayer, such as cash, notes, mortgages, or other debts assumed by the buyer. The fair market value
of any additional property or services given to the seller also contributes to the selling price. Typically,
Form 1099-S, Proceeds from Real Estate Transactions, is used to report real estate sales proceeds. If
this form is not received, taxpayers must rely on sale documents like the HUD-1 and other records.
Amount Realized: The “amount realized” is calculated by subtracting selling expenses from the
sales price. Expenses can include: realtor’s commissions, advertising fees, legal fees, and loan charges
paid by the seller, such as points.
Basis in a Home: The basis of a residence is determined by how the owner of the home acquired
the property. For instance, if an individual purchases a home, their basis would be the cost of the home.
If an individual constructs a home, their basis would be the building expenses plus the cost of the land.
In cases where an individual inherits a property, their basis would typically be its fair market value on

to-market” election (a Sec. 475(f) election) by the original due date (not including extensions) of the tax return for the year prior
to the year for which the election becomes effective. Once made, the “mark-to-market” election is generally irrevocable.
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the date of the previous owner’s death or on the later alternate valuation date selected by the
representative for the estate. And if an individual receives a home as a gift, their basis would typically
be the donor’s adjusted basis at the time of the gift.
Adjusted Basis: The adjusted basis is the taxpayer’s basis in the home increased or decreased by
certain amounts. Increases include additions or improvements to the home that have a useful life of
more than one year.
Repairs that simply maintain a home in good condition are not considered improvements and
should not be added to the basis of the property. Decreases to basis include deductible casualty losses,
credits, and product rebates.104
The formula for figuring adjusted basis:
Basis + Increases - Decreases = Adjusted Basis
Example: Raphael purchased his home ten years ago for $125,000. In 2024, he added another
bathroom and an outdoor pool to the property at a cost of $25,000. Raphael’s adjusted basis in his
home after these improvements is $150,000 ($125,000 purchase price + $25,000 improvements).
If the amount realized on the sale of a home is less than the adjusted basis, the difference is a
nondeductible loss. If the amount realized is more than the adjusted basis of the property, the
difference is a gain (but not always a taxable gain).
As we will cover later, the taxpayer may be able to exclude all or part of the gain. If not excluded,
and the taxpayer owns a home for one year or less, the gain is reported as a short-term capital gain. If
the taxpayer owns the home for more than one year, the gain is reported as a long-term capital gain.
Example: Misty is 49 years old and unmarried. She sells her main home for $350,000. She purchased
the home ten years ago for $50,000 and has lived in it continuously since then. She pays $4,000 in
realtor’s fees to sell the home. Her amount realized in the sale is $346,000 ($350,000 - $4,000 =
$346,000). Her basis is subtracted from her amount realized to figure her gain: ($346,000 - $50,000
basis) = $296,000.

Related Party Transaction Rules

Special regulations are in place for transactions between related parties. If a taxpayer sells an asset
to a family member or a business they own, they may not qualify for the full benefits of capital gains
tax rates and may be limited in deducting their losses. These rules were established to prevent the
transfer of assets between related persons or entities for the purpose of claiming improper losses.
In general, a loss on the sale of property between related parties is not deductible. When the
property is later sold to an unrelated party by the original party buyer, a gain is recognized by the
related party buyer only to the extent it is more than the disallowed loss to the original party seller.
However, if the property is later sold at a loss by the original party buyer, the loss that was disallowed
to the related party cannot be recognized.

104Depreciation reduces the basis of business assets, such as rental property or commercial buildings. Depreciation is never taken
on personal-use property, such as a primary residence.
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Example: On February 2, 2024, Roxie purchases 10 shares of stock from her father, Eugene, for $8,600.
Eugene’s basis in the stock is $11,000, which means he sold the stock to his daughter at a loss, but
Eugene cannot claim that loss on his tax return because it was a related-party sale. The stock continues
to decline in value, and Roxie eventually sells the stock on the open market for $6,900 on December
10, 2024. Her recognized loss is $1,700 (her $8,600 basis - $6,900 sales price). Roxie cannot deduct the
loss that was disallowed to her father.
In the case of a related party transaction, if a taxpayer sells multiple pieces of property and some
are at a gain while others are at a loss, the gains will generally be taxable while the losses cannot be
used to offset the gains.
More Than “50% Control” Rule: If a taxpayer has majority control (more than 50%) of a
corporation, partnership, or other business entity, any property transactions between the taxpayer
and the business are subject to related party transaction rules. This means that if a taxpayer sells or
trades property at a loss (except in the complete liquidation of a corporation), the loss cannot be
deducted if the transaction involves any of the following related parties:
• Immediate family members, such as a spouse, siblings, and direct ancestors (e.g., parents,
grandparents), and lineal descendants (i.e., grandchildren). For purposes of this rule, the
following are not considered related parties: uncles, aunts, nephews, nieces, cousins, step-
children, step-parents, in-laws, and ex-spouses.
• Partnership, corporation, or other business entity that is controlled by the taxpayer. “Control”
is defined as having “more than 50%” ownership in the entity. This also includes ownership by
other family members.
• A tax-exempt organization that is controlled by the taxpayer or a member of their family.
• A closely-related trust, or business entities controlled by the same owners.
Example: Selma buys 300 shares of stock from her brother, Spencer, for $7,600. Spencer’s cost basis
in the stock is $10,000. Spencer cannot deduct the loss of $2,400 because of the related party
transaction rules. Later, Selma sells the same stock on the open market for $10,500, realizing a gain of
$2,900. Selma’s reportable gain is $500 (the $2,900 gain minus the $2,400 loss that was not previously
allowed to her brother).
Example: Irene sells 100 shares of stock to her step-brother, Saul, for $5,000. She originally paid
$8,000 for the stock, so she recognizes a $3,000 capital loss on the transaction. Since her stepbrother
is not considered a “related party” for IRS purposes, she is allowed to claim the full loss on her tax
return.

Installment Sales
An installment sale is a type of financing arrangement. It is essentially a seller-financed purchase
of an asset in which at least one payment is expected to be received after the tax year in which the sale
occurs. The most common type of installment sale is the sale of business real estate (i.e., farmland,
rental properties, office buildings).
Other common installment sales include the sale of a small business, and the sale of intangibles
(such as a patent, client list, trademark, or a website). Installment sales are reported on Form 6252,

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Installment Sale Income, which is attached to the taxpayer’s Form 1040. A taxpayer may also be
required to complete Schedule D or Form 4797, depending on the type of asset that is being sold.
Example: Tammy is a successful enrolled agent who is retiring in 2024. She decides to sell her tax
business to Palmer. Tammy will sell her existing client list, her office furniture, and her existing website
to Palmer for an agreed contract price of $375,000. Tammy agrees to carry the note, and Palmer will
make annual payments to Tammy over three years, starting in 2024. This is an installment sale.
Example: Cooper owns a valuable website domain that he bought several years ago as an investment.
A potential buyer contacts him and offers a price of $1 million for the domain. Cooper originally bought
the domain for $600,000. Cooper will recognize a gross profit of $400,000 which means his gross profit
percentage is 40% on the sale ($400,000/$1 million = 40%). The buyer strikes a deal with Cooper
where he can make annual installment payments over the next 6 years. This is an installment sale.
If a taxpayer sells property and receives payments over multiple years, the seller may use the
installment method to defer tax by only reporting a portion of the gain as each installment is received.
The installment sale method is the default method in this situation, unless the taxpayer elects to report
all gain in the year of sale. If a seller “elects out” of the installment method, the seller must report all
the gain in the year of the sale. If applicable, any depreciation recapture must also be recognized in full
in the year of the sale. Each payment received on an installment sale typically consists of the following
three parts:
• Interest income
• Return of the adjusted basis in the property
• Gain on the sale (determined by applying the gross profit percentage to the amount of the
payment received minus the interest portion)
Each year the seller receives a payment, they must report the interest income and the portion of
the payments that relate to their gain on the sale. A taxpayer’s gain, or gross profit, is the amount by
which the selling price exceeds the adjusted basis in the property sold. A gross profit percentage is
calculated by dividing the gross profit from the sale by the selling price. The seller does not get taxed
on the portion that is the return of their basis in the property.
Example: Marisol owns a parcel of timberland that she inherited from her grandfather. Her basis in
the timberland is $40,000. She sells the land for $100,000 to an unrelated person in a private-party
sale. Rather than involve a bank, Marisol agrees to carry the buyer’s note. This way, she can earn some
interest on the sale, and her gains will be spread out over several years, lessening the tax impact. Her
overall gross profit on the sale is $60,000 ($100,000 sale price - $40,000 basis) for a gross profit
percentage of 60%. She receives a $20,000 down payment and the buyer’s note for $80,000 at the time
of the sale. In 2024, Marisol must report a $12,000 gain allocated from the down payment she received.
The note provides for four annual payments of $20,000 each, plus 8% interest, starting in January,
2024. Exclusive of the interest income, she must report $12,000 of her installment gain for each
$20,000 payment received ($20,000 × .60 = $12,000). [Based on an example in Publication 537,
Installment Sales].
The selling price includes the cash and any other property to be received from the buyer, any
existing mortgage or debt the buyer pays or assumes, and any selling expenses the buyer pays.
However, if the buyer assumes or pays off an existing mortgage on the property, the calculation of
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gross profit percentage is affected. The mortgage assumption is considered a recovery of basis in the
year of sale and is subtracted before calculating the gross profit percentage, except to the extent that
it exceeds the adjusted basis of the property for installment sale purposes.
In contrast, if the property is sold to a buyer who holds a mortgage on it and the mortgage is
canceled rather than assumed, the cancellation is treated as a payment received in the year of the sale
and is not subtracted in calculating the gross profit percentage.
If installment payments are made according to a schedule other than what was originally agreed,
income is recognized according to the actual payments received. However, if the parties subsequently
agree to adjust the selling price, the gross profit percentage must be recalculated, and income from
future installments must be recognized based upon the adjusted gross profit.
Sometimes, a taxpayer may choose to elect out of the installment method on purpose. This is
especially true if they anticipate their future tax rates to be higher.
Example: Pablo sells an acre of farmland to Marissa, an unrelated person. The sale price of the land is
$100,000 and Pablo’s basis in the farmland is $20,000. Marissa will make equal payments to Pablo over
five years. This is an installment sale. Pablo’s marginal tax rate in 2024 is relatively low, but he recently
started a new, high-paying job, so he expects his tax rate in future years to be much higher. Pablo
decides to elect out of the installment method, and reports all the gain from the sale in 2024, even
though he has not received all the payments yet. In this way, he expects to save substantially on his
taxes in future years.
The installment method cannot be used for publicly-traded securities, such as stocks and bonds
that are traded on an established securities market (i.e., NASDAQ or the New York Stock Exchange). A
taxpayer must report the gain on the sale of securities in the year of the sale regardless of whether the
proceeds are received in the following year. However, stock in a private company, such as a small
corporation that is being sold to a private buyer, can qualify for the installment method.
Example: Jorge owns 500 shares of Roca-Cola stock, which he sells at a $7,000 gain on December 29,
2024, through his online brokerage account. The proceeds of the sale were not deposited into his bank
account until January 3, 2025. Jorge must report the gain on the sale of the stock on his 2024 tax return,
not his 2025 return. He cannot delay reporting the gain, and the sale is not an installment sale.
The installment sale rules also do not apply to property that is sold at a loss, or to the sale of
inventory.
Example: Preston owns a pawn shop, where he sells a variety of collectibles, toys, and jewelry. All of
the items that Preston has in his showroom are inventory, and are available for sale to the public. He
sells a group of paintings to a collector for $200,000 in 2024. Preston allows the buyer to make
payments over the course of three years. The sale is not an installment sale, because the paintings are
inventory in his shop.
Installment sales to related persons are permitted. However, if a taxpayer sells a property to a
related person who then sells or disposes of the property within two years of the original sale, the
seller will lose the benefit of installment sale reporting (although there are exceptions to this rule for
involuntary conversions or death of the original seller or buyer).

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Example: Lorne sells a plot of farmland to his daughter, Mindy. The sale price is $25,000, and Lorne
realizes a profit on the sale of $10,000 (he paid $15,000 for the land). Mindy agrees to pay in five
installments of $5,000. A year later, Mindy decides she no longer wants the land, and she sells the land
to another, unrelated person. Lorne must report the entire profit of $10,000 on the sale, even though
he may not have received all the installment payments. The installment sale method is disallowed on
the related-party sale because the property was disposed of during the two-year holding period.

Special Rules for Worthless Securities

A loss from worthless securities receives special tax treatment. 105 A taxpayer may choose to
“abandon” a security that has lost its entire value in order to take advantage of the loss for tax purposes
rather than retaining ownership. Stocks, stock rights, and bonds (other than those held for sale by a
securities dealer) that became worthless during the tax year are treated as though they were sold for
zero dollars on the last day of the tax year.
Unlike other losses, a taxpayer is allowed to amend a tax return for up to seven years in order to
claim a loss from worthless securities. This is more than double the usual three-year statute of
limitations for amending returns.
To “abandon” a worthless security, a taxpayer must permanently surrender all rights to it and
receive no consideration in exchange. Taxpayers should report worthless securities on Form 8949 and
indicate the worthless security deduction by writing “WORTHLESS” in the applicable column of Form
8949.
Example: Leandro owns 500 shares of Crossroad Corporation stock. The company files for
bankruptcy, and the bankruptcy court extinguishes all rights of the former shareholders. Leandro
learns of the bankruptcy court’s decision on December 20, 2024. Rather than wait for a formal notice
from the court, he chooses to abandon all his Crossroad securities, knowing that his shares are
essentially worthless. He takes a capital loss on his 2024 tax return, reflecting the value of his worthless
shares as “zero.”
Example: Gerri owns 2,000 shares of DMX Manufacturing, Inc. She purchased the stock many years
ago for $7,500. In 2024, the company files for bankruptcy, and Gerri’s stock becomes worthless. She
chooses to abandon the securities to take a tax deduction in 2024. Then she reports the valueless stock
on Form 8949 and treats the abandonment as a sale. For the sale date, she puts December 31, 2024,
and she lists her proceeds as $0. She now has a long-term capital loss of ($7,500) that she can use to
offset other taxable income.
Note: Once a corporation has been delisted from a stock exchange as a result of bankruptcy, the
stockholder will usually have the option to fill out a worthless securities processing request. Some
brokerage firms will purchase worthless stock for a nominal amount (such as a penny), to provide
closure and an official sale date to the customer on their brokerage statement. 106

105 Digital assets, like cryptocurrency, do not currently qualify for this special treatment. The IRS Office of Chief Counsel recently
published Memorandum 202302011, stating that a taxpayer that owns cryptocurrency that has substantially declined in value
cannot deduct a cryptocurrency loss under section 165 due to worthlessness of the cryptocurrency.
106 “Worthless securities” are stocks or bonds that have a market value of zero. A taxpayer may treat worthless securities as though

they were sold on the last day of the tax year.

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Special Rules for Sec. 1244 Small Business Stock

IRC Section 1244 refers to a special tax treatment for stock in small, domestic corporations. Section
1244 stock is subject to beneficial tax treatment. Losses from the sale or exchange of Section 1244
stock can be treated as ordinary losses rather than capital losses. This allows for a deduction of up to
$50,000 for individuals, or up to $100,000 for joint filers. The benefit of this provision is that the loss
is not subject to the $3,000 “loss limitation” that normally applies to capital losses.
Example: Amina, who files as single, is one of the original founding shareholders in Acorn Energy Corp,
Inc. a small, domestic C Corporation. She decides to sell all her shares in Acorn Energy Corp, Inc., to an
unrelated party. The stock qualifies as Section 1244 stock. She sold the stock for $35,000, and her basis
in the shares was $50,000. Her only other income for the year was $95,000 in wages. Amina can deduct
the entire ($15,000) loss as an ordinary loss on her tax return, and not as a capital loss. She can deduct
the full amount of the loss, because it is not limited to the normal $3,000 “loss limit” that applies to
regular capital losses.
In order to qualify for this special tax treatment, the stock:
• Must be issued by a U.S. corporation. Foreign corporations do not qualify.
• The corporation's aggregate capital must not have exceeded $1 million when the stock was
issued.
• The corporation must derive more than 50% of its income from active business operations, not
passive investments like interest or dividends.
• Only the original shareholders of the stock of the corporation while it was still a small business
corporation are allowed to take advantage of the ordinary loss provisions (i.e., if an original
shareholder sells or transfers the stock to another taxpayer, Section 1244 status of the stock
does not carry over to the other party).
A corporation is a “small business corporation” only for purposes of Section 1244 stock if the
aggregate amount of money and other property received by the corporation for stock, as a contribution
to capital, and as paid-in surplus, does not exceed $1,000,000.

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Unit 8: Nonrecognition Property Transactions

For additional information, read:
Publication 544, Sales and Other Dispositions of Assets
Publication 523, Selling Your Home
When a taxpayer sells or exchanges property at a gain, usually, the gain will be taxable. However,
in certain situations the resulting gains may instead fall into one of three other categories: fully
nontaxable, partially taxable, or deferred. The three most common examples of nonrecognition
transactions are:
• Selling a primary residence (excluded gain under Section 121)
• Like-kind exchanges (nontaxable/deferred exchange under Section 1031)
• Involuntary conversions (exchange under Section 1033)
Note: On Part 1 of the EA Exam, you will primarily be tested on selling a main home, converting
personal-use property involuntarily, and exchanging residential rental properties as like-kind
properties. Part 2 of the EA Exam, you will be tested on nonrecognition property transactions
exclusively involving business property.

Sale of Main Home (Section 121 Exclusion)

When selling their primary residence, taxpayers can often exclude the gain from selling their
primary residence. For those who are unmarried or Married Filing Separately, up to $250,000 of gain
can be excluded. Joint filers have a higher exclusion amount of $500,000. Additionally, special rules
apply for taxpayers whose spouses have passed away.107
If the entire profit is excluded, it is not necessary to report the sale unless a Form 1099-S is received
for the proceeds. If a portion of the gain is taxable, the sale must be reported on Schedule D and Form
8949. Any profit earned from selling a home that is not considered the taxpayer’s primary residence
must be reported as taxable income.
The Section 121 exclusion only pertains to a taxpayer’s primary residence and does not apply to
rental properties, vacation homes, or secondary residences. A taxpayer’s main home is considered to
be the place where they reside for the majority of the year, and it does not have to be a typical house.
This could include a variety of living arrangements such as a houseboat, mobile home, cooperative
apartment, or condominium. The key criteria for a property to be classified as a home includes: having
sleeping quarters, a kitchen, and bathroom facilities.
Example: Parker resides in a house located in Phoenix, Arizona, as his primary residence. In addition,
he has a lake cottage in Lake Tahoe, Nevada, that he only uses during the summer months. Parker
decides to sell the vacation cottage, resulting in a $220,000 capital gain. Unfortunately, he cannot
exclude this gain from income tax since the cottage is not his main residence. As a result, he will be
responsible for paying taxes on the entire gain.

107 There is a special rule for surviving spouses, even if they cannot file as a qualified surviving spouse. If a spouse passes away, and

all the requirements (to be discussed later) were in place for the gain exclusion on their primary residence at the time of death of
their spouse, the surviving spouse can exclude up to $500,000 of gain if the widow(er) sells the house within two years of their
spouse’s death, regardless of their filing status in the year of sale, as long as they remain unmarried at the time of the sa le. IRC
section 121(b)(4).
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Example: Mickie owns a duplex and resides in one unit while allowing her brother, Harry, to live in
the other unit rent-free. She bought the property for $200,000 ten years ago. During the year, Mickie
sells the duplex for $340,000, a gain of $140,000. Since only half of the duplex counts as her main home,
Mickie may exclude only half of the gain ($70,000). She must report the other $70,000 as a long-term
capital gain on her individual return.

Eligibility Requirements for Section 121

To be eligible for the Section 121 exclusion, a taxpayer must:
• Have sold their main home
• Meet “ownership and use” tests
• Not have excluded gain in the two years prior to the current sale of a home (although there are
exceptions when the primary reason for selling the home residence was a change of
employment, health, or unforeseen circumstances, covered later).
Example: Paula is retired and lives in Miami, Florida. On January 1, 2024, Paula purchased a new home
in Tampa, Florida. On January 15, 2024, (two weeks later) Paula sells her old home in Miami at a
$40,000 gain. She had owned and lived in the Miami home for four years leading up to the sale. She can
exclude all the gain on the sale of the Miami home. Paula moves into the Tampa home, but she hates
her new neighborhood and decides to sell the home just a few months later. On October 1, 2024, Paula
sells the Tampa home. She has a $6,000 profit on the sale. The sale was not due to a change in place of
employment or health, Paula just sold the home because she hated the neighborhood. Because Paula
had excluded gain on the sale of another home within the two-year period, she cannot exclude the gain
on the sale of the Tampa residence. The entire gain is taxable as a short-term capital gain.

Ownership Test and Use Test

The IRS figures the ownership and use tests separately, and the time periods do not have to be
continuous. During the five-year period ending on the date of the sale, the taxpayer must have:
• Owned the home for at least two years (the ownership test), and
• Lived in the home as their main home for at least two years (the use test).
A taxpayer meets both tests if the taxpayer owned and lived in the property as their main home for
either 24 full months or 730 days (365 × 2) during the five-year period. The required two years of
ownership and use do not have to be continuous. Further, ownership and use tests can be met during
different two-year periods.
Example: Evelyn bought her home on February 1, 2021. She lived there continuously for 2 years and
11 months. She moves out on January 2, 2024, and starts advertising the home online as a rental.
Evelyn does not have any luck finding a good tenant, and eventually decides that she does not want to
try to rent the property anymore. December 30, 2024, approximately one year later, she sells the home
at a gain. Even though Evelyn moved out of the house for a year, she qualifies for the Section 121
exclusion because she personally owned and used the home for at least two years during the five-year
lookback period before the sale.

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Example: Mabel bought a house on September 1, 2019. After living there for ten months, she moved
in with her boyfriend and left her house vacant. They later broke up, and Mabel moved back into her
own house in 2022. She lived there for an additional 16 months until she sold it on September 1, 2024.
Mabel meets the ownership and use tests because, during the five-year period ending on the date of
sale, she owned the house for five years and lived in the house a total of 26 months—both more than
the required 24-month (2-year) requirements.
Example: Briella, who is 25 years old and unmarried, has always resided in her parents’ house since
birth. In January of 2024, she purchased her childhood home from her parents. Her parents had retired
and moved to a different state. Briella remained in the house until December. However, she ultimately
sells the property on December 26, 2024 because she wanted a larger residence. Despite living in the
house as her primary residence for over two years, Briella does not qualify for the Section 121
exclusion. Although she lived in the house for more than two years, she did not actually own it for two
years (it was owned by her parents, not her). Therefore, she fails to meet both the ownership and use
requirements and will be required to pay taxes on any gains she made from the sale.
To satisfy the “use” requirement, the taxpayer must physically occupy the home. However, brief,
temporary absences are still considered periods of use, even if the property is rented during that time.
Examples of short absences include short vacations and seasonal trips. However, longer breaks, such
as a one-year sabbatical, do not count towards the period of use.
Example: Alannah is a college professor who teaches Medieval history. She purchases and moves into
her home on June 1, 2022. On June 1, 2023, (exactly one year later) she moves abroad for a one-year
sabbatical to study ancient manuscripts in Germany. On August 1, 2024, she returns to the U.S. from
her sabbatical, and one month later, on September 1, 2024, she sells the house because she wants to
move into a smaller apartment. Even though she owned the home for over two years, the year-long
sabbatical is not considered a short, temporary absence. Therefore, she is not entitled to take the
Section 121 exclusion because she did not satisfy the “use requirement.”
Example: Sophie lived in and owned a house in Miami, Florida as her main residence for many years,
from 2015 until the end of 2019. On December 1, 2019, Sophie got a job overseas and permanently
relocated to Australia. Sophie’s daughter, Tamera, moves into the Miami house and lives there rent-
free until it is eventually sold on November 31, 2024. Sophie cannot exclude any of the profit from the
sale of the house because she did not use the property as her primary residence for at least two of the
five years prior to the sale. As a result, Sophie will be subject to paying long-term capital gains tax on
all the profits from the sale.
Example: Juanita bought her home on February 1, 2022. Each year, Juanita leaves her home for a two-
month summer vacation in Ecuador to visit her family. Juanita sells her house on June 1, 2024. She
owned and lived in the home for over two years, so she can exclude up to $250,000 of gain. Her
vacations are considered brief and temporary absences, which still count towards her overall period
of use for the property.
Remember, the periods of “use” and the periods of “ownership” do not need to be concurrent or
consecutive, so long as the total duration of “ownership” and “use” each separately adds up to two
years.

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Example: On January 2, 2021, Cillian began living in an apartment in New York, which he rented from
a landlord. The apartment complex was later converted to condominiums, and Cillian purchased his
unit on June 1, 2022. Sometime later, Cillian’s daughter invites her father to visit her in Hawaii, where
she owns a beach house. Cillian loves Hawaii and the beach house, and his daughter invites him to stay
and live with her. After some careful thought, on February 2, 2024, Cillian moves permanently into his
daughter’s home. Cillian does not return to his New York condo, and on August 1, 2024, while still
living in his daughter’s home, Cillian sells his condo. He can exclude all the gain on the sale because he
meets the ownership and use tests. His five-year “lookback” period is the five-year period before
August 1, 2024 (five years before the date he actually sells the condo). He owned the condo from June
1, 2022, until August 1, 2024 (more than two years). He lived there from January 2, 2021 until February
2, 2024 (more than two years), so he would qualify to exclude all the gain, even though his ownership
and use periods do not always overlap.

Different Rules for Married Homeowners

The ownership and use tests are applied differently to married homeowners. Married homeowners
can exclude gain of up to $500,000 if they meet all the following conditions:
• They file a joint return.
• Either spouse meets the ownership test (only one is required to own the home).
• Both spouses meet the use test.
• Neither spouse has excluded gain in the two years before the current sale of the home.
If the requirements are not met, the couple will not be able to claim the full $500,000 exclusion for
married couples. However, if only one spouse qualifies, that spouse may still be eligible for a separate
exclusion of up to $250,000.
Example: Irene owns her home and has lived in it continuously for the last seven years. She meets
Julien and marries him on September 1, 2024. They move in together, but Julien doesn’t like Irene’s
house, and he convinces her to sell it a few months later. Irene sells her home on December 10, 2024,
and has $350,000 of gain on the sale. Irene meets the ownership and use tests, but Julien does not meet
the use test because he only lived in the house for a few months. Irene can exclude up to $250,000 of
gain on her 2024 tax return, whether she files MFJ or MFS. Julien cannot exclude any of the gain. The
$500,000 exclusion does not apply in this case.
Example: Hubert owns a home that he has lived in continuously for a decade. On June 1, 2020, he
marries Jasmine, she moves into Hubert’s home, and they both live in the house together until
December 9, 2024, when the house is sold. Hubert meets the ownership test and the use test. Jasmine
does not own the home because Hubert is the sole owner of the property and the only one listed on
the deed. However, Jasmine meets the “use test” because she lived in the home for over two years with
her husband. Therefore, on a jointly filed return, they can claim the maximum $500,000 exclusion, even
though only one spouse actually owns the home.
Married spouses are eligible for the maximum $500,000 exclusion from gain on their jointly filed
returns. However, if an unmarried couple owns and lives in a house together, and later gets married,
the $500,000 exclusion applies if they file a joint return. If the couple files separate returns, each
spouse would have to figure their exclusion separately on their own return.
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Example: Mavis and Santiago have lived together for a decade, but only got married a year ago. In
2024, they sell the house they had co-owned and lived in together for 10 years. They are both listed as
co-owners on the deed, even though they were not married when they bought the home. They
purchased the house for $210,000 and sold it for $785,000, which means they have a profit of
$575,000. Mavis and Santiago may claim the maximum $500,000 exclusion for married couples when
they file jointly. Even if they chose to file separate returns, each one would still be eligible for a
$250,000 exclusion on a separate MFS return, because they both owned the home and used it as their
primary residence for the requisite 2 years. The remaining $75,000 of gain ($575,000 profit - $500,000
exclusion) is taxable as a long-term capital gain. They would have to recognize the gain whether they
file jointly or separately.

A special rule for the holding period applies to a home that is transferred by a spouse in a divorce.
The receiving spouse is considered to have owned the home during any period of time that the
transferor owned it. However, the receiving spouse must still satisfy the two out of five-year use test
on their own to qualify for the entire exclusion. This is a tax-free transfer of property “incident to a
divorce” (a Section 1041 transfer).
Example: Theodore buys a home for $400,000 on January 2, 2019. Approximately two years later,
Theodore meets Kayla, and they get married on February 1, 2021. Kayla moves in with Theodore, but
the home’s ownership remains in Theodore’s name only. They start having marital difficulties a few
years later, and Kayla moves out on March 1, 2024. Six months later, they get divorced. As part of their
divorce settlement, Theodore transfers complete ownership of the house to Kayla. Theodore’s basis
also transfers to Kayla. The home reminds Kayla of unhappy times, so on December 25, 2024, she sells
the home for $475,000, making a $75,000 profit on the sale. Kayla keeps the entire proceeds from the
sale for herself. She is entitled to the Section 121 exclusion on her individual return, because IRS
regulations treat Kayla as having owned the home during the time Theodore owned it. The time Kayla
occupied the home as her principal residence prior to and after the divorce will count toward the two-
year “use” test. She meets both tests, so she may exclude the entire $75,000 gain on her tax return.
Unrelated Individuals: An unmarried couple who own a home and live together may take the
$250,000 exclusion individually on their separate returns if they meet the use and ownership tests.
This would also be the case if it were any type of cohabitating partners. Whether or not they are related
to each other is irrelevant. As an example, siblings often cohabitate and own a home together.
Example: Shawn and Alan are retired Navy buddies. Both are unmarried. Shawn and Alan decide to
purchase a home together for $135,000. They both own the home and live in it together, as roommates,
for three years. In early 2024, they both met new girlfriends, and within a few months, they both got
married to their new partners. Shawn and Alan decide to sell the home, and on June 1, 2024, the home
sells for $245,000, generating a $110,000 overall gain, which they split equally between them. Each
one receives $55,000 ($110,000 gain ÷ 2 owners). The title company that handled the sale sent Shawn
and Alan a 1099-S reporting the gross sales price of the home. Since they received a 1099-S, Shawn
and Alan should report the sale on their individual tax returns, but the gain is not taxable, because they
meet the ownership and use tests, and each would qualify for the full $250,000 Section 121 exclusion
on their individual returns.

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Example: Harper and Carolyn are sisters. They are both retired and widowed, and decided to purchase
a home for $220,000 and live together. They live together in the home for six years, before selling the
home on December 1, 2024 for $600,000. Together, they have $380,000 in gain ($600,000 - $220,000
basis). The ownership and use tests apply to them individually, and each one would qualify to exclude
up to $250,000 for her portion of the sale on her individual return. This means that all their gain can
be excluded.
Deceased Spouses: In the case of a deceased spouse, special rules apply. The surviving spouse is
treated as if they owned and lived in the home during any period that the deceased spouse did. The
surviving spouse is permitted to exclude up to $500,000 of gain from the sale of the home, even if it
occurs within two years after the death of the deceased spouse (as long as the surviving spouse did not
remarry before the sale). Essentially, the holding period for the deceased spouse is transferred to the
surviving spouse, allowing them to benefit from the full exclusion for married couples.
Example: Rosalee has owned and lived in her own home for six years. She marries Caspian on
February 1, 2024, and he moves into the home with her. Rosalee dies suddenly seven months later,
and Caspian inherits the home. Caspian does not remarry. Caspian decides to sell the home on
December 1, 2024. Even though he did not own or live in the house for two years, he meets the
requirements for Section 121 because his period of ownership and use includes the period that Rosalee
owned and used the property before her death. Caspian may exclude up to $500,000 of the gain under
the special rule that applies to deceased spouses.

Military Personnel Exception: Members of the armed forces are often required to move and
might have difficulty meeting the tests for ownership and use within the five-year period prior to the
sale of a home. The five-year period can be suspended for up to ten years for U.S. military 108 as well as
for Foreign Service personnel, U.S. Peace Corps workers, and intelligence officers that are on official
extended duty. This offers taxpayers a greater chance to fulfill the two-year residency requirement,
even if they or their spouse did not physically reside in the home for the standard five-year timeframe
that applies to other taxpayers.
Example: Ensign Smith is a U.S. naval officer. He is single and owns his home. Ensign Smith bought and
moved into his home on January 2, 2016. He lived in it as his main home for 2½ years. For the following
6 years, he did not live in the home because he was on qualified official extended duty with the U.S.
Navy. He did not return to the home during that time and lived overseas. Ensign Smith sold his home
for a $125,000 gain on December 26, 2024. To meet the use test, he may suspend the normal 5-year
test period for the time he was on qualifying official extended duty. This means that Ensign Smith can
disregard the 6 years that he lived abroad when he is calculating his period of “ownership and use.” He
meets the “ownership and use” tests because he owned and lived in the home for at least 2 years.
Ensign Smith may exclude all the gain from the sale on his individual tax return.
Disability Exception: There is an exception to the use test if, during the five-year period before
the sale of the home, a taxpayer becomes physically or mentally disabled. They must have owned and
lived in the home for at least one year. However, a taxpayer is considered to have “lived in the home”

108 This includes members of the U.S. Army, Navy, Air Force, Marine Corps, etc.
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during any time that they are forced to live in a licensed facility, including a nursing home. The taxpayer
must still meet the two-year ownership test.
Example: Vera, age 72, retired and bought a new home in Florida on December 13, 2022. She moved
into her home and lived in the home continuously for 12 months, but then she fell and broke her hip.
Vera cannot walk, and the doctor says that her condition is unlikely to improve. So, on January 25, 2024
(1 year, and 1 month later) she is forced to move into a healthcare facility. Vera receives physical
therapy to regain mobility, but her hip does not heal very well, and ultimately, Vera’s disability
prevents her from returning to her own home. On December 25, 2024, while still living in the facility,
Vera sells her house, resulting in a $40,000 gain on the sale. Vera can exclude all the gain on the sale of
her home because she owned the home for over 2 years (she owned it for a total of 2 years and 13 days)
and she lived in the home at least a year before becoming disabled.

Rules for Reduced Exclusions

A taxpayer who owns and uses a home for less than two years (and therefore does not meet the
ownership and use tests) or who has used the home sale exclusion within the prior two-year period,
may still be eligible for a “reduced” exclusion if they meet one of the following three exceptions:
• Work-Related Move: This safe harbor applies if a new job is at least 50 miles farther from the
old home than was the former place of employment. If there was no former place of
employment, the distance between the new place of employment and the old home must be at
least 50 miles. Other circumstances may qualify as related to a job change even if the safe
harbor is not met based on the facts and circumstances.
• Health-Related Move: The health safe harbor applies if a doctor recommends a change of
residence for reasons of health of the taxpayer, a spouse, a child, or certain other related
persons. The related person does not have to be a dependent for the reduced exclusion to apply.
Other circumstances may qualify as related to health even if the safe harbor is not met based
on the facts and circumstances.
• Unforeseeable Events: The “unforeseen circumstances” safe harbors include the following:
o Death, divorce, or legal separation,
o Unemployment,
o Multiple births resulting from the same pregnancy,
o Damage to the residence resulting from a disaster, an act of war, or terrorism; and
o Involuntary conversion of the property or condemnation.
o Other situations may qualify as unforeseen circumstances.
The reduced exclusion amount equals the full $250,000 (or $500,000) multiplied by a fraction. The
numerator is the shorter of:
• The period the taxpayer owned and used the home as a principal residence during the five-year
period ending on the sale date, or
• The period between the last sale for which the taxpayer claimed the exclusion and the sale date
for the home currently being sold.
The denominator is two years or the equivalent in months or days. Thus, the amount of the reduced
exclusion is figured by multiplying the full exclusion amount by the number of days or months the
taxpayer owned and used the property and dividing by either 730 days or 24 months.
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Example: Katherine is unmarried. She bought her principal residence for $340,000 in San Diego, CA
on January 1, 2024. Nine months later, she loses her high-paying job and could no longer afford the
mortgage payments. She sells the house for $600,000 on December 31, 2024. She owned and lived in
the house exactly one year (365 days) before selling it. She has a $260,000 gain ($600,000 sale price -
$340,000 basis). Even though she only occupied the house for a year, she qualifies for the reduced
exclusion because she became unemployed. Katherine can exclude $125,000 of the gain ($250,000 ×
[365 ÷ 730]). The remainder of the gain would be taxable and cannot be excluded.
Example: On January 5, 2024, Thane, who is single, purchases a home in Mississippi and uses it as his
principal residence. A few months later, Thane’s employer transfers his job to Alaska. Thane is forced
to move to Alaska to begin working his new position. On July 5, 2024 (exactly six months later), Thane
sells his Mississippi home, generating $60,000 in gain. He qualifies for a reduced exclusion due to his
job relocation. He may exclude up to a maximum of $62,500 ($250,000 maximum exclusion × 6 ÷24
months) of the gain on the sale. Since his gain on the sale is less than $62,500, then he does not have a
taxable gain.
Land Sales: If a taxpayer sells the land on which their main home is located but not the house itself,
the gain is not excludible. Similarly, the sale of a vacant plot of land with no house on it does not qualify
for the Section 121 exclusion.
Example: Bernarda purchased an empty lot three years ago for $90,000, planning to build her dream
home. Construction was delayed due to difficulty getting the proper construction permits, and her
house was never completed. In December 2024, Bernarda sells the land for $150,000. She owned the
land for more than a year, so she has $60,000 of long-term capital gain. None of the gain can be
excluded from income because there is no residence on the property. Section 121 only applies to actual
homes, not to an empty lot.
In certain cases, a taxpayer may be able to exclude the gain from selling a vacant lot that is
connected to their primary residence. This exclusion can only be applied if the vacant land was used
in connection with the main home and the sale occurs within two years before or after selling the home.
The land must have been directly adjacent to the home and must have been owned and used as part of
the home, not for any business purposes. In terms of tax treatment, both the sale of the land and the
sale of the home are considered one transaction for the purpose of applying this exclusion.
Example: Gregory bought a property with 10 acres, which included a house that he uses as his main
residence. After living there for five years, Gregory sells eight acres of land on February 1, 2024,
earning a profit of $100,000. Ten months later, on December 1, 2024, he sells the remaining two acres
and the house, earning an additional gain of $140,000 from the sale. Since the first sale occurred within
two years of selling the dwelling unit, it is also considered a sale of his primary residence. As a result,
Gregory can exclude up to $250,000 of gain from both sales, effectively eliminating any taxable gain
($100,000 + $140,000 = $240,000).

Homes Used Partially for Business

If a taxpayer’s home was used partially for business purposes or as a rental property, the gain is
reported on Form 4797, Sales of Business Property. If a taxpayer claimed depreciation deductions for
using their home as a rental property or for other business purposes, they cannot exclude the portion

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of the gain equivalent to the amount of depreciation deducted.109 Section 121 only applies to the
personal portion of a home.
In addition, under IRC section 121(b)(5), an additional rule applies for properties that are
converted from a non-qualifying use (for example, as a rental) to a qualifying use (i.e., as a personal
residence). In these situations, generally, the time of the non-qualifying use of the property is
compared to the total time the property was owned by the taxpayer prior to sale.
This ratio is then applied to the realized gain on the sale of the property to determine (exclusive of
any depreciation deductions that may have been taken on the property prior to the date of sale) the
amount of the gain that can potentially be excluded under IRC section 121.
Example: Asami purchased a single family residence on January 1, 2019 and immediately rents it out
to tenants, and she continues to do so through December 31, 2021. On January 1, 2022, Asami no longer
has tenants, so she decides to move into the home as her personal residence, and she lives there
continuously until December 31, 2023. On January 1, 2024, she sells the property at a $290,000 gain.
Looking back at the uses of the property up to the date of sale, there were three years of non-qualifying
use (from January 1, 2019 through December 31, 2021, as a rental) and two years of qualifying use of
the property (January 1, 2022 through December 31, 2023, as her primary residence). As such, three-
fifths of the property’s use leading up to the sale was for non-qualifying purposes, therefore three-
fifths (60%) of the realized $290,000 is not eligible for the Section 121 exclusion (i.e., $174,000). The
remaining $116,000 of the realized gain (not including any applicable depreciation) can be excluded
under Section 121. Note that any depreciation applicable on the property during its time as a rental
would be subtracted from the $116,000 excludable portion of the gain noted above, resulting in a
slightly lower amount of the gain that can be excluded under Section 121.
Another common scenario is when a taxpayer has a home office for their business activities, and
they depreciate the home office and then later sell the home at a gain. The amount of straight-line
depreciation claimed in prior years is considered as “unrecaptured §1250 gain” up to the amount of
recognized gain.
“Unrecaptured §1250 gain” is technically long-term capital gain, with a special maximum rate of
25%. This only applies to the sale of depreciable real estate, and not to other types of business assets,
like machinery or equipment.
Example: Georgiana owns her home in San Antonio, Texas, and has lived in it continuously for several
years. She is a personal injury attorney who works exclusively out of a home office. She has a qualified
home office for which she deducts all relevant business expenses, including straight-line depreciation,
for five years. In 2024, Georgiana sells her main home at a gain. Since the home is her primary
residence, the sale qualifies for the section 121 exclusion, but the depreciation that she claimed on her
home office is classified as “unrecaptured section 1250 gain,” and will be subject to a maximum capital
gains rate of 25%. She would report the uncaptured Section 1250 gains on Form 4797, then transfer
that total to Schedule D.

109A unique tax rate applies to capital gains on the sale of real property for which a taxpayer has previously claimed depreciation.
Unrecaptured section 1250 gain is an income tax provision that provides that gain attributable to the depreciation will be subject
to a maximum 25% unrecaptured Section 1250 gain tax rate.
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Like-Kind Exchanges (Section 1031 Exchange)

A Section 1031 like-kind exchange takes place when a taxpayer trades one qualifying real property
for another. In this type of exchange, any realized gain (or loss)110 is considered postponed.
The most straightforward type of Section 1031 exchange involves a simultaneous swap of two
properties. The other type of exchange is called a “deferred exchange.” A deferred exchange allows a
taxpayer to relinquish their property and then replace it with one or more qualifying properties at a
later date. Deferred exchanges offer more flexibility but are more complex, and they also require a
qualified intermediary, or QI.
It’s important to note that like-kind exchanges only apply to real estate exchanges. Any exchange
of personal property will be treated as a non-cash sale and will not qualify for nonrecognition
treatment. The types of real property that may qualify for like-kind treatment include:
• Land, and improvements to land (such as buildings, concrete parking lots, foundations),
• Unsevered natural products of land, (such as natural mineral deposits, mines, and wells)
• Water and air space superjacent to land,
• Certain intangible interests in real property (such as leaseholds and options), and
• Property that is real property under state or local law.
The most common type of section 1031 exchange is a swap of one rental property for another.
However, taxpayers may exchange different types of real property, including buildings, farmland,
timberland, and even undeveloped land.
Note: The primary benefit of a Section 1031 exchange is the deferral of some or all of the realized gain
on the exchange. By reinvesting the proceeds from the relinquishment of one qualifying property into
another like-kind property, taxpayers can potentially defer paying taxes on the exchange. A Section
1031 exchange also gives the taxpayer more purchasing power: since taxes can be deferred, more cash
is available to invest in the replacement property. This can lead to acquiring a more valuable property
or multiple properties, enhancing the taxpayer’s real estate portfolio.
To qualify for nonrecognition treatment, the exchange must meet all the following conditions:
• The property must be held for investment or business use. Property held for personal use, such
as a personal residence, does not qualify.
• The property must NOT be “held primarily for sale” (such as inventory held by a real estate
dealer).
• There must be an actual exchange of two or more assets or properties (the exchange of property
for cash is always treated as a sale, not an exchange).
• If a property is being exchanged for another property at a later time (referred to as a "deferred
exchange"), the replacement property must be identified in writing or received within 45 days
after the initial transfer of the original property.
• For most exchanges, a “qualified intermediary” must be procured to facilitate the exchange
using escrow accounts. This type of qualified intermediary (sometimes also known as an

110 While Section 1031 can result in deferred gain or losses, in almost all situations taxpayers will not want to defer realized losses
in a Section 1031 exchange and instead would typically sell real estate at a loss instead of going through an exchange. However, it
is important to remember that 1031 deferral treatment applies to both realized gains and losses.
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exchange accommodator or facilitator) promises to return the proceeds of the exchange to the
transferor of the property.111
Deadlines: The replacement property in a section 1031 exchange must be received by the earlier of:
• The 180th day after the date on which the property was given up was transferred, or
• The due date, including extensions, of the tax return for the year in which the transfer of that
property occurs. The IRS is very strict about these deadlines.
Example: Sebastian is the owner of a vast piece of undeveloped land in Florida, which he has kept
solely for investment purposes. As its value continues to increase, he considers selling it for a profit.
However, he eventually decides to exchange it for an even larger property in Alaska which he will also
hold as a long-term investment. To help with the process, Sebastian enlists the help of a Qualified
Intermediary (QI), who assists him in exchanging the Florida land, which was acquired by another
party for $450,000, and the QI holds onto the proceeds in escrow. Within 45 days, Sebastian has
identified a suitable replacement property in Alaska that also qualifies as like-kind property for
investment purposes. He then uses the full $450,000 towards acquiring this new property, within 180
days. By completing this 1031 exchange, Sebastian is able to defer paying capital gains on his Florida
property and reinvests all of the proceeds into the larger Alaska property.
Taxpayers report like-kind exchanges on Form 8824, Like-Kind Exchanges. The taxpayer must
calculate and keep track of their basis in the new property they acquired in an exchange.
In general, any exchange of any real property generally qualifies as like-kind, regardless of how
each property is used or whether each property is improved or unimproved. For instance, the
exchange of an office building for farmland would qualify, as would the exchange of an apartment
complex for an office building.
Nonqualifying Exchanges: Personal-use realty is not eligible for a like-kind exchange. So, the
exchange of a personal residence for another personal residence does not qualify, nor would an
exchange of a personal residence for an apartment building. This prohibition would also apply to a
vacation home.
The exchange of property within the United States for similar property outside the United States
also would not be a qualifying exchange. Foreign real estate is not eligible for nonrecognition
treatment. And remember, inventory is never eligible for like-kind treatment.
Example: Maddie is a full-time house-flipper. She buys distressed properties at auction, fixes them up,
and then re-sells them, usually within six months of purchase. She does not rent them out or live in the
properties while they are being rehabbed. In 2024, she has five houses that are in the process of being
flipped. Once the current restorations are complete, Maddie intends to re-sell the homes to future
buyers. The properties are treated as inventory. Therefore, none of the properties would be eligible
for a section 1031 exchange.

111Only in a “simultaneous” 1031 exchange (a two-party swap) is a qualified intermediary not needed. That occurs only when the
exchange is processed on the same day and there is no delayed exchange.
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Example: Lawrence is a professional real estate developer. Lawrence purchases large tracts of land
and then sells the subdivided lots for later development. All the lots he purchases are available for sale
to customers. In this case, Lawrence is a professional real estate dealer: to him, the land is inventory.
Lawrence cannot use section 1031 to escape recognition of gain on the transfer or sale of his land lots.
Taxable Exchanges: If a taxpayer receives property in exchange for other property that does not
meet the like-kind exchange rules, he may need to recognize gain if the fair market value of the
property received is greater than the adjusted basis of the property given up. His basis in the property
received is generally its FMV at the time of the exchange.
Example: Cassidy exchanges a residential rental in Hawaii with an adjusted basis of $100,000 with a
residential rental property in Cancun, Mexico. The Cancun property has a fair market value of
$145,000. The exchange of foreign realty for real property in the United States does not qualify for
section 1031 treatment. Instead, the transaction is treated as a taxable sale. Since the exchange does
not qualify for nonrecognition treatment, Cassidy must recognize $45,000 of taxable income on the
transaction. Her basis in the Cancun property is $145,000, which would be the same treatment if the
property had been purchased with cash.

Cash Boot and Mortgage Boot

Although the Internal Revenue Code itself does not use the term “boot,” it is frequently used to
describe cash or other property added to an exchange to compensate for a difference in the values of
properties traded. A taxpayer must generally not receive “boot” in an exchange, in order for the
exchange to be completely tax-free.
This does not mean that the exchange is not valid, but the taxpayer who receives boot may have to
recognize taxable gain to the extent of the cash and the FMV of unlike property received, but the
recognized gain when boot is received is still limited to the realized gain on the exchange. The amount
considered boot would also be reduced by any qualified costs paid in connection with the transaction.
Example: Glenn exchanges a residential rental property for a parcel of farmland in a section 1031
exchange. The relinquished rental property has an FMV of $60,000 and an adjusted basis of $30,000.
The farmland Glenn receives has an FMV of $50,000, and he also receives $10,000 of cash as part of
the exchange. Glenn, therefore, has a realized gain of $30,000 on the exchange (combined value of
$60,000 received minus his basis of $30,000 in the rental he exchanged). He is required to pay tax and
recognize gain on only $10,000, the cash (boot) received in the exchange. The remaining $20,000 of
gain is deferred until he disposes of the farmland at a later date.
In situations when there is a realized loss on a section 1031 exchange, and the taxpayer receives
boot, none of the loss is recognized. However, the deferred loss is added to the basis of the contributed
like-kind property given to the other party to determine the basis of the like-kind property received.
Boot can be given, as well as received, in a like-kind exchange. If cash is given to the other party in
a like-kind exchange, none of the realized gain (or loss) will be recognized. However, if noncash boot
is given to the other party, then gain (or loss) will be recognized based on the difference between the
non-cash boot’s fair market value and adjusted basis at the time of the exchange.

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Example: Alice exchanges her commercial building for another commercial property. Her commercial
building is worth more than the building she is receiving. So, as part of the deal, she also receives a
valuable antique gold coin valued at $15,000 from the other party. Since the gold coin is not “like-kind”
property, this constitutes non-cash boot to Alice.
Example: Kaden wants to exchange his office building for a commercial warehouse. His office building
has a fair market value of $209,000 and an adjusted basis of $150,000. The warehouse has a fair market
value of $200,000. Since the warehouse is worth less, and Kaden’s office building is worth more, the
owner of the warehouse offers Kaden a forklift as part of the exchange. Kaden accepts the forklift,
which is valued at $21,000. Although the exchange still qualifies as a section 1031 exchange, Kaden
must recognize $21,000 (the FMV of the forklift) on his return because it is boot, and “unlike” property
(i.e., not qualifying real estate). 112
When an exchange involves property that is subject to a liability (such as an existing mortgage),
the assumption of the liability is treated as if it was a transfer of cash and thus considered boot by the
party who is relieved of the liability. Sometimes this is called “mortgage boot” or “debt reduction boot.”
On the other hand, if a party assumes a mortgage from the other party, it is treated as cash boot
given to the other party. If each property in an exchange is transferred subject to a liability, a taxpayer
is treated as having received boot only if they are relieved of a greater liability than the liability they
assume. When there is mortgage boot and cash boot in the same transaction, the mortgage boot paid
does not offset any “cash boot” received. Net cash boot received is always taxable if there is a realized
gain on the exchange.

Basis of Property Received in a Like-Kind Exchange

The basis of property received in a section 1031 exchange is the basis of the property given up with
some adjustments. Gain is only deferred, not forgiven, in a like-kind exchange.
Example: Cossette owns a residential rental property with a FMV of $355,000 and an adjusted basis
of $270,000. In 2024, she trades her rental property for a commercial parking lot with an FMV of
$360,000. The properties were very close in terms of fair market value, so no cash was exchanged, and
it was a straight exchange of properties. Cossette’s basis in the parking lot is $270,000, which is the
same as the adjusted basis of the rental property she gave up in the exchange. In other words,
Cossette’s basis remained the same.
If a taxpayer trades property and also pays money as part of the exchange, the basis of the property
received is the basis of the property given up, increased by any additional money paid.
Example: Charlie owns a parcel of timberland with a fair market value of $70,000. His basis in the
timberland is $30,000 (this is how much he paid for the land ten years ago). He wants to exchange the
timberland for a parcel of farmland in another state. The farmland has a FMV of approximately
$75,000, so it is more valuable than his timberland. Charlie agrees to pay the owner of the farmland an
additional $4,000 in cash to complete the transaction. Charlie’s basis in the new farmland is $34,000—
his original $30,000 basis in the timberland he gave up, plus the additional $4,000 cash he paid out-of-
pocket to acquire the farmland.

112 Scenarios based on examples illustrated in Publication 544, Sales and Other Dispositions of Assets.
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If a taxpayer receives boot in connection with an exchange and recognizes gain, the basis of the
like-kind property received is equal to the basis of the like-kind property given up plus the amount of
gain recognized, plus the basis of any boot given, minus the fair market value of any boot received,
minus any loss recognized. The basis of any non-cash boot received is its fair market value. The
taxpayer may reduce the amount of recognized gain by any exchange expenses (closing costs) paid.
Example: Joshua owns a tract of woodland with an adjusted basis of $80,000 and a current fair market
value of $110,000. Joshua wants to exchange the woodland for a small office building with an FMV of
$100,000. Since Joshua’s woodland is worth more than the office building, the seller of the office
building offers Joshua $10,000 in cash to complete the exchange. Joshua must recognize gain to the
extent of the cash boot he received. However, Joshua also pays $5,000 in legal fees and other related
closing costs in order to complete the exchange. Joshua’s recognized (taxable) gain is only $5,000,
figured as follows: (cash boot received $10,000 - $5,000 exchange expenses paid = $5,000 in
recognized gain).113
Example: Elaine owns a retail office building with a basis of $500,000 and a current fair market value
of $750,000. Rowan owns a strip mall with a fair market value of $900,000. Elaine and Rowan agree to
exchange properties. Since Rowan’s property is worth considerably more, Elaine pays Rowan
$150,000 in cash to complete the exchange, which is the difference in the property’s fair market values.
Once the 1031 exchange is complete, Elaine’s basis in the strip mall would be $650,000 ($150,000 cash
she paid to Rowan, plus the $500,000 adjusted basis in her old property).114

Like-Kind Exchanges Between Related Parties

Like-kind exchanges are permitted between related parties. However, if either party disposes of
the property within two years after a 1031 exchange, the exchange is disqualified from nonrecognition
treatment; any gain or loss that was deferred in the original transaction must be recognized in the year
the disposition occurs. For purposes of this rule, a “related person” includes a close family member
(i.e., spouse, sibling, parent, or child). It also includes a corporation or partnership in which a taxpayer
holds ownership or interests of more than 50%. This mandatory two-year holding period rule does not
apply:
•If one of the parties involved in the exchange subsequently dies;
•If the property is subsequently converted in an involuntary exchange (such as a fire);
•If it can be established to the satisfaction of the IRS that the exchange and subsequent
disposition were not done mainly for tax avoidance purposes.
The IRS closely scrutinizes exchanges between related parties because they can be used by
taxpayers to evade taxes on gains. Taxpayers must file Form 8824 for the two years following the year
of a related party exchange.
Involuntary Conversions (Section 1033 Exchanges)
An involuntary conversion refers to a situation where a taxpayer’s property is lost, damaged, or
destroyed, and the taxpayer receives a payment as a result. This can occur due to a casualty, disaster,

113 Example based on scenario in Publication 544, Sales and Other Dispositions of Assets.
114 Example based on scenario in Publication 551, Basis of Assets.
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theft, or condemnation. Sometimes, a taxpayer can have a taxable gain from an involuntary conversion.
This usually happens when a taxpayer’s insurance reimbursement exceeds their basis in the property.
Involuntary conversions are also called “involuntary exchanges.” Involuntary conversions can
occur with business property, investment property, as well as personal-use property, but the rules
differ for each. Gain or loss from an involuntary conversion is usually recognized for tax purposes
unless the property is a main home (covered later). A taxpayer reports the gain or deducts the loss in
the year the gain or loss is realized. However, an involuntary conversion does not automatically result
in a taxable event, even if the insurance reimbursement exceeds the taxpayer’s basis.
Under section 1033, a taxpayer can elect to defer reporting the gain from an involuntary conversion
if they reinvest the proceeds in similar property. In other words, the gain on an involuntary conversion
can be deferred until a later, taxable sale occurs. Unlike a 1031 exchange, replacing the converted
property with property purchased from a related party does not qualify for nonrecognition treatment.
Example: Vernon owns an office building. A catastrophic fire destroyed his building on January 3,
2024. He had purchased the building five years ago for $150,000. The depreciation deductions he had
taken were $78,000, so the building had an adjusted basis of $72,000. Vernon received a $120,000
insurance payout on May 3, 2024, realizing a gain of $48,000 ($120,000 insurance payment - adjusted
basis of $72,000). Vernon immediately spends $100,000 of the insurance payment to purchase a
replacement property. He uses the rest of the insurance money to go on vacation to Hawaii. Since
$100,000 of the $120,000 insurance payment was used to buy replacement property, his taxable gain
under the rules for involuntary conversions is limited to the remaining $20,000 insurance payment.
His taxable gain on the involuntary conversion is limited to $20,000 (the amount that he did not
properly reinvest).

Longer Replacement Period: While a section 1031 exchange only has a 180-day exchange period,
a section 1033 exchange has a much longer time for completion. The replacement period for an
involuntary conversion generally ends two years after the end of the first tax year in which any part of
the gain is realized. There is no requirement under Section 1033 that a qualified intermediary be
employed to hold the escrow funds or conversion proceeds.

Property Type Replacement Period

Most property, except those noted below; the two-year Two years
replacement period also includes personal homes.
Real property (real estate) that is held for investment or Three years
business use, such as residential rentals and office buildings
Sale of livestock due to weather-related conditions Four years
Main home in a federally declared disaster area Four to five years, depending on
IRS guidance

Real property that is held for investment or used in a trade or business is allowed a three-year
replacement period. The replacement period is four years for livestock that is involuntarily converted
because of weather-related conditions. Typically, any new animals bought must be used for the same

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purpose as the ones that were sold due to weather-related circumstances. For example, dairy cows
must be replaced with new dairy cows.
If a taxpayer’s main home is damaged or destroyed and is in a federally declared disaster area, the
replacement period is four years, but sometimes can even be extended to five years, depending on the
severity of the disaster.115
Example: Webster runs a farming business as a sole proprietor, and reports his income and loss on
Schedule F. On July 1, 2024, an explosion destroyed a grain silo on his land. He had originally purchased
the grain silo for $300,000, and depreciated it down to zero using section 179. Webster’s insurance
company reimburses him $300,000 for the entire loss on October 26, 2024. Webster is not required to
report the gain on his tax return if he reinvests all of the insurance proceeds in a new grain silo. He has
until December 31, 2026 (the end of the second year after the gain was realized) to replace the grain
silo using the insurance proceeds.
If a taxpayer reinvests in replacement property similar to the converted property, the replacement
property’s basis is the same as the converted property’s basis on the date of the conversion, subject to
certain adjustments.
The basis is decreased by any loss a taxpayer recognizes on the involuntary conversion, or any
money a taxpayer receives that they do not spend on similar property. The basis is increased by any
gain a taxpayer recognizes on the involuntary conversion and any additional costs of acquiring the
replacement property.
Example: A cyclone tears through Genevieve’s rental condo, leaving it in ruins. The condo had an
adjusted basis of $49,000, but Genevieve’s insurance company gives her a $175,000 insurance
settlement, which was the fair market value of the property before it was destroyed. Nine months later,
Genevieve uses all of the insurance proceeds to purchase a replacement rental property for $175,000
and also pays $3,000 in legal fees to a real estate attorney to transfer the title. Her gain on the
involuntary conversion is $126,000 ($175,000 insurance settlement minus her $49,000 basis).
However, Genevieve does not have to recognize any taxable gain because she reinvested all the
insurance proceeds in a similar property. The basis of her new property becomes $52,000 ($49,000 +
$3,000), reflecting both her original basis and the additional legal fees she incurred during the
acquisition of the replacement property.
Example: Reuben owns a rental fourplex in Texas with a basis of $250,000. He receives an insurance
settlement of $400,000 after the building is destroyed by a tornado. Six months later, Reuben
purchases another apartment building in Texas for $380,000. His realized gain on the involuntary
conversion is $150,000 ($400,000 insurance payout - $250,000 basis). He must recognize $20,000 of
gain because he received an insurance payment of $400,000 but only spent $380,000 on a replacement
property ($400,000 - $380,000). His basis in the new property is $250,000, which is calculated as the
cost of the new property minus the deferred gain ($380,000 - $130,000 = $250,000). If Reuben had
used all the insurance proceeds and reinvested them all in the new property, he would not have had to
report any taxable gain.

115A five-year replacement period has been applied to certain extreme disaster areas. The IRS will usually announce an extended
replacement period in a news release or other official guidance.
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Condemnations and Eminent Domain

A “condemnation” is a specific type of involuntary conversion that involves the legal process of
taking private property for public use. If a building poses a threat to public safety or health, it may also
be condemned by the government. This process is sometimes referred to as “eminent domain.” It is
considered a forced sale, where the owner is essentially selling their property to the government or
another party.
Eminent domain gives the government the power to take private property in exchange for
compensation. A condemnation can be initiated by a state or local government or by a private
organization with the authority to seize property. In most cases, the owner will receive some form of
payment or compensation for the property being taken.
Example: A local government informs Zavier that his farmland is being condemned to create a public
highway. Although Zavier does not want to sell his farmland, the government forces the sale and issues
a condemnation award to Zavier, paying him the property’s fair market value of $400,000. Zavier’s
original basis in the farmland was $80,000, because he bought the land many years ago. Zavier is
frustrated by his government and decides not to purchase replacement farmland. Therefore, he has a
taxable event, and he must recognize $320,000 as taxable income ($400,000 - $80,000 = $320,000).
However, if Zavier were to purchase replacement property with the condemnation award, he would
have a nontaxable section 1033 exchange. He has up to three years to decide if he wants to reinvest
the proceeds.
Amounts taken out of a condemnation award to pay debts on the property are considered paid to
the taxpayer and are included in the amount of the award.
Example: Kenton owns ten acres of farmland, which he uses to grow wheat and corn. He bought the
land several years ago, and still owes a mortgage on the property. The state condemned Kenton’s farm
and the surrounding land in order to build a light rail system. Kenton tries to fight the condemnation,
but he loses his case in court. The court award was set at $200,000. The state paid him only $148,000
because it paid $50,000 to his mortgage company and $2,000 in accrued real estate taxes that were
delinquent on the property. Kenton is considered to have received the entire $200,000 as a
condemnation award.
The deadlines for replacing condemned property are the same as other qualified section 1033
exchanges.
Example: Hammond owns a strip mall which he rents out to commercial tenants. On March 12, 2024,
the building was condemned by the county in order to build a public skatepark. Hammond decides not
to fight the condemnation, and the strip mall is torn down a few months later, and he receives his
condemnation award from the government on November 30, 2024. Since the strip mall is business-
related real estate, Hammond has three full years to reinvest the proceeds in a similar property. He has
until December 31, 2027, to replace the condemned strip mall with a similar building (three years
from the end of the year in which he received the condemnation award). As long as he buys a similar
business property within the next three years with the proceeds, he will not have to recognize any of
the gain or report it on his return.

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Condemnation or Destruction of a Main Home

If a taxpayer’s main home is condemned or destroyed, the taxpayer can generally exclude the gain
as if they had sold the home under the section 121 exclusion. This includes homes that are seized or
disposed of under the “threat of condemnation.” In the case of a condemnation, the property owner
must be aware of the threat and must reasonably believe that a condemnation is likely to occur.
If the taxpayer’s main home is eligible for a section 121 exclusion, single filers can exclude up to
$250,000 of the gain, and joint filers up to $500,000.
Example: Sharla has owned and lived in her home for seven years. On January 3, 2024, a local
government informed Sharla that it wished to acquire her home and surrounding land in order to
create a public park. This is a condemnation of private property for public use. After the local
government took legal action to condemn her property, Sharla went to court to keep her home. The
court decided in favor of the government. The governmental agency takes possession of Sharla’s home,
and Sharla receives a $355,000 condemnation award from the government on December 27, 2024. Her
basis in the home is $153,000. Even if she decides not to reinvest the proceeds of the condemnation
award, Sharla will not have a taxable gain, because the gain would have been excludable under section
121 if she had voluntarily sold the home ($355,000 award - $153,000 basis = $202,000 non-taxable
capital gain).
Any excess gains above these amounts may be potentially deferred under section 1033 if the
taxpayer reinvests all the proceeds in another, similar property. In order to qualify for deferral, the
taxpayer’s use of the replacement property must be substantially the same as the replaced property.
In other words, a home must be replaced with another home (see example, next).
Example: On February 8, 2024, a fire destroys Claudia’s main home. She bought the home ten years
ago for $80,000. Claudia’s insurance company pays Claudia $400,000 for the house, which was the fair
market value of the home when it was destroyed. Claudia realizes a gain of $320,000 ($400,000
insurance proceeds - $80,000 basis). Claudia decides to downsize, and on August 27, 2024, she
purchases a smaller condo at the cost of $100,000. Because the destruction of her old house is treated
as a “sale” for purposes of section 121, Claudia may exclude $250,000 of the realized gain from her
gross income. For purposes of section 1033, the amount “realized” is then treated as being $150,000
($400,000 insurance proceeds - $250,000 section 121 exclusion) and the gain realized is $70,000
($150,000 amount realized - $80,000 basis). Claudia elects under section 1033 to recognize only
$50,000 of the gain ($150,000 amount realized - $100,000 cost of new house). The remaining $20,000
of gain is deferred and Claudia’s basis in the new house is $80,000 ($100,000 cost - $20,000 gain not
recognized).116

116The examples in this section are modified from IRS Final Regulations, Exclusion of Gain from Sale or Exchange of a Principal
Residence, [TD 9030]. RIN 1545-AX28. https://www.irs.gov/pub/irs-regs/td9030.pdf.
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Unit 9: Rental and Royalty Income

For additional information, read:
Publication 527, Residential Rental Property (Including Rental of Vacation Homes)
Publication 946, How to Depreciate Property

Rental income refers to any payment received for the use or occupancy of physical property.
Examples of rental activities include residential rentals, transient lodging at hotels and motels,
commercial rentals, and personal property rentals such as car rentals or machinery rentals. Taxpayers
must report all rental income as part of their gross income, and the way in which rental activities are
reported may differ depending on the specific type of rental activity involved.
Royalty income is a form of income received for the use of another person’s property. This type
of income can come from patents, copyrights, or the use of natural resources like timberland, oil and
gas wells, or a copper mine. Generally, rental and royalty activities are declared on Schedule E (Form
1040), though there are some exceptions to this rule.
Example: Faris owns a residential duplex. He has two long-term tenants, one on each side of the
duplex. He is not a real estate professional. He manages the rental property himself and does many of
the repairs and general maintenance. The rental income Faris receives from his tenants is taxable and
would be reported on Schedule E, Supplemental Income and Loss. The income is subject to income tax,
but not self-employment tax.
Example: Madeline owns 200 acres of forestland that she inherited from her grandfather. She leases
the forestland to a lumber company that harvests and processes the timber. Madeline receives
quarterly payments under a contract agreement with the timber company based on the value of the
timber taken from her property during the year. At the end of the year, the timber company provides
Madeline with a Form 1099-MISC reporting the payments as “royalties” in Box 2. Madeline reports the
royalty payments received as royalty income on Schedule E, Supplemental Income and Loss. This
royalty income is subject to income tax, but not self-employment tax.

Rental Income Defined

Rental property owners are eligible to deduct various expenses related to the management,
preservation, and upkeep of their properties. These expenses may include:
• Interest on mortgage payments and property taxes
• Maintenance, lawn care, repairs, and cleaning services
• Expenses for advertising vacancies
• Utilities that are covered by the homeowner (such as sewer or trash)
• Insurance premiums for home, liability, and natural disaster coverage
• Depreciation
Advance Rent: Taxpayers must report rental income when it is constructively received (i.e.,
available without restrictions). This includes advance rent, which is any amount received before the
period that it covers. Thus, a taxpayer must include advance rent in income in the year they receive it,
regardless of the period covered or the accounting method used, unless the amounts are subject to
restrictions.
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Example: Hiraku rents out a duplex. On December 20, 2024, his tenant Cynthia pays two months of
rent in advance, in cash, for January 2025 and February 2025 because she is going to Europe on an
extended vacation. Hiraku cannot delay reporting the rental income. He must report all the advance
rent as taxable income in 2024 (when he received it).

Example: Calvin owns a residential rental property. His tenant, Angelique, is planning to go overseas
for four months. On December 31, 2024, she gives Calvin four checks for the rent of January 2025
through April 2025, but she post-dates all the checks. Since the post-dated checks are dated for a future
date, Calvin cannot deposit them until 2025. The checks are subject to “substantial restrictions,” so he
does not have constructive receipt of the income until he actually deposits the checks in the months in
which they are payable. He does not have to recognize the advance rental payments until 2025, when
he can legally deposit the checks.
Lease Cancellation: If a tenant pays a fee to cancel a lease, the amount received for the lease
cancellation is classified as rental income. The payment is included in the year received regardless of
the taxpayer’s accounting method.
Example: Frawley owns a commercial office building in downtown Chicago. One of Frawley’s tenants,
a medical doctor, wants to break his lease. The doctor plans to move to another state due to a divorce.
Frawley agrees to terminate the lease if the doctor pays an early termination fee equal to two months’
rent. The doctor agrees, and pays Frawley $4,000 to terminate the lease on his medical office. Frawley
must include the lease termination fee in his rental income on Schedule E.
Refundable Security Deposits: When a tenant pays a refundable security deposit upon renting a
property, the money is not considered income for the landlord at that time. However, if the property
owner keeps some or all of the security deposit because the tenant did not live up to the terms of the
lease or because they damaged the property, then the deposit amount retained is recognized as income
in the year it is forfeited by the tenant.
Example: Benjamin owns a residential rental. He signs a lease to rent his residential rental to Shelly,
his new tenant. Benjamin receives $750 for the first month’s rent and a $500 refundable security
deposit from Shelly. Benjamin must include $750 in his rental income, but the refundable security
deposit would not be reported, unless and until it was later forfeited by Shelly on account of damages
to his property.
Insurance Premiums Paid in Advance: If a taxpayer operates on a cash-basis and they pay an
insurance premium that covers multiple years, normally they can only deduct the portion of the
payment that applies to the current year. However, under the “12-month rule” in Treas. Reg. Sec.
1.263(a)-4(f), a taxpayer can generally deduct pre-paid insurance premiums (as well as other pre-paid
services) all in the year paid so long as the benefit of the insurance policy does not extend beyond the
earlier of: (1) 12 months from the first effective date of the pre-paid policy term, or (2) the end of the
tax year following the year of the pre-paid premium payment.
Local Benefit Taxes: In most cases, a property owner cannot deduct charges for local taxes that
increase the value of a rental property, such as assessments for streets, sidewalks, or water and sewer
systems. These charges are capital expenditures that must be added to the basis of the property. Only

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taxes to maintain or repair such infrastructure, or interest charges related to financing its construction,
can be deducted.
Property or Services in Lieu of Rent: If a landlord receives property or services as payment for
rent instead of cash, the fair market value must be recognized as rental income. If the tenant and
landlord agree in advance to a price, the agreed-upon price is deemed the fair market value unless
there is evidence to the contrary.
Example: Loretta owns an apartment complex with five separate units. One of Loretta’s tenants,
Maloney, is a professional chimney sweep. Maloney offers to clean all of Loretta’s chimneys in her
apartment building instead of paying three months’ rent in cash. Loretta accepts Maloney’s offer.
Loretta must recognize income for the amount Maloney would have paid for three months’ rent.
However, Loretta can deduct that same amount as a business expense for the maintenance of the
property.
If a tenant pays expenses on behalf of the landlord, the landlord must recognize the payments as
rental income. However, the property owner can also deduct the expenses as rental expenses.
Example: Woodrow owns a residential rental property that he manages himself. While he is out of
town on vacation, a pipe bursts inside the rental property and starts flooding the garage. Woodrow’s
tenant, James, contacts an emergency plumber, pays for the necessary repairs, and deducts the repair
bill from his rent payment. Woodrow should include both the net amount of the rent payment and the
amount James paid for the utility bills and the repairs as rental income. Woodrow can also deduct the
cost of the repair as a rental expense.

Example: Savannah owns an apartment building in New York. The furnace in the apartment building
broke down in the middle of the night. Temperatures are below freezing, so Savannah’s tenant, Diego,
pays for the emergency repairs out-of-pocket and deducts the furnace repair bill from his rent
payment. Savannah must recognize as rental income both the actual amount of rent received in cash
from Diego and the amount he paid for the repairs. Savannah can also deduct the cost of the furnace
repair as a rental expense.

Vacant Rental Property

A property owner cannot claim a “loss” of rental income for any period of time when the property
remains unoccupied. However, if the owner is putting in effort to attract tenants and make the property
available for rent, they can still deduct necessary expenses as soon as the property is deemed
“available” for renting, regardless of whether or not a tenant is found immediately. In other words, if
the property is available for rent, the owner can deduct expenses, including depreciation, even if the
property is unoccupied.
Example: Finnegan purchased a rental property and made the property available for rent on February
1, 2024, by advertising it in the local newspaper. Finnegan immediately started accepting rental
applications and found a tenant who moved in on June 1, 2024. Even though the rental property was
unoccupied from February until June, Finnegan can still deduct the mortgage interest and other
expenses related to the property during that period, because the property was available, ready, and
advertised for rent.

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Sometimes a rental property will stand vacant for other reasons. For example, if a landlord must
make repairs after a tenant moves out, the owner may still depreciate the rental property during the
time it is not available for rent. This is assuming the rental property had already been placed in service
as a rental.117
Example: Artie owns a residential rental that he has rented continuously for over a decade. In January
2024, he evicts his tenant for non-payment. Artie’s tenant vandalizes the property before leaving in
the middle of the night. When Artie finally visits the property, he discovers that it will need extensive
repairs, which may take over six months to fix. The home will be uninhabitable until the repairs are
completed. Artie may continue to claim the expenses on the property, including depreciation, while
the repairs are being made. This is considered “idle property.”

The rules are different, however, if the owner makes rental property repairs before actually placing
the property into service. In this case, the repairs must be capitalized and included in the property’s
basis. The owner can only deduct expenses once the property is placed into service for the production
of rental income.118
Example: Janessa purchased a “fixer-upper” rental property in Montana on November 1, 2024. The
cost of the home was $145,000. She spends an additional $12,000 on essential repairs before actually
placing the property into service on January 20, 2025 (the following year), when she begins advertising
it for rent. She cannot deduct any of the expenses in 2024, including any mortgage interest or repairs,
because the rental was not placed into service until the following year. Instead, all those repair costs
would be added to the property’s basis. She could begin depreciating the property and deducting
expenses in 2025, the year in which she actually placed the property into service (when it became
available for rent).

Depreciation of Rental Property

A landlord can start claiming deductions for the depreciation of a rental property once it is put into
use for generating income. A rental property is considered to be “put into use” when it is prepared and
available for rent. Depreciation stops when the landlord has either fully recuperated their cost or basis,
or when the property is no longer in use, whichever comes first. There are three main factors that
determine how much depreciation a landlord can deduct: the property’s basis, the recovery period for
the property, and the depreciation method used.
Most residential rentals are depreciated over 27.5 years. For example, a residential rental home
with a cost basis of $137,500 would generate depreciation of $5,000 per year ($137,500 ÷ 27.5 years)
over most of the years of its depreciable life. Nonresidential buildings are generally depreciated over
39 years, with a half-month’s worth of depreciation allowed for the first and last month of the
depreciable life of the property (i.e., the mid-month convention). An example of a nonresidential rental
would be an office complex, where the offices are rented to business tenants, but nobody lives or sleeps
in the building. The cost of land is never depreciated because land does not wear out, become obsolete,
or get used up.

See IRS Publication 527, Residential Rental Property, under the subheading “Idle Property.”
117

In order to deduct costs as expenses rather than having to capitalize them, the rental unit must be placed into service, i.e., it
118

must be “ready and available” for rent (IRS Reg. § 1.263(a)-2(d)(1)).

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Example: Stanislav owns a strip mall as well as an apartment complex. The strip mall is rented to
commercial tenants, mostly retail shops. The apartment complex is occupied by month-to-month
(residential) tenants, mostly families. The strip mall would be depreciated over 39 years. The
apartment complex would be depreciated over 27.5 years.
Example: Mason purchased a rental tri-plex on January 1, 2024, for $395,000. The assessed value of
the building is $275,000 and the assessed value of the land is $120,000. It is a residential rental so a
MACRS class life of 27.5 years is used. Using straight-line depreciation, the yearly depreciation amount
is calculated as follows: $275,000 ÷ 27.5 years = $10,000 depreciation expense per year just on the
building (the land is not depreciable). Mason would report the rental activity on Schedule E (Form
1040).
Example: In 2024, Bernice buys a residential rental property for $200,000 and immediately places it
into service as a rental. The most recent property tax assessment made by the county assessor’s office
is out of date, and it places the value of the home at only $160,000 (which is less than what she actually
paid), so she obtains a private appraisal of the property. The private appraisal comes in at a total value
of $210,000, so Bernice knows she got a good deal on the purchase of the home. Per the appraisal, 85%
of the appraised value of the property ($178,500) was attributable to the home and 15% ($31,500)
was attributable to the land. In order to figure out her basis for depreciation, Bernice can allocate 85%
of the purchase price to the house and 15% of the purchase price to the land. Therefore, the basis of
the house is $170,000 (85% of $200,000) and her basis in the land is $30,000 (15% of $200,000).
Bernice may use $170,000 as her basis for depreciation on the property.
Converting a Home to Rental Use: Sometimes, taxpayers will convert their personal residence to
a rental property. If a taxpayer converts a personal home to rental use at any time other than the
beginning of a tax year, the owner must divide the expenses between rental use and personal use. Only
the portion of expenses for the period when the property was used or held as a rental can be deducted
as rental expenses.
When converting a property to rental use, it will be considered “placed in service” on the date of
conversion. Additionally, if a taxpayer converts a personal home into a rental property, the basis for
depreciation will be the lesser of the fair market value or their adjusted basis on the date of
conversion.
Example: Albert bought his home for $180,000 five years ago. On the date he bought the house, the
land was assessed at $30,000 and the home was valued at $150,000. But on January 30, 2024, Albert
decided to turn his home into a rental property. However, a recent crime wave has caused real estate
values in the area to drop significantly. As a result, the county assessor’s office now estimates the Fair
Market Value (FMV) of the property to be $130,000, with $20,000 being for the land and $110,000 for
the house. The basis for depreciation of the house is the FMV on the date of conversion ($110,000)
because it is less than Albert’s allocated cost when he purchased the property five years ago
($150,000). Albert must use $110,000 as his basis to calculate depreciation on the converted rental,
which is reported on Schedule E, Supplemental Income and Loss. The cost of land cannot be depreciated,
so only the home’s value is included in the calculation.

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Section 179 Rules for Certain Types of Rental Property

In 2024, the maximum Section 179 deduction is $1,160,000. In the past, a landlord could not claim
the Section 179 deduction for any property that was used to produce rental income. This prohibition
included any rental assets (such as furniture and appliances) as well as capital improvements, such as
HVAC systems.
The Tax Cuts and Jobs Act expanded the Section 179 deduction to certain types of tangible personal
property that is used predominantly to furnish lodging. This new provision includes lodging facilities,
such as dormitories, hostels, drug treatment centers, or similar facilities where sleeping
accommodations are provided. As always, Section 179 is elective and can be taken on new or used
property. The TCJA also expanded the definition of “eligible property” to include certain expenditures
for nonresidential buildings: including roofs, heating, ventilating, and air conditioning (HVAC)
equipment, fire protection and alarm systems, and security systems. Nonresidential commercial
property includes office buildings, medical centers, hotels, and malls.
Example: Isaac owns a medical office building that he rents out exclusively to medical and dental
professionals. It generates $325,000 of taxable income (before any Section 179 deduction). During the
year, Isaac spends $17,525 on a new HVAC system for the building. He also installs a new alarm system,
which cost $16,750. Isaac may choose to deduct the entire cost of the equipment by taking the Section
179 election on his tax return. He does not need to depreciate the HVAC system or the alarm system
over their useful lives.

Example: Imogen owns the Bamboo Hostel in New Orleans. The hostel offers inexpensive, short-term
rentals to guests. Daily breakfast and clean linens are provided. During the year, Imogen invested in a
new air conditioning system, which cost $19,700. Her hostel is classified as a nonresidential business
property, so she is permitted to take Section 179 to deduct full cost of the air conditioning system in
the current year.
Example: Hassan owns a residential duplex that he rents out to month-to-month tenants. During the
year, Hassan spends $25,900 on a new roof for the duplex. He cannot deduct the cost of the roof, or
take Section 179 for the cost, because it is a residential rental. Hassan must capitalize and depreciate
the entire cost of the roof as an improvement.
All types of rental properties can produce revenue for their owners, although the tax treatment of
the revenue varies on several different factors.
Mixed-Use Buildings: Special rules apply to “mixed-use” buildings. Under current IRS rules, if 80%
or more of the annual gross rental income from a mixed-use building is generated from the residential
rental apartments, the entire building and its structural components will be classified as a residential
rental property.119 This also means that if 80% of the income generated is from residential rentals,
then the entire building and improvements are depreciated over 27.5 years. If the building does not
meet the 80% test, the entire building and improvements are depreciated over 39 years.

119 This rule for “mixed-use” properties does not include a unit in a hotel, motel, inn, or other establishment where the units are
rented on a transient basis. These types of properties are classified as “transient occupancy” residential structures, and are treated
as commercial properties by default.
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Example: Benny purchases a building in historic downtown Sacramento, California. He renovates the
building into a mixed-use development consisting of two distinct sections. The upstairs contains four
residential rental apartments, and the bottom of the building is a retail space rented out to two
commercial tenants: a coffee shop and a clothing retailer. 30% of Benny’s rental income is from the
upstairs residential apartments. The remaining 70% of the revenue comes from the commercial
tenants (the downstairs coffee shop and clothing store). In this scenario, the entire building would be
treated as nonresidential (commercial) property. Benny would depreciate the entire building over 39
years. Later in the year, Benny spends $14,000 to install sprinklers and a new fire protection system.
Since the building is treated as nonresidential commercial property, he may use Section 179 to expense
the entire cost of the upgrades.

Repairs vs. Improvements to Rental Property

Taxpayers often misunderstand when an expense qualifies as a repair or an improvement. A
taxpayer can expense the cost of repairs to rental property but cannot currently expense the cost of
substantial improvements.120 The IRS defines repairs and improvements in the IRS’ tangible property
regulations. These are a complex set of provisions governing repairs and capitalization that affect all
taxpayers who use tangible property in their businesses.
Unless the improvement qualifies for accelerated depreciation, a property owner must typically
recover the cost of an improvement by taking depreciation deductions over the asset’s applicable
recovery period.
A repair generally keeps an asset or property in good working condition but does not add to the
value of the asset or substantially prolong its life. Repainting a rental, fixing leaks, and replacing broken
windows are examples of repairs that are fully deductible in the year they are paid or incurred.
Improvements are major expenditures that go beyond normal repairs. This can include adding a
bedroom or completely replacing the plumbing system, and in most cases, these improvements must
be depreciated over time. An “improvement” is defined as anything that results in the betterment of
a property, restoration of a property, or adaptation of a property to a new or different use.

Repairs (Currently Expensed) Improvements (Capitalized and Depreciated)

Painting a room Adding a room addition or extra bathroom

Fixing a broken window Replacing all the windows on a property

Replacing a few broken roof tiles Replacing the entire roof

Power washing a driveway Repaving or installing an entirely new driveway

Repairing broken appliances Replacing all the plumbing

Fixing a broken garage door Construction of a swimming pool

120Sometimes, the IRS will use the different terms to mean the same thing, such as “betterment of a property” instead of
“improvement.” These are keywords that the IRS may use interchangeably on the exam.
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For the EA exam, most of the specific details of these regulations will likely not be tested. However,
you should have a general understanding of the concept that a rental property owner or business
owner may recover the costs of property either through current deductions or through periodic
depreciation deductions for items required to be capitalized.
Example: Odette owns a residential rental property, which she manages by herself. In 2024, she spent
$18,000 to replace all the plumbing, $9,540 to re-pave the entire driveway, and $575 to repair a couple
of broken gutters. Only the gutter repair ($575) can be expensed on her tax return. The costs of the
new plumbing and the new driveway must be capitalized and depreciated over time.
The capitalized cost of an improvement is depreciated separately from the original cost of the asset
or property that is being improved.
Example #1: Quaid owns a rental property. A baseball broke a window, so he replaced it with an
upgraded model, an insulated double-pane window that helps control heating and cooling costs. Even
though this window is a substantial upgrade from the previous one, it is still considered a repair,
because the old window was broken and needed to be replaced. If Quaid were to replace all the
windows in the house, the upgrade would be considered an “improvement,” rather than a repair, and
he would be required to capitalize the cost and claim depreciation deductions over a period of years.

Example #2: Later in the same year, Quaid also replaces the house’s septic tank at a total cost of
$19,500. This is considered a substantial improvement, and the cost of the septic tank must be
depreciated over time, rather than deducted against current income.
Under the de minimis safe harbor rule of the tangible property regulations,121 the taxpayer can
elect to expense tangible property costing no more than $2,500 per invoice or item in the year they are
used or consumed. The de minimis safe harbor election does not apply to inventory or to the purchase
of land, but can apply to land improvements, such as: livestock fencing, driveways, walkways, retaining
walls, and outdoor lighting.
Example: Kenneth owns a residential rental property. During the year, Kenneth replaces the linoleum
flooring in the bathroom and the kitchen. His friend is the installer, and gives him a big discount on the
price. The total cost for installation and materials is $2,100 and is clearly listed on the invoice. Kenneth
may deduct this cost as a repair or as supplies, because the total invoice amount is less than $2,500,
which is under the safe harbor rule. Kenneth should attach a statement claiming the “Section 1.263(a)-
1(f) de minimis safe harbor election” to his timely filed federal tax return.

Example: Annie is 75 years old and owns 50 acres of pastureland that she rents to local farmers for a
flat cash amount. During the year, Annie pays to have a barbed wire fence installed around the
property. The barbed wire fence is a land improvement, which typically must be capitalized and
depreciated. However, the fencing company gives Annie a generous senior discount, and the invoice
cost for the entire job ends up being $2,475, which is just under the de minimis safe harbor. Annie
makes the election and deducts the entire cost of the fence as an expense on Schedule E.

The tangible property regulations are covered in greater detail in Book 2, Businesses. For Part 1 of the exam, you may have to
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know how these regulations apply to rental property or sole proprietors.

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There is also an additional safe harbor election for small taxpayers (SHST) that applies to
landlords who own rental properties. Landlords can use the SHST only if the total amount paid during
the year for repairs, improvements, and similar expenses for a building does not exceed the lesser of
(1) $10,000 or (2) 2% of the unadjusted basis of the building. The SHST applies only to buildings with
an unadjusted basis of $1 million or less (not including the cost of the land).
Example: Mubarak is a landlord who owns a small office building. Mubarak’s office building has an
unadjusted basis of $800,000. He wants to upgrade the outdoor lighting system to energy-efficient
lights. Under the safe harbor election for small taxpayers (SHST) the annual expense limit for
Mubarak’s building is the lesser of $10,000 or 2% of the building’s unadjusted basis. The cost of the
lighting project is $6,500, well below the safe harbor threshold. Mubarak makes the SHST election by
attaching a statement to his income tax return for the year. Doing so will allow him to deduct the entire
cost of the lighting upgrade as a current expense on Schedule E.

Deductible Rental Losses

The tax treatment of rental income depends on several factors: whether a property owner is a real
estate professional or actively participates in managing a property; whether there is any personal use
of the rental property, and if so, whether the dwelling is considered a home; and whether the rental
activity is for “carried on” for profit. In general, a trade or business activity is considered a passive
activity if the taxpayer does not materially participate in it, and rental activities are generally
considered passive activities regardless of the participation of the owners. The deductibility of losses
from passive activities is limited, and a taxpayer usually cannot deduct losses from passive activities
to offset other nonpassive income (such as wages, or self-employment).
Note: Property owners that provide “substantial services” may be classified as self-employed, and
their rental activities are classified as business activities on Schedule C rather than rental activities on
Schedule E. The IRS defines “substantial services” as: regular cleaning, changing linen and towels, or
daily maid service (such as the services a guest might receive at a hotel). In this case, the rental income
and expenses, including interest and taxes, would be reported on Schedule C and subject to self-
employment tax. Motel and hotel owners are covered in more detail later in the chapter.
Generally, losses from passive activities that exceed income from passive activities in the same year
are disallowed. The disallowed losses are carried forward to the next taxable year and can be used to
offset future income from passive activities. There is a special “$25,000 exception” to this rule,
however, for rental real estate activities.
Special $25,000 “Loss Allowance” for Real Estate Rental Activities
If a landlord is actively involved in managing their rental properties, they may be eligible to deduct
up to $25,000 of losses from their nonpassive income. It is important to distinguish that active
participation does not require the same level of involvement as material participation.
Note: “Active participation” is not the same standard as “material participation.” Material participation
is a much higher standard. For example, the owner of a rental property will generally be treated as
actively participating if they make management decisions such as deciding rental contracts, approving
repairs, and other similar management decisions.

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To be considered “actively participating” in a rental activity, a property owner must own at least
10% of the rental property and must make management decisions in a significant and bona fide way,
such as approving new tenants and establishing the rental terms. Active participation can also include
participation by the property owner’s spouse.
Example: Basil owns a residential rental property in Los Angeles, California. He lives in Los Angeles
and has a regular full-time job as a teacher. Basil actively manages his rental by choosing his own
tenants, hiring contractors to do any required repairs, and personally collecting the rent. Basil is not a
real estate professional, but he is actively participating in his rental activity.
However, if the IRS determines a taxpayer has not “actively” participated, rental losses are not
currently deductible, and the taxpayer would not be eligible for the special $25,000 loss allowance.
Example: Camelia owns a rental condo in Hawaii. She lives and works in Nevada. Camelia hired a
management company to manage the property and screen new tenants. The management company
handles all the repairs and collects the rent. The management company charges a fee for its services
and then remits the net proceeds to Camelia monthly. It has been several years since Camelia has even
visited the property. Camelia is not actively participating in this rental activity. In 2024, she has
$43,000 in rental income from the property, but her expenses are $51,000, which means she had a net
rental loss of ($8,000). Since she is not actively participating in the rental activity, she is not eligible for
the special loss allowance. In 2024, she has $75,000 in wages and no other income. Since she does not
have any other passive income to offset, she must carry over her $8,000 passive rental losses to a future
tax year.
This special loss allowance is subject to an income phaseout. The full $25,000 loss allowance is
available for taxpayers, whether single or MFJ, whose modified adjusted gross income (MAGI) is
$100,000 or less.
Definition: MAGI is a taxpayer’s adjusted gross income with certain deductions added back in. These
may include IRA contributions, rental losses, student loan interest, and qualified tuition expenses,
among others. A taxpayer’s MAGI is used as a basis for determining whether he qualifies for certain tax
deductions.
If a taxpayer is married and files a separate return, but lived apart from their spouse for the entire
tax year, the taxpayer’s special allowance for rental losses cannot exceed $12,500; and this $12,500
allowance would only be available if the taxpayer’s MAGI is $50,000 or less. However, if the taxpayer
lives with their spouse at any time during the year and is filing MFS, the taxpayer cannot use any passive
rental losses to offset nonpassive income.
Example: Camden and Brenda are married and live together, but they choose to file separate returns.
They do not live in a community property state and have always kept all their income and assets
separate. Camden owns a residential rental as his sole property. Camden actively participates in the
rental activity by choosing his own tenants and making repairs to the property as necessary. In 2024,
he earned $68,000 in wages. His rental activity has an overall loss of ($14,800). Because he files
separately, but lived with his wife during the year, Camden cannot deduct any of the rental losses from
his nonpassive income (his wages). His entire rental loss must be carried forward to future years.

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Example: Mustafa and Fatima are married, but have lived apart for several years. They file separate
tax returns. Mustafa owns a residential rental that he manages himself. Mustafa’s wages for the year
were $42,000, and he had no other taxable income. Mustafa incurred a ($6,000) loss on his rental
property. Even though he files MFS, he is allowed to take the full rental loss because (1) he did not live
with his wife at any time during the year, (2) his MAGI was under $50,000, and (3) his rental losses
were less than $12,500 (one-half of the “special allowance”). After deducting his allowable rental losses
from his wages, his adjusted gross income would be reduced down to $36,000 ($42,000 wages - $6,000
allowable rental loss).
Only passive rental activities qualify for this “special loss allowance,” and not other types of passive
activities. Furthermore, certain taxpayers do not qualify for the special loss allowance. The following
taxpayers are not allowed to claim the special loss allowance:
• A limited partner in a business activity,
• A property owner who has less than 10% ownership in a rental activity,
• A trust or corporation (The $25,000 special allowance is available only to natural persons,
although disregarded grantor trusts are permitted.)
Example: Callum is a 5% minority-interest partner in Crestview Rentals, LLC, a partnership that owns
a 50-unit apartment complex in Texas. The other investors in the apartment building are unrelated to
Callum. The complex is managed by a professional management company. Callum has little or no
involvement in the rental activity. Since Callum does not own at least 10% of the activity, he cannot be
treated as “actively participating” in the rental. If the rental has losses for the year, Callum will not be
able to offset his active income with those losses. Instead, the losses would have to be carried to future
years to offset future passive income.
Rental losses that cannot be deducted due to the limitations described above can be carried
forward indefinitely and used in subsequent years, subject to the same limitations.
Example: Kamal works as a full-time grocery store manager and earns $80,000 in wages per year. He
also owns two residential rental properties, but he is not a real estate professional. He manages the
properties himself and personally collects the rents. Whenever repairs are needed, he hires
contractors to complete them. Kamal should report his rental income and losses on Schedule E. His
rental income is considered passive activity income, and it is not subject to self-employment tax. He is
also eligible for the $25,000 loss allowance if his rentals have losses for the year.
Example: Hamid and Emeline are married and file jointly. They own a residential rental duplex that
they manage themselves together. They have combined wages of $98,000 and a rental loss on the
duplex of ($26,800). Because they meet both the active participation and the MAGI tests, they are
allowed to deduct $25,000 of the rental loss as an offset to their nonpassive income (their wages). The
remaining amount over the $25,000 limit ($1,800) that cannot be deducted in the current year is
carried forward and may potentially be used in the following year.
If a taxpayer’s MAGI is more than $100,000, the “loss allowance” decreases by $1 for every $2 above
the threshold. If their MAGI reaches $150,000 or higher (or $75,000 if filing separately when married),
the full $25,000 allowance is phased out and any losses must be carried over to future years.

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Example: Ernesto and Fabiola file jointly and have MAGI of $140,000. They have $25,000 of losses
from the residential rental property that they actively manage. Because they actively manage the
property, they potentially qualify to deduct up to $25,000 of losses against their nonpassive income.
However, because their joint income is over $100,000, they are subject to a phaseout. Therefore,
Ernesto and Fabiola’s deduction for rental losses is reduced by $20,000 (0.5 × [$140,000 - $100,000]).
They can deduct $5,000 ($25,000 - $20,000) against their nonpassive income. The additional $20,000
of losses is carried forward to the following year.
Suspended losses can also be released when the taxpayer’s income goes below the applicable
thresholds, or also when the property is disposed of in a fully taxable sale.

Example: Guillermo owns a rental property in San Diego. He actively participates in the rental activity
by choosing all his own tenants and collecting the rents himself. In the prior tax year, he incurred
($9,000) in net losses on his rental. Guillermo’s modified adjusted gross income was $175,000 for the
year. Because of his income threshold, all of Guillermo’s rental losses were suspended, and he was not
allowed to deduct any rental losses. In 2024, Guillermo incurred an additional ($5,000) in losses from
his rental activity. However, he also switched jobs in the middle of the year, and now his salary is lower.
In 2024, Guillermo’s adjusted gross income is $89,000, so his rental losses are now permissible. His
suspended rental losses from the prior year ($9,000) and his current-year losses ($5,000) will be
allowed on his 2024 tax return, for a total loss of ($14,000) on Schedule E. This loss will offset his
wages, and give him a lower tax liability for the year.

Renting Only Part of Property

In the case of a taxpayer who only rents a portion of a property, they must allocate specific expenses
between the part used for rental purposes and the part used for personal use, essentially treating the
property as two separate units. Any costs related to the rental portion can be claimed as rental
expenses on Schedule E.
This would include a percentage of the home’s expenses that normally are nondeductible personal
expenses, such as painting the outside of a house. If an expense applies to both rental use and personal
use, such as a heating bill for the entire house, the landlord must divide the expense between the two.
The two most common methods for dividing such expenses are based on either (1) the number of
rooms in the house, or, (2) the square footage of the house.
Example: Dustin rents out a single bedroom in his house, which measures 12 × 15 feet, or 180 square
feet. The total area of his entire house is 1,800 square feet. As a landlord, Dustin can deduct 10% of any
expense that is divided between rental use and personal use. However, any expense solely for the
rental portion can be fully deducted. During the year, Dustin spends $525 to replace the wallpaper in
the rented bedroom; he does not replace the rest of the wallpaper in the house. This cost of the new
wallpaper can be fully deducted, because it was solely allocatable to the rental portion. Additionally,
Dustin’s heating bills for the whole house come out to $900 for the year, but only $90 ($900 × 10%)
can be deducted as a rental expense. The remaining $810 is a personal expense and cannot be deducted
by Dustin.

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A common scenario involves a duplex where the landlord resides in one unit while renting out the
other. In this situation, certain costs such as mortgage interest and property taxes must be divided in
order to determine which apply to the rental portion and which are personal expenses.
Example: Marisa owns a duplex with two units of the same size. She lives on one side and rents out
the other. Marisa paid $12,000 of mortgage interest and $4,000 of real estate taxes for the entire
property. Marisa can deduct $6,000 of mortgage interest and $2,000 of real estate taxes on Schedule E
(half of these costs). She can claim the other $6,000 of mortgage interest and $2,000 of real estate taxes
attributable to her personal use on Schedule A as itemized deductions.
If a taxpayer has partial ownership of a rental property, they can deduct expenses proportionate
to their share of ownership.
Example: Adrian and Carleen are first cousins. They are joint owners of a rental property in Lake
Tahoe that they inherited from their grandfather. They rent out the property to long-term tenants, and
manage it themselves. Each owns a 50% interest in the house, and they hold the title to the home
personally, not through an LLC or a trust. Adrian and Carleen divide the income and expenses 50-50,
and each reports their respective share on their individual returns on Schedule E.

Personal Use of Dwelling Unit

When a person owns a residence, whether it is their main home or a second home, and they use it
for both personal and rental purposes, they must allocate expenses accordingly. If a family member
lives in the property without paying rent, this counts as personal use.
Rental expenses generally will be no more than a taxpayer’s total expenses multiplied by the
following fraction: the denominator is the total number of days the dwelling is used, and the numerator
is the total number of days actually rented at a fair rental price. Any day where a fair rental price was
charged counts as a day of rental use.
Example: Pamela owns a vacation home in Florida, that she rented for 90 days in January, February,
and March. The rest of the year, her son lived in the home rent-free. Pamela can deduct the rental
expenses, including mortgage interest and real estate taxes on Schedule E only for those 90 days that
the property was rented at fair rental value. However, she can deduct expenses, the mortgage interest
and real estate taxes for the other 275 days of the year on her Schedule A.

Partial Rental Activity (with a Profit Motive)

If a taxpayer uses a property for both personal and rental purposes, the way expenses are handled
depends on if their personal use qualifies as usage of a “residence.” The home is considered a
“residence” if the owner uses the property for personal purposes during the year for more than the
greater of (1) fourteen days, or (2) 10% of the total days it is rented at a fair rental price. Personal use
includes when a member of the taxpayer’s family stays in the property without paying rent, anyone
else staying at the property for less than the fair rental price, or any day that the property is donated
to a charitable organization.
If the property is (1) deemed to be a personal residence, (2) the rental activity is a “partial rental
activity” and (3) the owner’s rental expenses exceed rental income, then the owner cannot use the
excess expenses to offset income from other sources. However, excess deductions may be carried

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forward to the next year and treated as rental expenses for the same property, subject to the same
limits.
Example: Ronnie lives primarily in Washington, but he also owns a condominium in Florida. He uses
his Florida condo as a personal residence for four months out of each year, during the winter. He rents
it out to tenants for the rest of the year. He has a profit motive in the rental activity. Ronnie’s total
rental income is $9,000 in 2024, and his rental expenses are $10,000 (during the months it was
available for rent). Ronnie cannot deduct the full $10,000 of rental expenses, because the condominium
is not strictly a rental. It is also a personal home that he used for several months. Ronnie can carry over
the remaining ($1,000) in disallowed losses and deduct that amount from future rental income on the
condominium. He would report the rental activity on Schedule E.

Any day the owner of the property spends working on repairs and maintaining the property is not
counted as “personal use,” even if the owner’s family is also staying at the property.
Example: Zachariah lives in San Diego, California, and owns a residential rental property in Boulder,
Colorado. Typically, Zachariah rents out the Boulder property all year round, however, in 2024,
Zachariah decided to visit the property while it is unoccupied between tenants. He spends a month
there, working on repairs and renovations such as replacing the carpet and painting the exterior. As
his main purpose for staying at the property was to perform necessary maintenance and upkeep, these
days do not count as personal use. Therefore, all the rental expenses associated with the property can
be claimed as usual on Schedule E.

Not-for-Profit Rentals and Below-Market Rentals

If a taxpayer does not rent their property with the intention of making a profit, they cannot claim
any rental expenses that exceed their rental income. In the case of a “not-for-profit” rental, the rental
income is not reported on Schedule E, and the taxpayer cannot deduct a loss. Any unused expenses on
a “not-for-profit” rental cannot be carried forward to the following year.
When a taxpayer rents below fair market price, such as rental to a close family member, the
taxpayer would be considered to be renting “not-for-profit.” Below-market rentals to a family member
or another related party is the most common type of “not-for-profit” rental. Not-for-profit rental
income is reported on Form 1040 as “other income.”
If the taxpayer itemizes deductions, they can deduct the mortgage interest and real estate taxes
(subject to the limitations on the deductibility of state and local taxes) on the appropriate lines of
Schedule A (Form 1040).
Example: Alessandra rents her second home to her grandson, Boris, for $500 per month, which is
much less than fair market value (fair rental value in her city would be $2,500 per month). There is no
profit on the rental, because Alessandra’s rental expenses exceed the income generated by the
property. Since the rental activity does not have a profit motive, Alessandra should report the rental
income on Form 1040, Schedule 1, Line 8j as “activity not engaged in for profit income.” The mortgage
interest and property taxes are deductible on Alessandra’s Schedule A, just like they would be for any
other second home. She would not use Schedule E to deduct the losses or claim any deductions.

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Minimal Rental Use (15-Day Rule)

If a taxpayer rents a main home or vacation home that is considered a “residence” for fewer than
15 days a year, the taxpayer does not have to recognize any of the income as taxable. This is called the
“15-day rule,” or “minimal rental use.” While the rental income is not taxable, the homeowner also
cannot deduct any expenses related to the rental of the property during this period. This includes costs
such as maintenance, utilities, insurance, and repairs.
Example: Estelle owns a condo on the Gulf Coast, which is her personal residence. She lives in the
home and does not have another residence. While she was away visiting her sister, she rented her
condo for 11 days, using an online hosting service, charging $100 per day for a total of $1,100. She also
had $320 in rental expenses during that time because her renters broke a bathroom window that she
had to replace. Estelle does not report any of the income or expenses, based on the exception for
minimal rental use.
Example: Jonah lives in Los Angeles, CA. In 2024, the World Series was held in Los Angeles, and Jonah’s
home is within walking distance of the ballpark. Jonah took this opportunity to rent his home during
the series to make some extra cash. He advertised his home for rent online and rented the home during
the World Series. During that time, he slept on his friend’s couch in a neighboring city. He rented his
personal home for 7 days, charging $350 per night, for a total of $2,450 in rental income. Since the
rental period is fewer than 15 days, it is considered minimal rental use. He does not have to report any
of the income. He also cannot deduct any expenses related to the rental.
Example: Ezekiel rented out his Miami beach house for 10 days to a New York family in 2024, earning
$7,000. This is not taxable income and he does not need to report it on his tax return due to the “15-
day rule.” During the 10 days the family stayed at his beach house, Ezekiel incurred some expenses
related to the rental. Ezekiel spent $290 on a cleaning service to tidy up before and after their stay.
This expense is non-deductible. If Ezekiel were to rent the beach house out for more than 15 days in
the future, he would need to report and deduct rental income and expenses accordingly.

Special Rules for Real Estate Professionals

For a taxpayer to be considered a “real estate professional,” they must meet certain criteria. If they
do qualify, any losses from rental real estate activities in which they materially participate are not
classified as passive and can be deducted in full.
However, if they do not meet the requirements for material participation, any rental losses are
typically classified as passive and can only be deducted up to $25,000 if they meet the active
participation exception that was previously discussed. 122
To be classified as a real estate professional, a taxpayer must provide more than one-half of their
total personal services in real property trades or businesses in which they materially participate, and
perform more than 750 hours of services during the tax year in real property business activities, which
includes: property development, renovation, construction, acquisition, conversion, rental, operation,

122The determination of whether someone qualifies as a “real estate professional” is based on a number of factors. In general, a
taxpayer qualifies as a real estate professional if (1) they perform more than 750 hours of services during the taxable year in real
property trades or businesses in which they materially participate, and (2) more than one-half of the total personal services
performed in trades or businesses by the taxpayer during the year are performed in real property trades or businesses in which
the taxpayer materially participates. Real estate professional status is covered in more detail in Part 2, Businesses.
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management, leasing, or brokerage services. The taxpayer must own more than 5 percent of any
activity for it to be considered under the real estate professional rules.
If a taxpayer is married and files jointly, one spouse must meet the 750-hour test and more than
one-half of personal services test with their own hours alone; however, for determining whether that
taxpayer materially participated, the spouse’s participation hours are considered.
Example: Hoshi spends 800 hours a year repairing, maintaining, and dealing with tenants at her five
apartment complexes, which she owns. Every spring, she also works part-time in her father’s
accounting firm to help him through the busy season. She works 500 hours total at her father’s
accounting firm. Because Hoshi (1) spends more than 750 hours materially participating in real estate,
and (2) the 800 hours of real estate services is more than half of the 1,300 hours of total time she
spends on both real estate and accounting services for the year, she is classified as a real estate
professional. As such, if she generates a tax loss in her rentals for the year, she will be able to deduct
the losses on her return without any limitations.
In most instances, even if a taxpayer is a real estate professional, but they only provide basic
services to tenants, such as trash collection, the owner would report rental income and expenses on
Schedule E, Form 1040, and the rental income would not be subject to self-employment tax.
Example: Sofia, who is unmarried, is a self-employed real estate agent. She also owns four residential
rental properties, all of which she manages herself. She also materially participates in each of the rental
activities, as she is the only one doing any work for them. Sofia works more than 2,000 hours per year
(40 hours a week), working in her real estate business and managing the rental properties that she
owns. She meets both hours tests for real estate professional status and can deduct any losses from
the rentals against non-passive income. She will report her rental activities on Schedule E, and her
realtor’s commissions on Schedule C. All of her work hours are spent entirely in real estate and rental
property activities, so she is classified as a “real estate professional.”

In contrast, owners of property who provide “substantial services” to the renter, such as maid
cleaning and housekeeping services, are generally required to report revenue and expenses related to
the property on Schedule C, Profit or Loss from Business, and any net profit is subject to self-
employment tax. The most common examples of property owners who report their rental activities on
Schedule C, instead of Schedule E, are hotel and motel operators (covered next).

Hotels, Motels, and Bed and Breakfasts

Operators of hotels, motels, boarding houses, and bed and breakfasts must report their rental
income on Schedule C, not Schedule E. If the property is rented on a transient basis, and if the owner
provides “substantial services” to the tenant, such as daily maid service, laundry service, or regular
breakfast service, the property owner should report the rental income and expenses on Schedule C
(Form 1040), Profit or Loss from Business, rather than Schedule E.
Example: Hattie owns a small, 10-unit motel near downtown Cincinnati. The hotel does not offer long-
term rentals, and Hattie’s hotel license only permits guests to stay a maximum of 30 days or less. Her
hotel offers full maid service, cleaning, and breakfast daily. Since Hattie provides “significant services”
as the motel owner, the income and expenses would be reported on her Schedule C.

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Example: Chilton owns a camping resort in the Rocky Mountains called “Chilton’s Wilderness Retreat.”
It has rustic cabins that attract tourists from all over the United States. Chilton provides substantial
services to his guests, including daily housekeeping, continental breakfast, hiking and sightseeing
activities, and transportation. Chilton reports all his rental income and expenses on Schedule C, due to
the substantial services he provides to his guests.
In some cases, renting out part of a house can be classified for tax purposes as the equivalent of
running a bed-and-breakfast. The facts and circumstances of each situation must be considered to
determine if the taxpayer is providing “substantial services” to a tenant.
Example: Moriah lives in a popular tourist area in Palm Springs, CA. She has a small granny cottage
behind her home. Moriah listed her granny cottage on a popular website for vacation rentals, Airweb.
She used Airweb to rent her cottage 140 days last year to several guests. She provides daily cleaning
service, continental breakfast service, and fresh towels and linens, just like a hotel would. Even though
she is not a real estate professional, Moriah would report the rental income and related expenses on
Schedule C, not Schedule E, because she is providing a short-term rental and “substantial services” to
her tenants.

Personal Property Rentals

The rental of personal property (such as vehicles, equipment, or formal wear) is not reported on
Schedule E. Instead, it is reported on Schedule C, if the activity is a trade or business. Taxpayers who
are “not in the business” of renting personal property but still have a profit motive, should report their
income on line 8l and expenses on line 24b of Schedule 1 (Form 1040).
For example, if a taxpayer only rents out their boat occasionally to friends and family, this would
be a personal property rental that may not rise to the level of a “trade or business.”
Note: Personal property is not the same as “personal-use” property that a taxpayer uses for personal
purposes. “Personal property” is an accounting term that is used to describe any tangible asset other
than real estate. In civil law, personal property is sometimes called “movable property.” Examples of
personal property include appliances, furniture, vehicles, and collectibles. The distinguishing factor
between personal property and real property is that personal property is movable, while real property,
such as land or buildings, remains in one location.
Note that the IRS publications do not specifically address the treatment of personal property
rentals, nor do they define at which point a personal property rental activity becomes a “trade or
business.” Advance payments for renting personal property must be reported in the year received.
Example: Ralph owns an RV that he rents out sporadically during the summertime to family and
friends. He rents his RV for $39 a day, which covers his costs as well as generates a small profit for him.
He does not advertise and only rents to people he knows. His rental activity does not rise to the level
of a trade or business, but he does have a profit motive in the activity. He should report his rental
income on line 8 of Schedule 1 (Form 1040), and any expenses associated with the personal property
rental activities may be entered as an adjustment to income on Schedule 1, Line 24b. The expenses
would be limited to his income from the activity.

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Example: Laurel owns Sunbelt Party Rentals, LLC which rents out catering equipment, pop-up tents,
and tables for weddings and other celebrations. Laurel has a profit motive in the activity and works in
the business full-time, all year round. She should report her personal property rental activity on
Schedule C, not Schedule E.
Royalty Income
Like rental income, royalties are typically reported on Schedule E of the taxpayer’s return, not
subject to self-employment tax. However, if the taxpayer is actively involved in the production or
maintenance of the property generating the royalties, they might be considered self-employment
income and could be subject to self-employment tax (explained next).
Natural resource royalties are paid for the extraction of natural resources, like timber, oil, gas, and
minerals. The owner of the land or mineral rights typically receives a royalty based on the value of the
resource extracted.
Royalties from copyrights on literary, musical, or artistic works are usually paid to a taxpayer for
the right to use a creator’s work over a specified period of time. Royalties can also be based on the
number of units sold. For example, an author might receive a royalty for each book sold, or a musician
might receive a royalty for each song streamed or downloaded. Royalty payments are always reported
to the taxpayer on Form 1099-MISC. A business is required to issue Form 1099-MISC, Miscellaneous
Income, to each person that has been paid at least $10 of royalties for the year.
Example: Corey owns 200 acres of fertile farmland. In 2024, natural gas deposits were discovered on
his property. Corey negotiates a contract with an energy company that wishes to extract the natural
gas from his land. The contract stipulates that he will receive 12% of the revenue generated by the gas
extracted from his property. During the year, Corey receives $98,000 in royalties from the energy
company. The amounts were reported as royalties to Corey on Form 1099-MISC, and he will report
this income on his Schedule E, Form 1040. The royalties are not subject to self-employment tax, and
Corey is not considered to be self-employed.

Special rules apply to self-employed writers, musicians, and inventors. These taxpayers must report
their royalty income on Schedule C, Profit or Loss from Business, and the income is also subject to self-
employment tax. This is because their personal efforts created the property. As stated in earlier
chapters, a copyright or trademark in the hands of its creator is not a capital asset.
Example: Tilda is a self-employed writer of a popular series of children’s books. She receives royalties
from her publisher based on the number of books she sells during the year. In 2024, Tilda’s most
popular children’s book, The Pretty Butterfly, was optioned for a cartoon movie, and Tilda received a
large sum from the movie studio to license her book’s copyright to them. Tilda must report all her
income, including the book royalties, as business income on her Schedule C.
Example: Lorelai is a professional photographer. All throughout the year, she visits movie premieres
and takes thousands of photos of popular celebrities, then sells them on several online stock photo
websites. Her celebrity photographs are licensed by media outlets worldwide. She earned $92,000 in
royalties during the year. Since she is self-employed, and the photographs were taken by her, she must
report these photography royalties as business income on Schedule C, not Schedule E.

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Example: Beckett is a versatile musician who writes, performs, and produces his own original jazz
music. He partnered with an online music distribution company, Music Fly, which compensates him
based on the number of streams and downloads his songs receive. As a self-employed artist, Beckett's
earnings from royalties through Music Fly are considered self-employment income. At the end of each
year, Music Fly sends him a 1099-MISC (not 1099-NEC) for $105,000, representing the total amount
of royalties he earned from his music. This income must be reported on Schedule C of Beckett's tax
return and is subject to self-employment taxes. It should not be reported on Schedule E.
In the event that the creator of an intellectual property asset passes away, and the asset is passed
down to a beneficiary through inheritance, it is classified as a capital asset for the beneficiary. Any
income earned by the beneficiary on this asset will no longer be subject to self-employment tax.
Example: Iggy Jones was an author who always reported his earnings on Schedule C. In 2024, Iggy
Jones dies, leaving his daughter Hazel as the sole heir of his estate. One of Iggy’s best-selling works was
an instructional handbook on survival techniques. After her father’s death, Hazel licenses the
copyrighted material to various educational institutions and publishers. As she did not create the
copyright herself (it was inherited from her father), any royalty income she receives will be reported
on Schedule E. This income is taxable to Hazel, but it is not subject to self-employment tax since she
did not create the copyright herself.

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Unit 10: Other Taxable Income

For additional information, read:
Publication 525, Taxable and Nontaxable Income
Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments
Publication 4345, Settlements—Taxability

This chapter covers various other types of taxable income. Any income that does not have a
designated line on the Form 1040 is typically recorded on Schedule 1, Additional Income and
Adjustments to Income. Schedule 1 allows for reporting of various types of miscellaneous income,
including taxable alimony, unemployment compensation, jury duty pay, and gambling winnings.
Taxable Recoveries
A “recovery” is a return of an amount a taxpayer deducted or took a credit for in an earlier year.
The most common recoveries are state tax refunds, medical reimbursements, and other rebates of
deductions that were previously reported on Schedule A.
Taxpayers must include a recovery in income in the year they receive it, but only to the extent the
deduction or credit reduced income tax in the prior year. Income tax refunds from state and local
governments are only taxable if the taxpayer itemized deductions in the year they overpaid those taxes
and only to the extent the amount paid in the previous year reduced their tax liability. The entity
issuing the refund will provide a Form 1099-G, Certain Government Payments, to the taxpayer and send
a copy to the Internal Revenue Service by January 31st.
Example: Corby lives in California. He claimed the standard deduction on his prior-year federal tax
return. In 2024, he received a California state tax refund of $700 for state income taxes that he overpaid
in the prior year. The state tax refund is not taxable in 2024 because Corby received no federal tax
benefit from his state tax payments because he did not itemize his deductions in the previous year. In
other words, since he did not deduct his state income taxes in the prior year, he does not have to report
his state tax refund as taxable in the current year.
Federal income tax refunds (i.e., IRS tax refunds) are not included in a taxpayer’s income because
they are never allowed as a deduction.
Taxable Alimony Received
The Tax Cuts and Jobs Act changed the treatment of alimony starting in 2019, making it
nondeductible to the payor and nontaxable to the recipient. Divorce and separation agreements
entered into before 2019 are “grandfathered,” so there will continue to be alimony deductions and
taxable alimony income for individuals with divorce agreements that were finalized prior to 2019.
The payor does not have to itemize to deduct alimony payments made (for divorce decrees that
are grandfathered). In contrast, child support is never taxable income to the receiver and not
deductible by the payor because it is viewed as a payment a parent makes simply to support their own
child.

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For a payment to qualify as deductible alimony to the payor, in a pre-2019 grandfathered divorce:
• The divorce agreement may not include a clause indicating that the payment is something else
(such as repayment of a loan).
• The payor must have no liability to make any payment after the death of the former spouse.
Not all payments that are made to an ex-spouse qualify as alimony. Alimony does not include:
• Payments that are a former spouse’s share of income from community property
• Payments to keep up the payor’s property, or free use of the payor’s property
• Noncash property settlements, and any payment made other than in cash
• Any payments made to an ex-spouse when the divorce was finalized in 2019 or later years.
Also, if alimony payments continue after the death of the receiving spouse, the payments will not
be considered alimony for federal tax purposes.

Example: On February 20, 2024, Connie and Derrick divorced. According to the terms of their divorce
decree, Derrick is obligated to pay Connie $1,000 monthly in alimony and an additional $1,200 per
month for child support. These payments are not deductible by Derrick and are not taxable to Connie,
because their divorce was finalized in the current year and not before 2019.
Example: Teagan and Patsy divorced in 2017. As a result, their divorce decree is considered
“grandfathered” and the pre-TCJA rules apply. They have a 9-year-old son together, who lives with
Patsy. Their divorce decree requires Teagan to pay Patsy $2,000 per month as child support and $1,500
per month as alimony for a minimum of ten years. Teagan makes all his child support and alimony
payments on time. Therefore, in 2024, he can deduct $18,000 ($1,500 × 12 months) as alimony paid,
and Patsy must report $18,000 as taxable income on her return. The amount paid as child support,
$24,000 ($2,000 × 12), is not deductible by Teagan and is not reported as income by Patsy.
If an alimony payment is subject to reduction based on a contingency relating to a child (e.g.,
attaining a certain age, marrying, or going to college), the amount subject to a reduction is treated as
child support, not alimony, for tax purposes. This is regardless of what the divorce decree states, or
whether or not the contingency is likely to occur.
Example: Khalil and Reema’s divorce became final in 2017. Khalil agrees to pay Reema $4,000 in
alimony per month ($48,000 per year), but their divorce agreement specifies that the alimony
payments will be reduced by $3,000 a month (down to $1,000 a month) once their only child, Taavi,
reaches the age of 18. Since this is clearly a “contingency related to a child,” only $1,000 of the monthly
payments are actually considered “alimony” for federal tax purposes. In 2024, Reema pays a tax
attorney to carefully review her divorce decree, and he notifies her about the contingency in her
decree. Reema decides to report only $12,000 as taxable alimony ($1,000 × 12 months). Khalil, on the
other hand, reports the full $48,000 as alimony paid, deducting the amounts from his taxable income.
Both of their returns are subsequently audited. Reema shows the IRS auditor the contingency in her
divorce decree, and the auditor agrees with her. Reema will only be taxed on $12,000 of alimony, and
Khalil will have his return adjusted by the IRS, reducing the amount of alimony paid that he is
permitted to deduct.
If a “grandfathered” divorce decree is later modified by a court order, and expressly invokes the
new treatment, then the alimony receives the new treatment.
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If a divorce agreement specifies payments of both alimony and child support and only partial
payments are made by the payor, the partial payments are considered child support until all the child
support obligations are fully paid. Any additional amounts paid are then treated as alimony.
Example: Dayna and Clemente divorced in 2017. Their divorce decree is “grandfathered” and the pre-
TCJA rules apply. Their decree requires Clemente to pay Dayna $2,000 a month ($24,000 [$2,000 × 12]
a year) as child support and $1,500 a month ($18,000 [$1,500 × 12] a year) as alimony. Clemente falls
behind on his payments and pays only $36,000 during the year. In this case, the first $24,000 paid is
considered child support, and only the remaining $12,000 ($36,000 - $24,000) is considered alimony.
Clemente can deduct $12,000 as alimony paid. Dayna must report $12,000 as alimony income received.
Note: Property settlements are simply a division of property and are not treated as alimony. In general,
property transferred to an ex-spouse as part of a divorce proceeding is not a taxable event.
Example: Brooklynn and Galvin file for divorce. As part of their divorce agreement, Brooklynn must
transfer a portion of her 401(k) account to Galvin. The transfer is properly outlined in their divorce
settlement agreement, and a QDRO123 is issued by the court. On October 1, 2024, their divorce becomes
final. Two days later, the retirement plan transfer is completed, and $105,000 is transferred directly
from Brooklynn’s 401(k) to Galvin’s retirement account. The transfer is considered a division of
marital assets and is not subject to the 10% early withdrawal penalty.
Payments made to a third party can be considered alimony in some cases. For example, if, under
the terms of a divorce agreement, a husband is required to pay the medical bills of his ex-wife, a cash
payment to the hospital can count as alimony. However, these additional payments must be made
based on their written divorce or separation agreement in order to be classified as alimony.
Government Benefits
Most government welfare benefits, including food stamps, heating assistance programs, and
poverty assistance from state or local agencies are exempt from federal taxation. Worker’s
compensation is a form of insurance that provides wage replacement and medical benefits to workers
who are injured on the job. Worker’s compensation is not subject to federal income tax.
In contrast, unemployment compensation is taxable. Unemployment compensation is a type of
government benefit that is paid to workers who have lost their jobs. It is intended to replace wages
that would have been subject to tax if the individual had not lost their job. Therefore, individuals
receiving unemployment compensation must report it as taxable income on their federal tax return.
Example: Haima was laid off from her job in 2024. She received $300 a week of unemployment
compensation for 26 weeks. When she was unable to find another job, she began receiving benefits
from her state’s WIC program, which provided vouchers for food for her and her toddler. The
unemployment compensation would be taxable income, but the welfare (WIC) benefits would not be
taxable income.

123Both employer plans and IRA funds can be awarded to a spouse in a divorce, but to split an ERISA-qualified plan, (such as a
401(k)) a qualified domestic relations order is required. A QDRO (Qualified Domestic Relations Order) is a court judgment or court
order that is used to legally assign company-provided benefits to an alternate payee, typically as part of divorce or marital
separation proceedings. An ex-spouse (or spouse, if legally separated and not yet divorced) may roll over tax-free all or part of a
distribution from a qualified retirement plan that they received under a QDRO.
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Social Security Income

Social Security is a type of government benefit that applies to individuals who have earned enough
Social Security credits and are at least 62 years of age.124 Social Security income is reported to
taxpayers on Form SSA-1099, Social Security Benefit Statement.

The portion of benefits that are taxable depends on the taxpayer’s income and filing status. To
determine the taxability of Social Security benefits, a taxpayer must compare the base threshold
amount for their filing status with the total of:
• One-half of their Social Security benefits, plus
• All of the taxpayer’s other income, including tax-exempt interest.
If the sum is less than the base amount for their filing status, none of the Social Security is taxable.
If the sum is more than the base amount for their filing status, a percentage of the Social Security may
be taxable. The taxable portion of Social Security benefits is never more than 85%.

Base Amounts for Calculating Taxability of Social Security

Married filing jointly $32,000

Single, HOH, QSS, or MFS (and lived apart from their spouse all year) $25,000

MFS (if lived with spouse at any time during the year) $0

Spouses who file jointly must combine their incomes and Social Security benefits when figuring the
taxable portion of their benefits, even if one spouse did not receive any benefits.

Example: George and Mabel are both 67 years old. They file jointly, and both received Social
Security benefits during the year, but they also have income from other sources. At the end of
the year, George received a Form SSA-1099 showing net benefits of $7,500. Mabel received a
Form SSA-1099 showing net benefits of $3,500. George also received wages of $20,000 and
taxable interest income of $500. He did not have any tax-exempt interest.

1. Total Social Security benefits $11,000

2. Enter one-half of Social Security (× 50%) $5,500

3. Enter taxable interest and wages $20,500

4. Sum ($5,500 + $20,500) $26,000

George and Mabel’s benefits are not taxable because the total above is not more than the base
amount ($32,000) for married filing jointly.

124Social Security benefits include monthly retirement, survivor and disability benefits. They don’t include supplemental security
income (SSI) payments, which aren’t taxable. SSI payments are monthly payments to adults and children with a permanent
disability or blindness who have income and resources below specific financial limits.
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Other Types of Income

Examples of types of “other income” include gambling winnings, cancellation of debt income, hobby
income, certain types of court awards, lottery winnings and other prizes, and taxable distributions
from a Coverdell education savings account or qualified tuition program if they exceed the qualified
higher education expenses for a designated beneficiary. It is important to note that all taxable income
must be reported, regardless if they receive a document from the payor reporting the amount paid.
Gambling Winnings
Gambling income may include winnings from lotteries, raffles, horse races, and casinos. Gambling
winnings will typically be reported to a taxpayer on Form W-2G, Certain Gambling Winnings. A
taxpayer must report and pay tax on all gambling winnings, regardless of whether the taxpayer
receives a Form W-2G. Gambling losses are deductible on Schedule A as a miscellaneous itemized
deduction, but the deduction is limited to the amount of gambling winnings for the year.
Example: Deirdre had $11,000 of gambling winnings and ($23,000) of gambling losses during the
taxable year. Her itemized deduction for gambling losses cannot exceed $11,000, the amount of her
winnings. To claim the deduction for her losses, Deirdre must itemize and list her gambling losses on
Schedule A, Form 1040. If Deirdre does not itemize, she will not be able to deduct any of her gambling
losses.
Note: The Tax Cuts and Jobs Act changed the definition of “gambling losses.” In prior years,
professional gamblers who filed on Schedule C were able to generate a deductible loss from their
wagering activities. The TCJA modified the limit on gambling losses so that all deductions for expenses
incurred in carrying out gambling activities, not just direct gambling losses, are limited to the extent
of gambling winnings. For example, an individual who is a professional gambler can include expenses
traveling to and from a casino as gambling losses as an offset against any gambling winnings, but
cannot use the expenses to generate a loss on Schedule C.125
The taxpayer must keep an accurate diary or similar record of gambling winnings and losses, along
with tickets, receipts, canceled checks, and other documentation. The taxpayer is not required to
include these supporting records with their tax return, but they should be retained in case of an audit.
Cancellation of Debt Income
When a taxpayer’s debt is canceled or forgiven, they may be required to report the amount of
forgiven debt as part of their gross income. This can create confusion for taxpayers since the canceled
debt may occur in a year when no cash was received. In cases where a property is surrendered or
repossessed, like in a foreclosure, the taxpayer may assume that relinquishing the property means they
are no longer responsible for the debt. However, this is not always true and tax implications must still
be considered.
If a lender cancels a debt and issues Form 1099-C, Cancellation of Debt, the lender will indicate on
the form if the borrower was personally liable for repayment of the debt. The tax impact depends on
the type of debt, and whether the loan is recourse or nonrecourse. Canceled debt income may include

125The TCJA modified IRC Sect. 165(d) to provide that all deductions for expenses incurred in carrying out gambling and wagering
activities are limited to the extent of gambling winnings. This is a temporary provision that ends after tax year 2025.
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any indebtedness for which a taxpayer is personally liable, or which attaches to the taxpayer’s
property, such as an auto loan, home mortgage, or home equity loan.
A recourse debt holds the borrower personally liable. All other debt is considered
nonrecourse.126 Whether a debt is recourse or nonrecourse may vary from state to state, depending
on state law. If a lender forecloses on property subject to a recourse debt and cancels the portion of
the debt in excess of the FMV of the property, the canceled portion is treated as taxable income.
This amount must be included in gross income unless it qualifies for an exception or an exclusion.
Most home mortgages are “nonrecourse loans.” This means that if the borrower defaults, the lender
can seize the home, but cannot seek out the borrower for any further compensation, even if the FMV
of the home does not cover the remaining loan balance. In other words, if a mortgage is nonrecourse
and the borrower does not retain the home (after a foreclosure by a lender), the borrower does not
have to recognize the cancellation of debt as income.
If the taxpayer abandons property that secures a debt for which the taxpayer is not personally
liable (a nonrecourse loan), the abandonment is treated as a sale or exchange. However, there is a
deemed sales price based on the amount of the nonrecourse loan at the time of the abandonment,
foreclosure or short sale.
Example: Denny lost his home to foreclosure because he got fired from his job and could no longer
make his mortgage payments. At the time of the foreclosure, Denny owed a balance of $170,000 to his
mortgage lender, and the fair market value of the home was $140,000 (the home had gone down in
value). Denny’s mortgage is a nonrecourse loan. Denny moves out, abandoning the property, and the
bank forecloses on the home a few months later. Denny is not personally liable for the debt (since it is
a nonrecourse loan). The abandonment and subsequent foreclosure are treated as a disposition (for
tax purposes), and the “selling price” would be $170,000, which is the balance of his loan. Even if Denny
later receives a Form 1099-C from the bank, the debt cancellation is not a taxable event.
Note: A “nonrecourse” loan does not allow the lender to pursue anything other than the collateral to
collect the debt. For example, if a borrower defaults on a nonrecourse home loan, the bank can only
foreclose on the home. The bank cannot take further legal action to collect the money owed on the
debt.
Example: Edith borrows $10,000 on her credit card in order to take a vacation. She takes her vacation
and then defaults on the balance after paying back only $2,000. She has the ability to pay back the loan,
but chooses not to. The credit card company writes off the remaining balance of the loan instead of
legally pursuing Edith for the credit card balance. Therefore, there is a cancellation of debt of $8,000,
which is taxable income to Edith, unless an exclusion applies.
If the original debt is a nonbusiness debt, the canceled debt amount is reported as “other income”
on line 8c of Schedule 1, Form 1040. If a personal asset such as a home or a vehicle is repossessed, the
taxpayer may have to report two transactions: (1) the cancellation of debt income, and (2) gain or loss
on the sale or repossession, generally equal to the difference between the FMV of the property at the
time of the foreclosure and the taxpayer’s adjusted basis in the property.

126 There is no taxable income from a canceled debt if it is intended as a gift (for example, if a taxpayer owes his parents money, but

they choose to forgive the debt).

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Remember, a repossession or foreclosure is treated as a “sale” for tax purposes, so a gain or loss
must be computed. Any loss related to a personal-use asset would be nondeductible.
Example: Zeus lost his personal yacht to repossession because he could no longer afford to make his
payments. At the time of the repossession, he owed a balance of $190,000 to the lender, and the FMV
of the yacht was $130,000 (it had declined in value). Zeus is personally liable for the debt (it is a
recourse loan), so the repossession of the yacht is treated as a sale. The “selling price” from the
repossession is $130,000, and Zeus must recognize $60,000 in debt forgiveness income ($190,000
outstanding debt - $130,000 FMV).

Nontaxable Canceled Debt

Even if a loan is a recourse loan, there are certain scenarios where the resulting canceled debt is
still not subject to taxation.
There are several circumstances in which canceled debt is not taxable, even if the loan is recourse.
Federal law has established exceptions that allow for exclusion of canceled debt from income or deem
it nontaxable, depending on the type of debt, or financial situation of the taxpayer. The most common
exclusions to canceled debt income are:
• Bankruptcy or insolvency
• Cancellation of qualified farm indebtedness, or qualified real property business indebtedness
• Cancellation of student loan debt
• Cancellation of qualified principal residence indebtedness127
If a taxpayer can exclude their canceled debt under any of the situations listed above, they must
attach Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness to their individual return
and check the appropriate box that applies to them.
Bankruptcy: Debts discharged through bankruptcy court in a Title 11 bankruptcy case (generally,
Chapters 7 and 13) are not taxable. Some common types of debt that can be discharged in bankruptcy
are credit card debt, personal loans, and medical debts. The taxpayer must attach Form 982, Reduction
of Tax Attributes Due to Discharge of Indebtedness, to their federal income tax return to exclude any
debt canceled in bankruptcy.
Example: Niall had a severe auto accident a few years ago in which he was at fault. He was badly
injured and incurred large medical debts totaling $1.5 million. He was also sued by the other driver
and incurred legal bills due to the lawsuit. On the advice of his attorney, Niall decides to file for
bankruptcy. Niall’s only major asset is his teacher’s pension, which is protected by state law. The entire
$1.5 million in debt is discharged by the bankruptcy court. The canceled debt is not taxable to Niall.
Insolvency: This is a condition in which the fair market value of all assets is less than one’s
liabilities. A taxpayer is legally insolvent when total debts exceed the value of their total assets
immediately prior to the discharge of their debt. If a taxpayer is insolvent when their debt is canceled,
the canceled debt is not taxable, but only to the extent of the insolvency. For this purpose, the
taxpayer’s assets include the value of everything they own, including pensions and retirement
accounts.

127 Qualified real property business indebtedness is debt incurred in connection with, real property used in a trade or business.
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Extended example: Rocio owns a vacation condo in Hawaii. She has a HELOC (home equity loan) on
the property which she financed through a mortgage lender. The proceeds of the HELOC were not used
to acquire or substantially improve the condo, instead, she used the HELOC to pay off credit cards.
Rocio becomes ill and defaults on the HELOC. The HELOC is a recourse loan, and she is personally liable
for all the debt. Rocio’s mortgage lender foreclosed on the condo when the loan balance was $280,000
and the fair market value of the condo was only $260,000. Rocio later receives a 1099-C from the
lender for $20,000 of canceled debt. Since the property is a vacation home, and not her main home, all
the canceled debt is potentially taxable. Rocio believes that she may qualify for an exclusion under the
insolvency provisions. She prepares an insolvency worksheet, totaling up her assets and liabilities at
the time of the cancellation.

Rocio’s Insolvency Determination Worksheet

Assets (FMV) Liabilities

Condo FMV $160,000 Mortgage on condo $180,000

Vehicles FMV $5,000 Vehicle loans $25,000

Bank accounts $1,000 Credit card debt $10,000

Traditional IRA $60,000 Hospital bills $40,000

Furniture $2,000 Outstanding student loan $13,000

Clothing $600 Real estate taxes owed $8,000

Total assets $228,600 Total Liabilities $276,000

Total assets minus total liabilities = ($47,400). Rocio’s liabilities exceed her assets; therefore, she is
insolvent, and her insolvency exceeds the canceled debt, so her canceled debt is not taxable. 128

Insolvent individuals may also be subject to legal proceedings, such as bankruptcy, to resolve their
financial issues. In some jurisdictions, insolvency can lead to the seizure of assets by creditors. Note
that the amount of a taxpayer’s insolvency is sometimes expressed as a negative net worth.
Example: Lucy had $5,000 of credit card debt, which she could not afford to pay. The credit card
company decided to cancel the entire $5,000 balance. She received a Form 1099-C from her credit card
company showing canceled debt of $5,000. Immediately before the cancellation, Lucy’s total debts
were $15,000, and the fair market value of her total assets was $12,000. Therefore, at the time the debt
was canceled, Lucy was insolvent to the extent of $3,000 ($15,000 total liabilities minus $12,000 FMV
of her total assets). Lucy can only exclude $3,000 of the canceled debt from income; the remaining
$2,000 is taxable. Lucy must report the amount of debt forgiven on her return and the excluded amount
by completing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.

128 This example and table are based on an insolvency example in IRS Publication 4491.
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Primary Residence Debt Cancellations

Normally, when a bank forecloses on a home and sells it for less than the borrower’s outstanding
mortgage, the bank forgives the unpaid mortgage debt. The canceled debt may be taxable to the
homeowner. However, a taxpayer may exclude canceled debt if the cancellation of the mortgage occurs
on a taxpayer’s principal residence.
This is true even if the mortgage debt is a recourse debt.129 “Qualified principal residence
indebtedness” or QPRI, is a mortgage secured by a taxpayer’s principal residence that was taken out
to buy, build, or substantially improve that residence and may also include debt from refinancing. 130
QPRI cannot be more than the cost of the home (plus improvements).
To exclude QPRI, the taxpayer must report the amount of debt forgiven by completing Form 982,
Reduction of Tax Attributes Due to Discharge of Indebtedness. The maximum amount of qualified
principal residence debt that can be discharged tax-free in 2024 is $750,000 ($375,000 for married
individuals filing separately).
The QPRI exclusion only applies to a main home: it does not apply to second homes, raw land, rental
properties, or vacation homes.131
Example: Broderick refinanced his mortgage two years ago, and his primary residence is now subject
to a $320,000 recourse mortgage. Broderick gets sick and stops making his payments. Broderick’s
mortgage lender forecloses on the home on January 10, 2024, and Broderick moves out. The residence
is later sold by the bank for $280,000 on May 20, 2024. Broderick has $40,000 of canceled debt income
from the discharge of indebtedness. All of the mortgage debt was qualified principal residence
indebtedness. Therefore, he can claim the qualified principal residence exclusion by filing Form 982
with his individual tax return.
Example: Lorcan used a local lender to finance the purchase of an empty lot for $175,000. He had plans
to build a house on the land, but he unfortunately lost his job and was unable to keep up with the loan
payments. As a result, he defaulted on the loan and the lender took back the property. Eventually, the
lender was able to sell the land for $130,000. The remaining balance of $45,000 was forgiven by the
lender. Lorcan has a valuable 401(k) that he refuses to touch, so he was not insolvent or in bankruptcy
at the time the debt was forgiven. Since the canceled debt does not meet any exclusions, Lorcan is
required to report it as taxable income. This is because the qualified principal residence indebtedness
exclusion only applies to primary residences, and in this case, Lorcan’s property was an empty lot
rather than a home.
Remember, even if the canceled debt does not qualify under the qualified principal residence
indebtedness exclusion, canceled mortgage debt does not have to be included in taxable income if the
debt was canceled in a bankruptcy case or while the taxpayer was insolvent (up to the amount of the
insolvency of the taxpayer right before the debt cancellation).

129 Under the Mortgage Forgiveness Debt Relief Act, mortgage debt on a primary residence that was forgiven was excluded from
taxable income. This provision was set to expire, but was extended through 2025.
130 QPRI can include debt resulting from the refinancing of debt if that debt was incurred to acquire, construct, or substantially

improve a principal residence.

131 The lender is required to report the amount of the canceled debt to the taxpayer a Form 1099-C, Cancellation of Debt.

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Example: Irving’s vacation condo in Hawaii is subject to a $320,000 recourse mortgage. Irving loses
his job and stops making payments on the loan. Irving’s mortgage lender forecloses on the home on
January 20, 2024, when the fair market value of the home was $280,000. The residence has declined
in value because a serious construction defect was discovered in the foundation, which would have
cost thousands of dollars to fix. The home is later auctioned off by the bank for $280,000. Irving has
$40,000 of canceled debt from the discharge of indebtedness because the mortgage was $40,000 more
than the property’s fair market value at the time of the foreclosure. The home was not his main home,
so the canceled debt is not QPRI, or “qualified principal residence indebtedness.” However, right before
the foreclosure, Irving was insolvent – with the amount of all his debts (including this mortgage, his
auto loan and credit card debts) equaling $400,000. The value of all his assets was $350,000 at that
time – resulting in an insolvency amount of $50,000. Since the $40,000 canceled debt is less than the
$50,000 extent of his insolvency, the forgiven debt is not taxable. Irving can exclude the forgiven debt
by completing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and marking the
box to report his insolvency.

Cancellation of Student Loans

Special rules apply to canceled student loans. The American Rescue Plan Act (ARPA) allows
exclusion from taxation on most student loans forgiven through tax year 2025. This includes all federal
student loans and certain private loans and institutional loans.132
Example: Pascal takes out a student loan of $32,500 and uses it to pay his college tuition and textbooks.
He is personally responsible for the loan. On February 1, 2024, Pascal becomes disabled in a car
accident. The student loan is forgiven by the lender on December 1, 2024. The forgiven debt is not
taxable to Pascal on his tax return, regardless of whether he receives a 1099-C or not.
Qualified Farm Indebtedness: If a taxpayer incurred the canceled debt in a farming business, it
is generally not considered taxable income.
Canceled Debt that is Otherwise Deductible: If a taxpayer uses the cash method of accounting,
they should not recognize canceled debt income if payment of the debt would have otherwise been a
deductible expense.
Example: Alexa is a self-employed interior designer. A CPA firm agrees to file her business tax return
and bill her later. Alexa receives $2,200 of tax preparation and bookkeeping services for her business
on credit. Later, Alexa loses a major design account and has trouble paying her debts, so her CPA
forgives the amount she owes. Alexa does not include the canceled debt in her gross income because
payment of the debt would have been deductible as a business expense had it been paid.

Hobby Income
A “hobby” is an activity that is usually done for enjoyment or leisure, rather than for financial gain.
Even if it occasionally brings in some income, a hobby is not considered a business because it is not
carried on to make a profit. Any income earned from a hobby must be reported on Form 1040, Schedule
1 and is taxable.

132 The American Rescue Plan Act (ARPA) exempted federal student loan forgiveness from gross income through 2025 (IRC Section

108(f)(5)). The IRS advises that Form 1099-C, Cancellation of Debt, should not be filed for student loans covered by this expanded
forgiveness under the American Rescue Plan Act. Note that student loan forgiveness may still be taxable at the state level.
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If expenses related to the hobby exceed the income generated, taxpayers will have a loss from the
activity. However, this loss cannot be deducted from other forms of income. Although expenses for a
hobby are not deductible, one benefit is that hobby income is not subject to self-employment tax.
The determination of whether an activity is being carried out for profit depends on individual
circumstances and can be subjective. To provide some clarity, Sec. 183(d) offers a safe harbor
provision stating that if certain criteria are met, the activity will be presumed as a for-profit endeavor.
Under the IRS safe harbor test, an activity is presumed to be operated for profit if it generates a profit
at least three out of the last five years, including the current year. The safe harbor is two out of the last
seven years for activities involving horse breeding or racing.
The use of hobby expenses to offset hobby-related income is not permitted. The Tax Cuts and Jobs
Act repealed most miscellaneous itemized deductions, including the deduction for hobby-related
expenses on Schedule A. However, a taxpayer with hobby income is still allowed to utilize cost of goods
sold (COGS), as a reduction of the hobby’s taxable gross income, in order to arrive at taxable income. 133
Example: Stefan works full time as a bank manager. He also buys and breeds aquarium fish as a hobby.
Twice a year, he travels to the International Exotic Fish convention to showcase and sell some of his
exotic aquarium fish. Although he occasionally makes a profit from this hobby, it is mainly a source of
enjoyment for him. Stefan has no plans to stop attending the conventions, regardless of how much
money he makes. Therefore, any income he earns is considered hobby income. His expenses are not
deductible, (such as the cost of his travel), but his income from selling the fish is taxable. Stefan is
permitted to utilize cost of goods sold (i.e., the cost of the fish he sells to customers) to calculate his
hobby-related income as a reduction of the hobby’s gross income.

Taxation of Court Awards and Damages

The tax treatment of court awards varies, based on the origin of the legal claim. Court awards for
compensation for lost wages or profits are generally taxable as ordinary income, as are punitive
damages. Interest payments on any settlement award are also taxable. Compensatory damages for
personal physical injury or physical sickness are not taxable, whether they are from a legal settlement
or an actual court award.
Damages received for emotional distress due to “physical injury or sickness” are treated the same
way as damages for physical injury or sickness, so they are not included in income. However, if the
plaintiff’s emotional distress is not due to a physical injury (for example, an employment lawsuit in
which a taxpayer suffers emotional distress for injury to reputation), the proceeds are taxable, except
for any damages received for medical care that are directly related to that emotional distress.
“Emotional distress” can include physical symptoms such as headaches, depression, insomnia, and
stomach disorders.
Example: Terrill was injured in a car accident. Both his legs were broken, and he suffered other serious
physical injuries. He received an insurance settlement for his injuries totaling $950,000. The
settlement is nontaxable because it is payment for a physical injury. He does not have to report the
amounts on his tax return.

133 Treasury Regulation Section 1.183-1(e) states that a taxpayer may determine gross income from any activity by subtracting the
cost of goods sold (COGS) from the gross receipts so long as he consistently does so and follows generally accepted methods of
accounting in determining such gross income.
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Example: Sheila won a court award for emotional distress caused by unlawful discrimination. The
emotional distress resulted in her hospitalization for a nervous breakdown. The court awarded Sheila
damages of $100,000, including $30,000 to refund the cost of her medical care for the nervous
breakdown. In this case, $70,000 ($100,000 - $30,000) would be considered a taxable court award.
The $30,000 awarded to reimburse her medical care would not be taxable to Sheila.
Punitive damages are always taxable, even if the punitive damages were received in a settlement
for personal physical injuries or physical sickness. Punitive damages are legal damages awarded by a
jury or a court in order to “punish” the defendant for outrageous or malicious conduct. Punitive
damages should be reported as “Other Income” on line 8z of Schedule 1 (Form 1040).134
Example: Aileen purchases a new car; a sporty sedan called the “Flinto.” She enjoys the vehicle and
drives it to and from work every day. After about six months of ownership, she has a small fender-
bender on a residential street. During the accident, her car’s gas tank mysteriously explodes. Aileen
manages to escape the burning vehicle, but she experiences third-degree burns on her right arm and
leg from the blast. Aileen later discovers that the “Flinto” has a serious design flaw, and the
manufacturer of the car knew about it, but refused to issue a recall. She decides to sue the manufacturer
of the car in a civil action. The case goes to trial, and the jury awards Aileen $2 million in compensatory
damages for her injuries, but also an additional $15 million in punitive damages, which was designed
to punish the manufacturer for its conduct. The $2 million in compensatory damages would not be
taxable to Aileen, as it was payment for her physical injuries. The $15 million in punitive damages
would be taxable as “other income” on Schedule 1 of her Form 1040.
Civil damages, restitution, or other monetary awards that the taxpayer received as compensation
for wrongful incarceration are not taxable.
Example: Ryan was wrongfully convicted of murder and later released after spending almost 15 years
in prison. Ryan was awarded $50,000 per year of wrongful imprisonment. None of the wrongful
incarceration award is taxable income to Ryan.
No tax deduction is allowed for any settlement, payout, or attorney fees related to sexual
harassment or sexual abuse if the payments are subject to a nondisclosure agreement.
Example: Arsenio is a self-employed therapist who files on Schedule C. Arsenio has several employees
who work in his office. On January 4, 2024, Arsenio’s full-time secretary, Keira, sues him for sexual
harassment. Rather than risk a public lawsuit that might damage his reputation, Arsenio settles with
Keira, coming to a confidential settlement with Keira and her attorney. The settlement was $25,000,
and their settlement agreement was subject to a nondisclosure clause. Arsenio also incurred $5,000 in
legal fees for his attorney to negotiate the settlement. Arsenio cannot deduct the settlement or his
related legal fees as a business expense. However, Keira is required to report the full amount of the
settlement as taxable income on her individual return.

Prizes and Awards

Prizes and awards are taxable and are reported as “other income” on Line 8i of Schedule 1 of Form
1040. If the prize or award is in the form of property rather than cash, the fair market value of the

134 Refer to IRS Publication 4345, Settlements—Taxability, for more information on the tax treatment of court settlements.
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property is treated as the taxable amount. The winner may avoid taxation of the award by rejecting
the prize. The taxpayer may also avoid taxation by having the payor directly transfer the prize to a
charity or other nonprofit organization.
Example: A national education association chooses Paulo, a college instructor, as its teacher of the
year. He is awarded $3,000, but he does not accept the prize. Paulo directs the association to give all
his winnings to a charitable college scholarship fund, instead. Paulo never receives a check or has
control over the funds; therefore, the award is not taxable to him.
Employee awards for safety, length-of-service, or achievements are generally not taxable to the
employee unless they exceed specified limits. These types of awards are treated as fringe benefits, and
are covered in detail in Book 2, Businesses. Employee fringe benefits are commonly tested on Part 2 of
the EA exam.
Tax-Free Educational Assistance
Many types of educational assistance are tax-free if they meet certain requirements. Tax-free
educational assistance includes scholarships, Pell Grants, and employer-provided educational
assistance. Qualifying educational assistance plans (Qualified EAPs) provided under an employer’s
qualified educational assistance program, also include the payments of tuition and fees, as well as
student loans, up to an annual maximum of $5,250 in 2024.135
Example: Deloft Accountancy, Inc. is an accounting firm. The company offers an educational assistance
program to its employees as a fringe benefit. As part of the plan, the company reimburses costs for
tuition, fees, and books for college and university classes. Gregory is a junior auditor working for Deloft
Accountancy. During the year, he incurs $6,300 in educational expenses. He submits copies of his
tuition statements and receipts for his books to his employer. The company reimburses Gregory for
$5,250 worth of his expenses (the annual maximum). The reimbursed amounts are not taxable to
Gregory and are fully deductible by the company. However, if Gregory is eligible for an education credit
(such as the American Opportunity Tax Credit), he is required to reduce the amount of his qualified
educational expenses by the amount that was reimbursed by his employer.
Scholarships and Fellowships: A scholarship is an amount paid to an undergraduate or graduate
student to pursue a college degree. A fellowship is an amount paid to an individual to pursue research.
A scholarship or fellowship may be excluded from income only if:

• The taxpayer is a degree candidate at an eligible educational institution

• The amounts do not exceed qualified educational expenses.
• It is not designated for other purposes, such as room and board.
• It does not represent payment for teaching, research, or other personal services.
Qualified educational expenses include: tuition, required fees, and course-related expenses such as
books and required equipment. An athletic scholarship is tax-free only if it meets the requirements
described above.

135The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) added student loan repayments to the types of payments
that are eligible for this exclusion. This provision was extended through 2025.
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Example: Marybeth is a graduate student at a private university. She received a total scholarship of
$30,000. Under the scholarship’s terms, she must work part-time as a teaching assistant. From the
$30,000 scholarship, she receives $14,500 for teaching, which is reported to her as wages on Form W-
2 by the university. The remaining amount, $15,500, was applied directly to her tuition costs. She had
qualified educational expenses of $20,000 for tuition, fees, and course-related books. Marybeth may
exclude $15,500 of the scholarship funds from income, but the $14,500 she earned as a teaching
assistant is taxable as wages and must be included on her individual tax return.
Pell Grants: A Pell Grant is a need-based grant that is treated as a scholarship for tax purposes. It
is tax-free to the extent it is used for qualified educational expenses during the specified grant period.
Payment to Service Academy Cadets or Midshipmen: An appointment to a United States
military academy is not a scholarship or fellowship. Cadets and midshipmen receive free tuition and
room and board, which is nontaxable. However, they may also receive government pay while attending
the military academy; these amounts are taxable income.
Veterans’ Educational Benefits: Veterans’ education benefits (VA benefits) are tax-free if
administered by the Department of Veterans Affairs. Payments from all GI Bill programs are tax-free.
This is true for the servicemember, as well as dependents or surviving spouses of servicemembers who
die in the line of duty.
Example: Reggie served in Afghanistan as a medic and Blackhawk pilot. He has since returned to
college full-time. He is studying chemistry and he is a degree candidate. Reggie receives two education
benefits under the GI bill: a $1,200 monthly basic housing allowance and $3,500 tuition paid directly
to his college. Neither of these benefits is taxable to Reggie, and he is not required to report them on
his tax return. However, if Reggie wants to claim educational tax credits based on his education
expenses, he will need to subtract his GI education benefit payments from his qualifying educational
expenses.
Qualified Tuition Programs (529 Plans)
Section 529 plans, also known as QTPs, allow taxpayers to contribute to an account for future
education expenses. The contributions are not tax-deductible, but the earnings grow tax-free. Anyone
can be designated as a beneficiary136 and there are no age or income limits. A Section 529 contribution
is considered a gift for tax purposes, so a donor can give up to $18,000 in 2024 per beneficiary without
filing a gift tax return.137 This is also why 529 plans are often used for estate planning, as donor
contributions to a 529 are excluded from the donor's gross estate.
Unlike a Coverdell ESA, (covered in the next section), a 529 plan does not impose age limits or
income limits to contribute. Distributions are taxable if they exceed qualified education expenses,
which may include tuition, fees, books, computer equipment, and even room and board. Eligible
institutions include: accredited colleges, universities, vocational schools, and postsecondary
educational institutions.

136 Anyone can be named a beneficiary of a 529 plan: the taxpayer, their child, a grandchild, or even an unrelated person; the donor

and beneficiary do not need to be related to one another.

137 Additionally, there's a special provision for 529 plans called "super funding," which allows a donor to make a lump-sum

contribution of up to five times the annual gift tax exclusion amount (i.e., up to $90,000 in 2024) and spread it over five years for
gift tax purposes.
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If distributions from a 529 exceed a student’s adjusted qualified expenses, an allocable portion of
the earnings is taxable. In this type of taxable distribution, an additional excise tax of 10% generally
applies to the taxable amount that must be included in income. If a 529 plan beneficiary dies or
becomes disabled, the 10% penalty for withdrawing earnings is waived.
Example: Brandon is a 26-year old college student with a 529 plan, which his parents set up for him
many years ago. Brandon distributes money from the plan in January, intending to pay his tuition and
fees. His total distribution is $10,000, of which $2,000 are the earnings. He ends up dropping out of
school within a week of starting the Spring semester, and instead uses the $10,000 distribution to buy
a motorcycle. His total qualified expenses for the year are zero, so $2,000 of the distribution is taxable.
The $2,000 is additionally subject to a 10% penalty since it was not used for qualifying educational
expenses, so he will owe an additional $200. To calculate the penalty, Form 5329, Additional Taxes on
Qualified Plans (including IRAs) and Other Tax-Favored Accounts, must be completed and attached to
Brandon’s tax return. The taxable amount will be reported on Schedule 1, Form 1040.
Section 529 plans allow tax-free distributions (up to $10,000) for tuition and fees at public, private,
or religious K-12 schools. The SECURE Act 1.0 expanded this to include apprenticeship programs like
electrical certification, dental assistants, and welding. Additionally, these plans can be used to pay off
up to $10,000 of student loans (this is a lifetime limit) for the designated beneficiary or their sibling.
Distributions from a 529 plan are not taxable when rolled over to another plan for the same
beneficiary or a family member, such as a sibling. If it is an indirect rollover, the distribution must be
transferred within 60 days to another educational account.
Example: Bernardo still had $3,000 left in his 529 plan after he graduates from college. He wants to
help his younger sister, Angelina, who was still a senior in high school. She also plans to go to college.
He distributed the entire amount that was left in his 529 plan, and within 60 days after the distribution,
Bernardo contributed all the money to his sister’s 529 plan. As a qualified rollover, the distribution
was not taxable to him or his sister. Instead of taking a distribution, Bernardo could also have
instructed the trustee of his 529 account to change the name of the beneficiary on his existing account
to his sister’s name.
SECURE 2.0 added a provision that became effective in 2024 that permits rollovers from a Section
529 account into a Roth IRA. Beneficiaries of 529 accounts may roll over up to the annual allowed Roth
IRA contribution amount per year (disregarding the income limitations) up to a lifetime maximum of
$35,000 if the 529 account has been open for more than 15 years.
Coverdell Education Savings Accounts (ESA)
A Coverdell ESA is a self-directed, tax-advantaged investment account for higher education.
Formerly called “Education IRAs,” these plans were named after the late Senator Paul Coverdell, who
was their primary backer.
Age and Income Restrictions: Unlike 529 plans, Coverdell accounts have age and income
limitations. Contributions must be made before the beneficiary turns 18 and used by age 30 (unless
they are special needs). If there is a remaining balance at age 30, it must be distributed within 30 days
(or after death if applicable). The beneficiary can transfer to another family member, such as a younger
sibling, to avoid taxes.

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Example: Arjun was awarded a full scholarship to Stanford University. He enrolled in college when he
was 18 and had a Coverdell ESA with a balance of $52,000 that was set up by his parents when he was
a baby. Since his tuition was already paid by a scholarship, Arjun only used the Coverdell to pay for his
textbooks, required equipment, and lab fees. Arjun graduated from college 4 years later and had only
used a total of $14,000 from his ESA. Rather than withdrawing the remaining money in the account
and paying a 10% penalty, Arjun transferred the Coverdell to his younger sister, who is 17 and still in
high school. His sister can use the remaining amounts in the Coverdell ESA for her own future college
expenses. His sister will have until age 30 to use the funds for her own college expenses.
If the beneficiary is special needs, the Coverdell account can continue in existence even after the
beneficiary turns 30.
Example: Hallie has a Coverdell education savings account that her parents set up for her when she
was a child. Hallie has autism and is considered disabled. She is enrolled in a special college program
for students with diagnosed learning disabilities. This year, Hallie turned 30 years of age. She is not
required to withdraw or transfer the amounts in her Coverdell because she is special-needs.
In 2024, the income limits for a Coverdell Education Savings Account (ESA) are $95,000 -$110,000
for single filers and $190,000 -$220,000 for joint filers. If MAGI exceeds these phase-out ranges, a
taxpayer cannot contribute to a Coverdell ESA. Contributions to a Coverdell ESA are not tax-deductible,
but amounts deposited in the account grow tax-free until they are later distributed. The funds
withdrawn from a Coverdell are tax-free when used for qualifying educational purposes. If a
distribution exceeds qualified education expenses, a portion of the earnings is taxable. In addition, a
penalty tax of 10% applies to distributions that are not used for qualifying educational expenses. 138
Example: Evaline is 21 years old. She enrolled in college for the first time on January 6, 2024. Evaline’s
parents set up a Coverdell account for her when she was a child. Her parents contributed a total of
$9,000 to Evaline’s Coverdell over the years, and now her account is worth $10,000. Evaline withdraws
the entire amount from the Coverdell account and then promptly spends the withdrawn funds on a
vacation to Cabo San Lucas. Ten percent of the balance on the account is earnings, so $1,000 of the
distribution is taxable. In addition, Evaline will owe a 10% penalty on the $1,000 taxable portion of the
distribution, because she did not have any qualifying education expenses.
The additional 10% tax will not apply to withdrawals made due to the beneficiary’s death or
disability, or to the extent that the beneficiary receives a tax-free scholarship.
Example: Oliver is 24 years old. He is the beneficiary of a Coverdell ESA that was set up for him by his
parents. There is $19,000 in the Coverdell account at the beginning of the year. Oliver signs up for an
automotive certificate program at his local community college. The tuition and books for the program
cost $13,700. Oliver withdraws $13,700 from the Coverdell account, intending to use the amounts to
pay for his tuition. Before the semester starts, Oliver is in a serious auto accident and becomes disabled,
and he ends up using the funds for medical bills instead. He receives a Form 1099-Q to report the
taxable (earnings) portion of the withdrawal. Due to his disability, the distribution is exempt from a
10% penalty.

The beneficiary may also avoid this 10% penalty by rolling over the full balance to another Coverdell ESA for another family
138

member, such as a sibling.

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Coverdell ESAs offer more flexibility in investing. Coverdell accounts are self-directed, which
means that there are a variety of investment options available, whereas 529 plans are limited to the
state’s selected investment options.
All contributions must be in cash, and must be made by the due date of the donor’s tax return, not
including extensions. So, for example, if a parent wanted to set up a Coverdell account for their child in
2024, the parent would have until April 15, 2025, to set up the account and fund it.
There is no limit to the number of Coverdell accounts that can be established for a beneficiary;
however, the total contribution to all accounts on behalf of a beneficiary cannot exceed $2,000 per
year, no matter how many accounts are established.
Excess Contributions: All contributions that exceed $2,000 for a single beneficiary per year will
be treated as excess contributions. There is a 6% excise tax if the excess contributions and earnings on
them are not withdrawn from the child’s accounts by May 31 of the following tax year. This excise tax
will apply to each year in which the excess remains in the account. Any earnings withdrawn as part of
a corrective distribution are taxable in the year of the excess contribution, even if the corrective
distribution occurs in the following year.
Example: Three Coverdell ESAs were set up for Kendra when she was born: one by her parents, one
by her grandparents, and one by her favorite uncle. In 2024, her grandparents contribute $1,500 to
Kendra’s account. The most her parents and uncle can contribute is a combined $500, because the
maximum contribution per year for a single beneficiary is $2,000.
The 6% penalty for excess contributions is imposed on the beneficiary of the account (usually a
minor child), and not on the person who overcontributed to the account. The excise tax must be
reported on the child’s income tax return, using IRS Form 5329, Additional Taxes on Qualified Plans
(Including IRAs) and Other Tax-Favored Accounts. This rule seems contrary to common sense, but the
penalty is imposed on the child, not the child’s parents, or the contributor of the excess funds.
There is no law that prevents a taxpayer from contributing to both a Coverdell and a 529 for the
same beneficiary, so a taxpayer could potentially set up a Coverdell and a Section 529 for the same
child, and the earnings would grow tax-free in both accounts.
If a beneficiary receives distributions from both a 529 plan and a Coverdell ESA in the same year,
and the total distributions exceed the beneficiary’s adjusted qualified education expenses for that year,
the educational expenses must be allocated between the distributions from each account.

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Comparison Chart Between a Coverdell ESA and a Section 529

COVERDELL ESA SECTION 529

• Contribution Limits: Up to $2,000 per • Contribution Limits: Contributions to a 529
beneficiary per year. Contributions must plan are considered gifts for federal tax
be made in cash, and are not deductible. purposes. This means they are subject to the
• Income Limits: Contributions are phased annual gift tax exclusion limit. For 2024, the
out for single filers with modified adjusted annual gift tax exclusion is $18,000 per
gross income (MAGI) between $95,000 beneficiary.
and $110,000, and for joint filers between • Qualified Expenses: Primarily for higher
$190,000 and $220,000. education expenses; up to $10,000 per year can
• Investment Options: Offers a wide range be used for K-12 tuition and $10,000 (lifetime)
of investment choices, similar to an IRA. to pay student loans.
• Age Limits: Contributions must be made
before the beneficiary turns 18, and the
account must be used by the time the
beneficiary turns 30.
• Qualified Expenses: Can be used for a
wide range of educational expenses,
including K-12 and higher education
costs.
Benefits: Flexibility in using funds for both K- Benefits: Contributions have no income or age
12 and higher education expenses and a limits. No income limitations for the donor.
broad range of investment options.

Drawbacks: Lower contribution limit Drawbacks: 529 plans are administered by each
compared to 529 plans. Income limits may individual state, and investment choices can be
restrict eligibility for some families. Funds limited.
must be used by age 30, or they may be
subject to taxes and penalties.

Miscellaneous Other Income

Other types of income that are taxable to the recipient and reported on Schedule 1 (Form 1040)
include the following (this list is not exhaustive):
• Union strike benefits,
• Jury duty pay (when not turned over to an employer and deducted as an adjustment to income),
• Alaska Permanent Fund dividends
• Fees paid by an estate to a personal representative/executor, 139
• Gifts or gratuities received by a host or hostess of a party or event where sales are made.

139Executor fees are considered taxable income to the recipient. Executors of an estate will typically receive some type of
compensation for their work on the estate. Many U.S. states have a specific set of statutory rates (based on the value of the estate)
that can be paid to an executor of an estate as listed in their probate codes. We will cover estates more extensively in a later unit.
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Example: Shirley is 72 years old and retired. She supports herself primarily with her Social Security
income. In 2024, she receives a jury duty summons. She is chosen for the jury, and she is paid $40 a
day for serving ten days on a jury trial. Shirley was also reimbursed by the court for reasonable
transportation expenses and parking fees. The $400 she earned for jury duty is taxable and must be
reported on Line 8h of Schedule 1 of her Form 1040. The reimbursement for transportation and
parking fees is not taxable and does not have to be reported on her return.
Example: Ethan is the executor of his grandmother’s estate. His grandmother died on January 29,
2024. Her estate includes several rental properties that must be managed after her death. Ethan is not
an attorney or professional executor, but he did agree to manage his grandmother’s estate. Ethan pays
bills, hires an accountant to file the estate’s tax returns, and manages his late grandmother’s rental
properties until they can be sold. His grandmother’s final will stipulates that the executor should
receive 4% of the income generated by the estate, as well as reimbursement for all estate-related
business expenses. In 2024, Ethan receives $9,500 in executor fees, which he reports as other income
on his Form 1040 (Line 8z of Schedule 1).
Example: Johanna hosts a cooking party for 15 of her friends, which includes a live demonstration by
a Pampered Chef consultant. At the end of the evening, the women order $2,000 worth of Pampered
Chef cookware and other merchandise from the consultant. Johanna receives a gift of $115 of cookware
for hosting the party, which she must report as income at its fair market value.

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Unit 11: Adjustments to Gross Income

For additional information, read:
Publication 504, Divorced or Separated Individuals
Publication 970, Tax Benefits for Education
Publication 590-A, Contributions to Individual Retirement Arrangements

“Adjustments to income” refers to deductions that can be made before calculating taxable income,
thus reducing the amount of tax owed. These adjustments are reported on Form 1040, Schedule 1,
Additional Income and Adjustments to Income.
Adjustments are taken before AGI is calculated; they are often called “above-the-line” deductions.
Adjustments are subtracted from gross income to arrive at adjusted gross income (AGI), whereas
itemized deductions and the standard deduction are subtracted from AGI. Adjustments are beneficial
because they directly reduce taxable income, and may increase a taxpayer’s eligibility for certain
credits and deductions. Unlike other deductions, adjustments are not added back when calculating the
alternative minimum tax.
Common Adjustments to Gross Income
There are many types of adjustments to gross income, and we will cover the most common ones in
this unit. These are the adjustments listed in the order they are reported on the 2024 version of the
Schedule 1, Form 1040:
• Line 11: Qualified educator expenses
• Line 12: Certain business expenses of Armed Forces reservists, performing artists, and fee-
basis government officials.
• Line 13: Health savings account deduction (HSA deduction).
• Line 14: Moving expenses for members of the Armed Forces.
• Line 15: Deductible part of self-employment tax.
• Line 16: Self-employed SEP-IRA, SIMPLE, and qualified plans
• Line 17: Self-employed health insurance deduction
• Line 18: Penalty for early withdrawal of savings
• Line 19: Alimony paid (the form requires the amount paid, recipient’s SSN, and the date of the
original divorce or separation agreement)
• Line 20: Traditional IRA deduction
• Line 21: Student loan interest deduction
• Line 22: Reserved for future use (no deduction listed on this line of the form)
• Line 23: Archer MSA deduction
• Line 24: Other adjustments
o a) Jury duty pay remitted to an employer
o b) Deductible expenses related to the rental of personal property
o c) Nontaxable amount of the value of Olympic and Paralympic medals
o d) Reforestation amortization and expenses
o e) Repayment of supplemental unemployment benefits
o f) Contributions to section 501(c)(18)(D) pension plans
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o g) Contributions by certain chaplains to section 403(b) plans
o h) Attorney fees for actions involving unlawful discrimination claims
o i) Attorney fees paid in connection with an IRS whistleblower award
o j) Housing deduction from Form 2555
o k) Excess deductions of section 67(e) expenses from Schedule K-1 (Form 1041)
o z) Other (write in) adjustments.

Line 11: Qualified educator expenses

This is sometimes called the "Teacher Credit" or "Educator Expense Deduction." Educators who
qualify can deduct up to $300 of unreimbursed expenses in 2024. On a joint return, if both spouses are
teachers, they can claim a maximum deduction of $600, but the amount of qualifying expenses is still
limited to $300 for each spouse.
Example: Wilbur and Tammy are both elementary school teachers and file a joint return together. For
2024, Wilbur paid $800 for qualifying expenses for his class and Tammy paid $200 in qualifying
expenses for her class. Even though collectively, they pay $1,000 in qualifying expenses, because this
deduction is limited to $300 per spouse, they can only deduct $500 as an educator expense on their
joint tax return ($300 for Wilbur and $200 for Tammy).
Expenses that exceed these limits cannot be claimed as unreimbursed employee business expenses
on Schedule A.
Eligible expenses include books, supplies, computer equipment (including related software and
services), other equipment, and supplementary materials used in the classroom. Professional
development expenses are also eligible for deduction.
For health and physical education courses, expenses are deductible only if they are related to
athletics. Nonathletic supplies for physical education and expenses related to health courses do not
qualify for this deduction, and materials used for homeschooling do not qualify for this deduction.
To qualify for the credit, an educator must work at least 900 hours in a K-12 school. This can include
teachers, school counselors, principals, classroom aides, and school coaches. College instructors are
not eligible.
Example: Donnie is a part-time biology teacher at an elementary school. He spent $185 on qualified
expenses for his students to use in the classroom. During the tax year, he worked 550 hours at the
school. However, because he does not have enough documented hours of employment as an educator
during the tax year, he cannot deduct any of his unreimbursed educator expenses. The required
minimum is 900 hours during the school year.
Example: Gayle is a fifth-grade art teacher who worked 1,600 hours during the tax year. She spent
$262 on supplies for her students, of which $212 was for educational design software. The remaining
$50 went towards supplies for a unit on reproductive health. Only the $212 spent on educational
software is considered a qualified educator expense and can be deducted on Gayle’s tax return.

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Line 12: Certain business expenses of reservists, performing artists, and fee-
basis government officials
Although most employee-related business expenses are no longer deductible, work-related
expenses for reservists, performing artists, and fee-basis government officials are still permitted.140
Form 2106, Employee Business Expenses, is used to calculate the deduction.
This adjustment applies only to reservists141 (members of the reserve component of the Armed
Forces of the United States, National Guard, etc.), qualified performing artists; and state or local
government officials who are compensated on a fee basis (examples may include a town mayor, county
commissioner, justice of the peace, local registrars).
Regarding deductible expenses for reservists, Armed Forces Reservists can claim a deduction for
amounts attributable to travel more than 100 miles away from their home. The travel must be reserve-
related for it to be deductible.
Example: Wilfred is an Army reservist. He also has a regular full-time job in addition to his job as a
reservist. Wilfred’s drill location is 200 miles away from his home, where he normally reports for
reserve drills and official meetings. He trains one weekend a month plus an additional two weeks per
year. Wilfred is allowed to deduct the mileage and other travel expenses related to his reservist duties
on Form 2106. The amounts are then transferred to Schedule 1, Form 1040, and claimed as an
adjustment to income.

Line 13: Health savings account deduction

A high-deductible health plan (HDHP) can be combined with a health savings account (HSA),
allowing the taxpayer to pay for medical expenses on a tax-favored basis. The HSA contributions are
deductible as an adjustment to income on Form 1040.
Before a taxpayer can contribute to an HSA, the taxpayer must first be enrolled in a high-deductible
health plan (HDHP). Once the HSA is set up, the taxpayer can take tax-free withdrawals from the HSA
to pay for his qualifying medical expenses. An HSA must be established exclusively to pay medical
expenses for the taxpayer, a spouse, and/or their dependents. HSA accounts are usually set up with a
bank, an insurance company, or through an employer. To qualify for an HSA, the taxpayer:
• Must not be enrolled in Medicare,
• Cannot be claimed as a dependent on anyone else’s tax return,
• Must be covered under a high deductible health plan and have no other health coverage, other
than for a specific disease or illness; a fixed amount for a certain time period of hospitalization;
or liabilities incurred under worker’s compensation laws or tort liabilities.
An employee and his employer are both allowed to contribute to the employee’s HSA in the same
year. If an employer makes an HSA contribution on behalf of an employee, it is excluded from the
employee’s income and is not subject to income or payroll taxes.

140 An employee with impairment-related work expenses is also still allowed to deduct employee business expenses, if the expenses

are directly related to their work and disability.

141 These deductions for travel-related expenses are not available for active-duty service members, only reservists.

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2024 HSA and HDHP Limits

HSA Contribution maximum Self-only: $4,150, Family: $8,300

HDHP minimum deductible Self-only: $1,600, Family: $3,200

Maximum out-of-pocket (not including insurance Self-only: $8,050, Family: $16,100

premiums)

HSA catch-up contributions (age 55 or older) $1,000

HSA holders who are age 55 and older get to contribute an extra $1,000, beyond the regular limits
(as detailed in the chart), as a catch-up contribution. Any amount the employer puts into the
employee’s HSA counts toward the employee’s contribution maximum for the year. 142 Any excess
contributions over the annual limits are subject to a 6% penalty, if the taxpayer does not withdraw the
excess contributions.143
Example: Otto is 32 years old and married with children. His employer provides a health care HSA and
a high-deductible health plan that covers Otto’s entire family. Otto’s employer adds $1,500 to his HSA
account during the year. Otto may contribute up to $6,800 ($1,500 + $6,800 = $8,300 limit in 2024)
more to his HSA account if he wishes. The amounts that Otto contributes to his own HSA would be
deductible as an adjustment to income, and he is able to withdraw the amounts tax-free, as long as he
uses the amounts to pay for qualified medical expenses.
Medical expenses that qualify for deductions are also allowable for Health Savings Accounts
(HSAs). The CARES Act expanded qualifying expenditures to include over-the-counter medications
(such as aspirin and cough syrup) and menstrual products.
While funds from an HSA can be withdrawn at any time, withdrawals not used for qualifying
medical expenses are subject to income tax and may also incur a 20% penalty, except when a taxpayer
reaches the age of 65, becomes permanently disabled, or dies.
Example: Rooney is age 66, unmarried, and has an HSA through his employer. In 2024, he has no
qualifying medical expenses for the year, but his car breaks down, and he doesn’t have the funds to
repair it. Rooney withdraws $2,000 from his HSA to pay for the car repairs. Since he did not use the
funds to pay for qualifying medical expenses, the entire withdrawal is subject to income tax. However,
Rooney avoids the 20% additional penalty tax because he is over 65.
A taxpayer will receive annual Form 5498-SA from their HSA trustee showing the year's
contributions. The deduction for an HSA is reported on Form 8889, Health Savings Accounts. To claim
the HSA deduction for a particular year, the HSA contributions must be made on or before that year’s
tax filing date, without extensions, so by April 15, 2025, for the 2024 tax year.

142HSA contribution limits must be prorated by the number of months one is eligible to contribute to a health savings account.
143A taxpayer may withdraw the excess contributions and avoid paying the excise tax. They must withdraw the excess
contributions by the due date, including extensions, of their tax return for the year the contributions were made.
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Note: Do not confuse an HSA (Health Savings Account) with a Healthcare FSA (Flexible Spending
Arrangement). The two are not the same thing. Although both types of accounts are used to pay medical
expenses on a pre-tax basis, there are significant differences between an HSA and a Healthcare FSA. An
HSA is always paired with a high-deductible health plan, and the funds in the HSA belong to the
participant, not the employer. Unlike an FSA, funds in an HSA do not expire from year-to-year.

Line 14: Moving Expenses for Members of the Armed Forces

The Tax Cuts and Jobs Act suspended the moving expense deduction for most taxpayers through
2025, except for those in the Armed Forces who are moving under military orders or for a permanent
change of station. Members of the armed forces can also deduct the costs of moving their spouse,
dependents, pets, and household goods. However, they cannot claim any expenses already reimbursed
by the government as a deduction.
The standard mileage rate for moving expenses in 2024 is 21 cents per mile. Armed Forces
personnel must calculate their qualifying moving expenses using Form 3903, Moving Expenses.
Example: Catarina is a U.S. Army medic. In 2024, she was transferred from Fort Rucker Army Base in
Alabama to the Tripler Army Medical Center in Hawaii. The Army offers her a relocation
reimbursement that covers most of her moving expenses. The only costs that the Army would not cover
were the transport costs for her pets. She pays $1,200 to a pet relocation service in Hawaii to process
the transportation of her pets on a private airline, as well as to board her pets for the quarantine period
required by the state of Hawaii. The cost of transporting pets is a deductible moving expense, and
Catarina is eligible to deduct any out-of-pocket moving expenses related to household goods and
personal effects, including pets, because she is an employee of the U.S. Armed Forces. She files Form
3903, Moving Expenses, and correctly deducts the $1,200 that she paid to transport her pets.
If a taxpayer is not a U.S. service member and their employer reimburses their moving expenses, it
is considered taxable as wages. Employers must report these reimbursements on the employee's Form
W-2 and the full amounts are subject to income tax and payroll tax.
Example: Cedric was offered a job at Highland Engineering, Inc. on February 2, 2024. He agreed to
accept the offer if the company paid all his moving expenses. The cost of his professional movers was
$9,600, which the company paid. Highland Engineering also reimbursed Cedric $7,500 for temporary
storage fees and other travel expenses. The total reimbursement was $17,100. Because moving
expenses are no longer deductible expenses, the entire $17,100 is taxable as wages, and must be
included on Cedric’s Form W-2. The amount is deductible to Highland Engineering, but it is categorized
as a wage expense and subject to payroll taxes.

Line 15: Deductible Part of Self-Employment Tax

A self-employed taxpayer can subtract from income 50% of their self-employment tax, equal to the
amount of Social Security and Medicare taxes that an employer normally pays for an employee, which
is excluded from an employee’s income. The deduction is figured on Schedule SE. The self-employment
tax rate is a percentage of the taxpayer’s net income from self-employment.

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The rate for self-employment tax is 15.3%, which is a combination of 12.4% Social Security tax and
2.9% Medicare tax.144 It is calculated from 92.35% of self-employment net income. A self-employed
taxpayer cannot deduct one-half of the Additional Medicare Tax on earned income.145

Line 16: Self-employed SEP, SIMPLE, and qualified plans

When taxpayers are self-employed, they have access to many of the same kinds of retirement plans
that are utilized by larger employers. Self-employed individuals can deduct contributions to the
following types of retirement plans:
• Simplified Employee Pension (SEP) plans
• Savings Incentive Match Plan for Employees (SIMPLE) plans
• Qualified plans, such as a 401(k)
A self-employed taxpayer must have qualifying income to contribute to their own plan.146 This
means that their business must show a profit. However, a self-employed business owner does not need
to show a profit on Schedule C in order to contribute to a retirement plan for their employees.
Example: Rakeem is a self-employed kickboxing instructor. He has a full-time receptionist named
Dayanara who works in his training gym. At the end of the year, Rakeem makes a large fitness
equipment purchase. The fitness equipment qualifies for Section 179 and bonus depreciation. Rakeem
claims Section 179 depreciation on all the equipment and reduces his taxable income to zero for the
year. He cannot contribute to his own retirement plan because he has no taxable income on his
Schedule C. However, Rakeem is still allowed to contribute to Dayanara’s retirement plan. This is true
even if there is a loss on his Schedule C.

Line 17: Self-employed health insurance deduction

A self-employed taxpayer may be able to deduct 100% of their health insurance premiums as an
adjustment to income (as long as the business has profits for the year). Premiums paid by the taxpayer
for a spouse and dependents under age 27 are also deductible. The deduction is limited to the net
profits from the business. The taxpayer must either:
• Be self-employed and have a net profit for the year,
• Be a partner in a partnership with net earnings from self-employment, or
• Have received wages from an S corporation in which the taxpayer was a more-than-2%
shareholder.
Long-term care insurance and Medicare premiums are also considered health insurance for
purposes of this deduction.

144 Employees and their employers typically “split” the amounts for Social Security tax and Medicare tax. Each pays 7.65% (the
employer pays 7.65%, and the employee also pays 7.65%). But self-employed individuals are responsible for both halves, resulting
in the full 15.3% self-employment tax.
145 The Additional Medicare Tax and other provisions of the Affordable Care Act are covered later.
146 SEP, SIMPLE, and qualified retirement plans are primarily tested on the businesses section of the EA exam (Part 2), so they are

covered in much more detail in Book 2, Businesses.

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Example: Breton is unmarried and runs his own business as a refrigerator repairman. During the year,
he paid health insurance premiums of $3,000 ($250 per month). After deducting all his business
expenses, his Schedule C shows a profit of $15,500. He may deduct the full $3,000 in health insurance
as an adjustment to income on Schedule 1 (Form 1040).
If a self-employed individual (or their spouse, if filing jointly) has the option to join an employer-
sponsored and subsidized health insurance plan, they are not eligible for the self-employed health
insurance deduction, even if they decline to enroll in the employer’s plan.147
Example: Heather and Jeremy are married. Jeremy is a self-employed carpenter and pays for his own
individual insurance policy. Heather works for a grocery store as a cashier. Jeremy was eligible to
participate in a subsidized health plan through his wife’s employer, but Jeremy declined the coverage
because he didn’t want to switch doctors. Jeremy cannot take a deduction for the health insurance
premiums that he paid because he declined to participate in his wife’s employer-sponsored coverage.

Line 18: Penalty for early withdrawal of savings

If a taxpayer withdraws money from a certificate of deposit (CD) or other time-deposit savings
account prior to maturity, they usually incur a penalty for early withdrawal. The bank or other financial
institution charges this penalty and withholds it from the taxpayer’s proceeds.
Taxpayers can take an adjustment to income for early withdrawal penalties. The penalties are
reported on a taxpayer’s Form 1099-INT, Interest Income, or on Form 1099-OID, Original Issue
Discount, which lists interest income as well as the penalty amount.
Example: On January 4, 2024, Nikita invested in a $45,000 one-year certificate of deposit through her
credit union. Later that year, she had an unexpected medical expense and had to liquidate the CD early.
She paid a penalty of $450. Nikita can claim the entire penalty ($450) as an adjustment to income on
Schedule 1 of Form 1040. She can take the deduction for the early withdrawal penalty even if she did
not have any interest income for the year.

Note: Do not be confused by this concept! Only the penalty for early withdrawal from a timed deposit
(a certificate of deposit) is tax-deductible. The penalty for early withdrawal from an IRA or a
retirement plan is never deductible.

Line 19: Alimony paid

By definition, alimony is a payment to a former spouse under a divorce or separation instrument.
Sometimes these payments are called “spousal support” or “separate maintenance.” The payments
must be made in cash, but they do not have to be made directly to the ex-spouse. For example,
payments made on behalf of the ex-spouse for expenses such as medical bills and other expenses can
also qualify as alimony.
While alimony paid on divorces finalized since 2019 is not deductible, if the divorce decree was
finalized before 2019, alimony paid is normally an adjustment to income for the payor on Line 19a of

147For self-employed individuals filing a Schedule C or F, a health insurance policy can be either in the name of the business or in
the name of the individual.
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Schedule 1. In order to deduct alimony paid, the payor’s Form 1040, Schedule 1 requires the amount
paid, the recipient’s SSN, and the date of the original divorce or separation agreement.
On the other side, alimony received on pre-2019 divorces is taxable income to the payee, which is
claimed on Schedule 1 (Line 2a) of Form 1040.
Example: Elizabeth and Archibald’s divorce decree was finalized on May 3, 2024. Their divorce
agreement requires that Archibald must pay his ex-wife $12,000 a year in alimony, as well as $19,000
a year in child support. Also, per their divorce agreement, Archibald also must pay Elizabeth’s ongoing
medical insurance costs. Archibald cannot deduct any of these payments as alimony, because their
divorce was finalized in 2024.
Example: Farrah and Esteban were legally divorced on November 10, 2018. Farrah is a wealthy
actress, and their divorce settlement requires that Farrah must pay her ex-husband $58,000 a year in
alimony. Since their divorce was finalized before 2019, it is considered “grandfathered,” and all the
alimony is deductible by Farrah and taxable to Esteban.
Voluntary payments that are not required by a divorce decree or separation instrument do not
qualify as alimony.

Example: Finnigan and Annabella legally divorced in 2018. Under the terms of their divorce, Finnigan
must pay his ex-wife $12,600 per year in alimony ($1,050 per month). Finnigan also pays $10,000 a
year for Annabella’s medical insurance, because that is required as part of their divorce settlement. As
a personal favor, he also makes $2,400 in auto loan payments on her car, so she can keep steady
employment. Since his divorce was final before 2019, Finnigan can claim $22,600 ($12,600 +$10,000)
as alimony paid, and claim the amounts as an adjustment to income on his Form 1040. Annabella must
also report these amounts as taxable alimony on her return. However, Finnigan cannot deduct the auto
payments as alimony because they are not required by the divorce agreement. Those voluntary
payments would be treated as a gift.

Line 20: Traditional IRA deduction

An individual retirement arrangement (IRA) offers tax advantages for setting aside money for
retirement. Most taxpayers can claim a deduction for the amounts contributed to a traditional IRA.
Only amounts contributed to a traditional IRA are deductible. Amounts that do not qualify for the IRA
deduction include:
• Contributions to a Roth IRA,
• Contributions to a traditional IRA that are nondeductible because the taxpayer and/or spouse
is covered by an employer-sponsored retirement plan and modified adjusted gross income
(MAGI) exceeds certain limits,
• Contributions that apply to the previous tax year,
• Rollover contributions.
Individuals who are not covered by a retirement plan at work may fully deduct contributions made
to a traditional IRA. However, for those already covered by another retirement plan at work, the
deduction for their IRA contributions may be reduced above certain income thresholds. The rules

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regarding IRA contributions, distributions, and rollovers are covered in detail later, in a dedicated unit
for retirement plans.
Line 21: Student Loan Interest Deduction
The interest paid on a qualified student loan may be deductible. A qualified student loan refers to
a loan used solely for paying qualified higher-education expenses for the taxpayer, their spouse, or
their dependents. To claim the deduction, the taxpayer must have personally paid the interest on a
qualified student loan and cannot be claimed as a dependent on someone else’s tax return. Married
couples who file separate tax returns are not eligible for this deduction.
Example: Sharon and Winston are married, but choose to file separate returns. They both have
qualified student loans, and both are paying interest. Sharon pays $2,100 in student loan interest on
her loan, and Winston pays $3,000 in interest on his student loan. Sharon and Winston decided to file
separate returns. Neither one of them can take a deduction for student loan interest, because they are
filing separate tax returns (MFS).
In order for student loan interest to qualify, the student must have been enrolled in a higher
education program leading to a degree, certificate, or other recognized educational credential. A
student who used the loan for other purposes does not qualify.
The maximum deduction for student loan interest in 2024 is $2,500. The student loan interest
deduction limit is per return, not per student. For example, if a taxpayer has three children and pays
$2,000 in student loan interest for each of them, their maximum deduction is still only $2,500 per year.
A phaseout applies to higher-income taxpayers.
This deduction is subject to income limitations and begins to phase out for taxpayers with MAGI
between $80,000 – $95,000 for unmarried taxpayers, and $165,000 – $195,000 for joint filers in 2024.
Example: Tasha is an unmarried physician with a modified adjusted gross income of $209,000. She
paid $5,400 of student loan interest during the year. Due to her high income, she cannot deduct any of
her student loan interest as an adjustment to income.
Example: Rudy graduated from a technical college where he was enrolled full-time in a certificate
program for Electrical Technology. Rudy is single and earned $48,000 in wages during the year. He had
no other income. Rudy paid $1,250 in student loan interest during the year. He may take the student
loan interest deduction and deduct all the interest that he paid as an adjustment to income.
A student loan is not eligible if it is from certain related persons (such as family members or related
corporations, partnerships, or trusts). Loans from an employer plan also do not qualify. Qualifying
higher-education expenses include the costs of attending an eligible educational institution, including
graduate schools, such as:
• Tuition and fees,
• Room and board,
• Books, supplies, and required equipment, and other necessary school-related expenses.
The amounts for qualified expenses must be reduced by the amounts of tax-free items used to pay
them, such as tax-free scholarships and fellowships, veterans’ educational assistance benefits, or any
other nontaxable assistance (except gifts or inheritances) that are received for educational expenses.
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Lenders are required to send the taxpayer Form 1098-E, Student Loan Interest, when the amount of
student loan interest paid exceeds $600 or more.
Line 22 and Line 23
Line 22 is reserved for future use (there is no deduction listed on that line). Line 23 is the deduction
for contributions to Archer MSA accounts. Archer MSA accounts are an older type of tax-advantaged
medical savings account available to self-employed taxpayers and employees of small businesses with
fifty or fewer employees. New Archer MSAs are no longer available, but grandfathered plans still exist.
Archer MSA accounts are not listed on the EA exam content outlines for 2024.

Line 24: Other Adjustments

The last lines of Schedule 1, Form 1040 are used for other miscellaneous adjustments and writing-
in more obscure deductions. Although these deductions are not frequently seen, they are still available.
A taxpayer does not need to itemize in order to deduct these amounts. These “other adjustments” are
covered in more detail in the instructions for Form 1040.
An example of one of these “uncommon” adjustments is the deduction for legal costs from unlawful
discrimination claims. A taxpayer may deduct, as an adjustment to income on Schedule 1 (Form 1040),
attorney fees and court costs for legal claims involving a claim of unlawful discrimination.
This includes job-related discrimination on account of race, sex, religion, age, or disability as well
as other federal, state, and local legal actions related to the employment relationship. However, the
amount the taxpayer can deduct is limited to the amount of the judgment or settlement the taxpayer
includes in income for the tax year. In 2024, the deductible legal fees will be reported on line 24h of
Schedule 1.
Example: Francine, age 62, sues her employer for age discrimination after discovering an
incriminating email from her supervisor, stating that the company was planning to fire Francine
because she was “too old” and they could hire a younger worker for less money. She makes a copy of
the email and gives it to her lawyer, who immediately files suit. Rather than face an expensive trial,
Francine’s employer agrees to settle the suit. The total settlement amount is $800,000, and Francine’s
employment lawyer charges a 40% contingency fee, which is typical for her type of legal claim.
Francine must report the full amount of the settlement as income, but she is allowed to take a
deduction for the legal fees she paid to her attorney, which are $320,000 ($800,000 × 40%).

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Unit 12: Standard Deduction and Itemized Deductions

For additional information, read:
Publication 502, Medical and Dental Expenses
Publication 529, Miscellaneous Deductions
Publication 936, Home Mortgage Interest Deduction
Publication 526, Charitable Contributions
The Tax Cuts and Jobs Act (TCJA) brought significant changes to the standard and itemized
deductions. With the standard deduction almost doubling, fewer taxpayers choose to itemize. Many
itemized deductions have been suspended or restricted until 2025. Taxpayers may choose between
the standard deduction or itemizing, based on which results in a lower tax liability.
The Standard Deduction
The standard deduction is a specific dollar amount that reduces the amount of income on which a
taxpayer is taxed. Using the standard deduction eliminates the need for a taxpayer to itemize his actual
allowable deductions, such as medical expenses, charitable contributions, or state and local taxes. The
standard deduction amounts are based on a taxpayer’s filing status and are adjusted every year for
inflation. The standard deduction amounts for the 2024 tax year are as follows:
Filing Status 2024 Standard Deduction
Single or MFS $14,600
Head of Household $21,900
Married Filing Jointly or QSS $29,200
Dependent Standard Deduction $1,300 (see next section)

Additional Standard Deduction

An additional standard deduction is available to taxpayers who, at the end of the year, are:
• 65 or older, and/or
• Blind or partially blind.
The standard deduction is $1,550 higher for joint filers who are over 65 and/or blind, and $1,950
higher for unmarried taxpayers (single and head of household). A taxpayer who is both blind and 65
or older may take the basic standard deduction, as well as additional standard deduction amounts for
both age and blindness. For filing purposes, a taxpayer is considered to be age 65 in the tax year 2024
if they were 65 on December 31, 2024, or if they turned 65 on January 1, 2025.

Additional Standard Deduction Amounts–2024

Taxpayers who are age 65 and/or blind
Filing Status Additional Amount Allowable
Single, HOH $1,950
MFS, MFJ, QSS $1,550

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The additional amount for blindness is allowed if the taxpayer is blind on the last day of the year,
even if the taxpayer was not blind the rest of the year. In order to qualify, the taxpayer must obtain a
statement from an eye doctor stating that their vision cannot be corrected to better than 20/200 with
eyeglasses or that their peripheral vision is limited to 20 degrees.
Example: Thane, an unmarried taxpayer, is age 40 and legally blind. His vision cannot be corrected
with glasses. He would be entitled to a basic standard deduction plus an additional standard deduction
for his blindness. This means that his standard deduction amount would be $16,550 in 2024 ($14,600+
$1,950).

Example: Larry, age 67, and Priscilla, age 60, are married and file jointly. They do not plan to itemize
their deductions. Because they file jointly, their base standard deduction is $29,200 in 2024. Larry is
over 65, so he can claim an additional standard deduction amount of $1,550. Therefore, the total
standard deduction in 2024 is ($29,200 + $1,550) = $30,750.
Example: Angelo, age 65, and Allegra, age 50, are married and always file jointly. Allegra is blind. They
decide not to itemize their deductions. Since Angelo is over 65 and Allegra is blind, they get two
additional standard deductions in 2024 ($29,200 + $1,550 + $1,550) = $32,300.
Example: Jensen is 83 years old and unmarried. He became legally blind during the year due to a
serious infection in both eyes. Jensen is entitled to the regular standard deduction for single filers
($14,600) plus two additional standard deductions. One for being over the age of 65 and blind (2 ×
$1,950). In 2024, his standard deduction is $18,500 ($14,600 + $1,950 + $1,950).
The standard deduction for a deceased taxpayer is the same as if the taxpayer had lived the entire
year, with one exception: if a taxpayer dies before their 65th birthday, the higher standard deduction
for being 65 does not apply.
Example: Octavio was 64 and unmarried when he died on November 6, 2024. He would have been 65
if he had lived to reach his birthday on December 18, 2024. He does not qualify for a higher standard
deduction because he died before his 65th birthday, even though it would have happened during the
tax year. His standard deduction is $14,600 in 2024, which will be his final income tax return, which
must be filed by his executor on or before the filing deadline.

Standard Deduction for Dependents

In 2024, the standard deduction for dependents is limited to the greater of: (1) $1,300, or (2) their
earned income plus $450 (but the total cannot be more than the basic standard deduction for their
filing status as listed at the beginning of this unit, noting that the standard deduction amount can be
higher if the dependent happens to be 65 or older and/or blind.
If a dependent must file an income tax return but cannot file it due to age or any other reason, the
parent, guardian, or other legally responsible person must file the return for the child. If a child cannot
sign their own return, the parent or guardian must sign the child’s name followed by the words: “By
(parent’s signature), parent for minor child.”

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Example: Rosanna Jones is 17 years old and single. She is a high school student who is also legally
blind. Rosanna’s parents can claim her as a dependent. Rosanna’s grandfather gifted her investments
several years ago, so she has interest income of $1,300 as well as wages of $4,900 from a part-time job
in 2024. She has no itemized deductions. Rosanna uses the standard deduction worksheet for
dependents in Publication 501 to calculate her standard deduction. She enters her wages of $4,900 on
line 1a. She adds lines 1 and 2 and enters $5,350 on line 3. On line 5, she enters $5,350, the larger of
lines 3 and 4. Because she is single, Rosanna enters $14,600 on line 6. She enters $5,350 on line 7a.
This is the smaller of the amounts on lines 5 and 6. Because she is blind, she enters $1,950 on line 7b.
She then adds the amounts on lines 7a and 7b and enters her standard deduction of $7,300 on line 7c.
(Based on an example in Publication 501).

Itemized Deductions
Itemized deductions may be taken in lieu of the standard deduction; they allow taxpayers to reduce
their taxable income based on specific personal expenses. In most cases, taxpayers may choose
whether to claim itemized deductions or the standard deduction, depending on which is more
beneficial. However, the following taxpayers are required to itemize, and cannot take the standard
deduction:
• MFS filers whose spouses itemize: If both spouses are filing MFS, and one spouse itemizes,
the other spouse also must itemize (or else deduct $0 as a standard deduction). As such, in lieu
of a $0 standard deduction, they both must itemize.148

This rule only applies when both spouses are filing MFS. If one spouse is MFS, but the other spouse qualifies for Head of
148

Household, then the spouses are not forced to itemize, and they may take the standard deduction if they wish.
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• Nonresident Aliens: Most nonresident and dual-status aliens filing Form 1040-NR must
itemize deductions and cannot take the standard deduction.149
• Short tax year: If the taxpayer files a tax return for a period of less than twelve months due to
a change in accounting methods (this scenario would be extremely rare for an individual
taxpayer).
Itemized deductions are reported on Schedule A, Form 1040. Nonresident aliens can also claim a
limited amount of itemized deductions on Schedule A, Form 1040-NR. We will review the specific
requirements for various itemized deductions next.
Medical and Dental Expenses
Medical and dental expenses (other than self-employed health insurance premiums) are deductible
only if a taxpayer itemizes deductions. Qualifying medical expenses include diagnosis, treatment, and
prevention of diseases or disabilities, but does not include expenses that are merely beneficial to
general health, such as: vitamins, spa treatments, and gym memberships. Qualifying medical expenses
include:
• Doctors and hospitals: Fees paid to doctors, in-patient hospital care or nursing home services,
including the cost of meals and lodging charged by the hospital or nursing home, acupuncture
treatments, lactation supplies (breastfeeding supplies).
• Treatment centers: treatment for alcohol or drug addiction, participation in smoking-
cessation programs, and prescription drugs to alleviate nicotine withdrawal, weight-loss
programs prescribed by a physician (but not diet food items, such as weight-loss shakes).
• Medicine: Insulin and prescription drugs (but prescription drugs shipped to the U.S. from a
foreign country are generally not deductible).
• Dental and vision Care: Costs for dental care, false teeth, reading or prescription eyeglasses,
contact lenses, hearing aids, etc.
• Medical conferences: Admission and transportation to a medical conference relating to a
chronic disease (but the costs of meals and lodging while attending the conference are not
deductible),
• Service animals: Veterinary care when it relates to the care of animals trained to assist
persons who are visually impaired, hearing-impaired, or disabled.
This list is not exhaustive. There are many other qualifying medical expenses. IRS Publication 502,
Medical and Dental Expenses, includes a comprehensive list and more detailed information.
Example: Carnell is a Gulf War Veteran. Carnell is recovering from severe post-traumatic stress
disorder. He also has frequent seizures related to a head injury sustained during combat. Carnell’s
physician recommends that he obtain a service dog to help him with his recovery. The doctor gives
Carnell a written physician’s statement explaining the recommendation. With the help of a Veteran’s
support group, Carnell obtains a trained service dog. The dog’s veterinary costs are deductible medical
expenses on Carnell’s individual tax return.

149 There are several itemized deductions that nonresident aliens may be eligible for, such as state and local income taxes, charitable

contributions (as long as they are made to U.S. charities), and casualty losses incurred in U.S. disaster zones (qualifying FEMA
disasters).
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A taxpayer may only deduct medical expenses they paid during the year, regardless of when the
services were provided.150 Qualified medical expenses include expenses paid for the taxpayer, their
spouse, and their dependents. The dependent must generally have been a dependent at the time the
medical services were provided or at the time the expenses were paid. However, there is an exception
to this rule for children of divorced or separated parents. Also, a parent can also deduct medical
expenses paid on behalf of an adopted child, even before the adoption becomes final.
Note: If a child of divorced or separated parents is claimed as a dependent on either parent’s return,
each parent can deduct medical expenses they individually paid for the child. This is true even if the
other parent claims the child’s dependency exemption. Basically, it does not matter which parent
claims the child—the medical expenses are deductible for the parent who pays them.

Example: Bernard and Cindy are divorced. Their 10-year-old son, Michael, lives primarily with Cindy,
who claims him as a dependent on her tax return. Cindy deducts Michael’s annual medical and dental
bills, including orthodontia expenses for his braces. However, in September, Michael falls on the
playground and fractures his arm. The out-of-pocket expenses for Michael’s broken arm are $15,400.
Michael’s father, Bernard, pays for the emergency room visit and all the expenses related to his son’s
injury. Therefore, Bernard can deduct the expenses on Schedule A, even if he does not claim his son as
a dependent.
A taxpayer can deduct medical expenses paid for a dependent parent. All the rules for a dependency
exemption apply, so the dependent parent does not have to live with the taxpayer to qualify.
Example: Lorelei is 45 years old and unmarried, filing as head of household. She claims her father,
Uriel, age 86, as a dependent on her tax return. Lorelei is responsible for all of her father’s out-of-
pocket medical expenses and provides him with financial support. Although he does not live with her,
Uriel is considered a dependent on Lorelei’s tax return. She can deduct the medical expenses she paid
for him as an itemized deduction, as long as they exceed the 7.5% threshold of her adjusted gross
income.
Taxpayers can deduct only the amount of unreimbursed medical expenses that exceed 7.5% of
adjusted gross income (AGI).
Example: Renea incurred medical expenses of $8,000 in 2024. Her AGI was $70,000. She plans to
itemize her deductions. She can deduct the amount in excess of the 7.5% AGI floor ($70,000 × 7.5% =
$5,250). This means that she may claim a deduction of $2,750 for medical expenses on Schedule A
($8,000 medical expenses - $5,250 7.5% AGI floor).
Example: Hattie, age 53, incurred $2,500 of out-of-pocket medical expenses in 2024. Her AGI was
$40,000. Hattie cannot deduct any of her medical expenses on Schedule A because they are not more
than 7.5% of her AGI ($40,000 × 7.5% = $3,000).
Example: Garrison, age 46, paid $12,000 in out-of-pocket expenses for knee surgery in 2024. His AGI
was $100,000. The amount of medical expenses in excess of $7,500 (AGI of $100,000 × 7.5%), or
$4,500, is allowed as an itemized deduction on Schedule A.

150 An exception to this rule exists for deceased taxpayers (covered later).
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Medical Insurance: When a taxpayer receives an insurance reimbursement for medical expenses,
they cannot deduct those amounts. Only insurance premiums paid with after-tax dollars for medical
and long-term care insurance can be considered as qualifying medical expenses. Medical expenses
reimbursed out of a health savings account (HSA) are not deductible, but contributions to HSAs may
be deducted as an adjustment to gross income, and withdrawals from an HSA are tax-free as long as
they are used to pay for qualifying medical costs.
Note: The cost of an employee’s annual health care coverage is typically reported on Form W-2. The
amount includes the portions paid by both the employer and the employee. Although this amount is
reported on Form W-2, it does not mean the amount is taxable; it is for informational purposes only.
Long-Term Care Premiums: A taxpayer may include amounts paid for qualified long-term care
services and insurance premiums in his medical expense deductions. Long-term care services include
necessary diagnostic, preventive, therapeutic, rehabilitative, maintenance, and personal care services
that are required by a chronically ill individual and provided under a plan of care by a licensed doctor.
The deductibility of costs of qualified long-term care premiums is limited by the age of the taxpayer.
The expenses generally cannot include costs that would be reimbursed under Medicare. In 2024, the
amounts paid for long-term care premiums up to the amounts shown below can be included as medical
expenses on Schedule A. The limits are per person, not per tax return.

Taxpayer’s Age at the End of Tax Year 2024 Deductible Limit

40 or less $470

More than 40 but not more than 50 $880

More than 50 but not more than 60 $1,760

More than 60 but not more than 70 $4,710

More than 70 $5,880

Other Medical Expenses: If a taxpayer or a dependent is in a nursing home, and the primary
reason for being there is medically related, the entire cost, including meals and lodging, is a medical
expense. A taxpayer can deduct any legal fees necessary to authorize treatment for mental illness.
However, legal fees for the management of a guardianship estate or for conducting the affairs of a
person being treated are not deductible as medical expenses.
Medical Expenses of Deceased Taxpayers: In addition to expenses paid before a taxpayer’s
death, a deceased taxpayer’s executor (or personal representative) can elect to treat medical expenses
paid by the estate within one year after death as if the taxpayer had paid when the medical services
were provided. In other words, an executor can elect to treat medical expenses as if they were paid at
the time they were incurred, even if the expenses are paid the year after the taxpayer’s death.151

151If this election is made by the executor, the medical expenses cannot be claimed as a deduction for Federal estate tax purposes
as well (no double-dipping).
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Example: Harrison had heart surgery on November 3, 2024, and incurred over $20,000 of medical
bills. The surgery did not go well, and when he died on December 20, 2024, his medical bills had not
yet been paid. The executor of Harrison’s estate is his adult son, Dominic. Dominic pays his late father’s
outstanding medical bills on March 3, 2025. As the executor, Dominic may elect to deduct Harrison’s
final medical expenses on his father’s 2024 individual return (Harrison’s final tax return), even though
the medical expenses were not paid until 2025. This special election only applies to deceased
taxpayers.
Cosmetic Surgery: Cosmetic surgery is only deductible if it is used to correct a defect or disease.
A cosmetic procedure simply for the enhancement of someone’s physical appearance is not a
deductible medical expense.
Example: Delia was diagnosed with breast cancer. She undergoes a mastectomy to remove her breasts
as part of her breast cancer treatment. After Delia recovers from the cancer, she wants to have
reconstructive surgery. A cosmetic surgeon later reconstructs her breasts to correct the deformity that
is directly related to cancer. The cost of the cosmetic surgery is deductible as a medical expense
because the surgery corrects an earlier defect or disease.
Medically Related Transportation, Meals, and Lodging: Vehicle mileage may be deducted if
transportation is for medical reasons, such as trips to and from doctors’ appointments. If a taxpayer
uses his own car for medical transportation, he can deduct actual out-of-pocket expenses for gas and
other expenses, or he can deduct the standard mileage rate for medical expenses. In 2024, the medical
mileage rate is 21 cents per mile.
A taxpayer can also deduct the costs of taxis, buses, trains, planes, or ambulances, as well as tolls
and parking fees. A taxpayer can deduct the cost of meals and lodging at a hospital or similar institution
if the principal reason for being there is to receive medical care.
The amount for lodging cannot be more than $50 for each night for each person, although the
taxpayer can include lodging for a person traveling with the person receiving the medical care, up to
$100. Even if included in the lodging bill, the cost of meals is not included in the lodging amount.
Example: Andrew is 12 years old and has severe allergies. Andrew’s father, Harlan, accompanies his
son to a medical facility in a neighboring state so Andrew can receive medical treatment from an allergy
specialist. Harlan books a hotel room directly across the street from the hospital, where they stay for
one week while Andrew is receiving outpatient medical treatment and blood tests for his allergies. The
cost of lodging at the hotel is $110 per night. Harlan may deduct up to $100 per night as a medical
expense.152
Capital Improvements for Medical Reasons: Capital improvements such as home improvements
are usually not deductible. However, a home improvement may qualify as a deductible expense if its
main purpose is to provide medical care to the taxpayer (or to family members).
The amount that can be deducted for capital improvements is limited to the difference between the
cost of the improvements and the corresponding rise in the home’s fair market value. Home
improvements that qualify as deductible medical expenses may include:

152 Based on an example in Publication 502, Medical and Dental Expenses.

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• Wheelchair ramps
• Lowering of kitchen cabinets
• Railings and support bars
• Elevators
• Special lift equipment
Tenants can deduct the entire cost of disability-related improvements, even if they are not the
owners of the property.
Example: Elliott, age 61, has a serious heart condition. He cannot easily climb stairs or get into a
bathtub. On his doctor’s advice, Elliott pays for the installation of a special sit-in bathtub and a stairlift
in his rented home. Elliott does not own the property, and his landlord did not pay any of the costs.
Elliott can deduct the entire amount that he spent on these devices (bathtub and stairlift) as a medical
expense, subject to the 7.5% threshold.

State and Local Income Taxes (SALT)

Taxpayers can deduct certain taxes if they itemize deductions. In order to be deductible, a tax must
have been imposed on the taxpayer and paid by the taxpayer during the tax year. Deductible taxes
include:
• State, local, and foreign income taxes,153
• State and local sales taxes,
• Real estate taxes (but not for foreign real estate),
• Personal property taxes (such as the portion of DMV fees based on the value of the car).
The Tax Cuts and Jobs Act instituted a temporary cap on state and local taxes (also called the “SALT
cap”). This deduction is capped at $10,000 ($5,000 for MFS filers) through 2025.
State and Local Taxes: Taxpayers are allowed to deduct either sales/use taxes or state and local
income taxes, depending on which provides the larger deduction, but not both. Income taxes paid
include taxes withheld from salaries and wages, amounts paid for prior years, and estimated tax
payments.
For sales/use taxes, taxpayers can either use (1) the actual amount of sales/use taxes paid during
the year, or (2) they can use the Optional State Sales Tax Table provided by the IRS in lieu of actual
sales/use taxes paid. The Optional State Sales Tax Table provides estimated sales tax figures that are
based on a number of factors, including: (1) the filing status of the taxpayer; (2) the number of claimed
dependents; (3) the taxpayer’s AGI; (4) the amount of certain non-taxable income received during the
year; and (5) the location of the taxpayer.
However, certain actual sales/use taxes paid on certain specified large expenses, such as purchases
of a vehicle, boat, aircraft, or a home renovation can be added to the estimated sales taxes determined
using the “Optional State Sales Tax Table” 154 to arrive at a total sales tax figure that can then be
compared to actual amount of state and local income taxes paid for the year.

153 Foreign income taxes are not subject to the “SALT” cap. These taxes are still deductible in full. Also, taxes incurred in a trade or
business, or for the production of income, (on Schedules C, E, and/or F), are not subject to the SALT cap.
154 To figure the state and local general sales tax deduction, a taxpayer can use either their actual expenses or the optional sales tax

tables in the Schedule A (Form 1040) instructions.

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Example: Glenn, a single taxpayer, plans to itemize his deductions this year. He lives in California, and
paid both state income taxes and sales taxes on a new vehicle that he purchased. He paid $5,950 in
state income taxes, and $4,200 in sales taxes on the new car. The amount of estimated sales taxes using
the Optional State Sales Tax Table for Glenn was $2,000 for the year. After comparing the two amounts
($5,950 in state income taxes and $6,200 in applicable sales taxes [$4,200 + $2,000]), he would choose
to deduct the higher amount of $6,200 for sales taxes on his Schedule A, to maximize his deduction for
the year.
Real Estate Taxes: State and local real estate taxes, based on the assessed value of the taxpayer’s
real property (such as a house or land), are deductible. If the taxes are paid from a mortgage escrow
account, the taxpayer can deduct only the amount actually paid out of the escrow account during the
year to the taxing authority.
Some real estate taxes are not deductible, including taxes imposed to finance improvements of
property, such as local assessments for streets, sidewalks, and sewer lines. In addition, homeowner’s
association fees are not deductible.
Example: Minnie makes the following payments in 2025: state income tax, $7,000; real estate taxes on
her main home, $900; city fee for maintaining the sewer system, $75; and homeowner’s association
fees of $550. Minnie’s total deductible taxes are $7,900 ($7,000 + $900 = $7,900), which is the amount
she can claim as an itemized deduction on Schedule A. The $75 sewer fee and the $550 homeowner’s
association fee are not deductible.
Real estate taxes paid on foreign real property are not deductible on Schedule A; however, they
may be deducted as an expense in other situations, such as the rental of foreign real property.
Escrow accounts: If a portion of the taxpayer’s monthly mortgage payment goes into an escrow
account, and periodically the lender pays the real estate taxes out of the account to the local
government, the taxpayer is only allowed to deduct the amount that was actually paid out of the escrow
account during the year to the taxing authority.
Personal Property Taxes (including DMV Fees): Personal property taxes for individuals are
deductible if they are:
• Charged on personal property, including cars, motorcycles, and boats;
• Based on the value of the property; and
• Charged on a yearly basis, even if collected more than once a year.
Example: Debbie receives an annual registration notice for her automobile from the California
Department of Motor Vehicles. The DMV bill is broken down as follows:
Registration: $25
Vehicle license fee: $58
Weight fee: $32
County fee: $13
Owner responsibility fee: $15
The notice states that the vehicle license fee is based on the car’s value. Only the vehicle license fee is
tax deductible on Schedule A.

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As mentioned previously, the Tax Cuts and Jobs Act eliminated the deduction for foreign real estate
taxes on personal homes. These taxes are no longer deductible on Schedule A as an itemized deduction.
However, foreign income taxes are still deductible on Schedule A.
Foreign income taxes are also not subject to the SALT cap. Foreign income tax is listed on line 6, of
Schedule A, under “Other Taxes.”
Example: Hideo is a U.S. citizen who lives and works in Japan. He earns $178,000 in wages working
for an international investment firm. He owns a home in Japan, which is his primary residence. During
the year, he pays $3,600 in foreign property taxes on his home. These amounts are not deductible,
because the home is considered foreign real estate. Hideo also pays $29,000 in foreign income taxes to
Japan. The foreign income taxes are fully deductible on Schedule A and not subject to the SALT cap.
Example: Zahra lives and works in New York, which has a high cost of living. She earns $195,000 in
wages per year. Zahra paid $14,000 in property taxes on her NY condo, and $11,900 in NY state income
taxes. The state income tax was automatically withheld from her wages. She also owns a vacation home
in Rio de Janeiro, Brazil. She paid $4,000 in foreign real estate taxes on her vacation home. The foreign
real estate taxes are not deductible at all, and the other taxes are limited because of the SALT cap. The
maximum deduction that she can take for the taxes she paid on Schedule A is $10,000.
Foreign Income Taxes: Generally, a taxpayer can choose between claiming the Foreign Tax Credit
or claiming an itemized deduction on Schedule A for income taxes paid to a foreign country, depending
on which option results in the lowest tax. The rules regarding which foreign taxes qualify for either the
credit or the deduction are covered later. Foreign income taxes are not subject to the “SALT cap.”
Deductible Interest
Taxpayers are allowed to deduct certain types of interest. Qualified interest payments are
deductible as itemized deductions on Form 1040, Schedule A. Deductible interest includes:
• Home mortgage interest,
• Late fees on a mortgage loan,
• Points on a mortgage loan,
• Investment interest expense.
Home Mortgage Interest
A taxpayer is allowed to deduct the mortgage interest related to a primary residence and a second
home. The loan must be secured by the taxpayer’s home, in order for the interest to be deductible. The
loan may be a mortgage, a second mortgage, a home equity loan, or a line of credit.
The maximum amount of qualified acquisition Indebtedness secured by a qualified primary or
secondary residence to allow a full deduction for home mortgage interest is $750,000 in 2024
($375,000 for MFS).155
Interest paid on debt related to a primary and secondary residence is only tax deductible if the
proceeds from the loan were used to acquire, build, or significantly enhance the main home. For
instance, if a taxpayer takes out a $250,000 home equity line of credit and uses all of it towards

155If the home was purchased on or before December 15, 2017, the qualified acquisition indebtedness limit is “grandfathered” at
a higher limit of $1 million ($500,000 MFS).
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improving their home, the entire amount would qualify for the mortgage interest deduction. This
dollar limit also applies to construction debt, such as home renovations.
Example: Peggy is single and purchased her first home on March 4, 2024, for $450,000. A month after
she purchases the home, she takes out an additional $28,000 home equity line of credit to install an
inground swimming pool. The pool is completed on August 30, 2024. This is considered a capital
improvement to the home. The interest Peggy incurs on the mortgage, as well as the home equity line,
is deductible as mortgage interest on Schedule A, because the loan proceeds were used to “acquire,
build, or substantially improve” her home.

Example: Donatella takes out a $30,000 home equity loan during the year to pay off her credit cards.
She uses all the loan proceeds to pay off her credit card debt. This home equity line is secured by her
residence, but the interest is not deductible, because the home equity loan was not used to “acquire,
build, or substantially improve” her primary residence.
Example: Jeannette is single and owns her home. She has an existing mortgage totaling $475,000.
Jeannette wants to expand the size of her home, so she applies for a home equity line of credit to finance
new home improvements. She decides to add an extra bedroom and a new bathroom, and she installs
a pool in the backyard. The new bedroom addition cost $66,000, the new bathroom cost $22,000, and
the new pool cost $29,000, for a total cost of $117,000. Since the home equity loan was used entirely
to improve the property, and her total mortgage debt does not exceed $750,000, all the mortgage
interest is deductible on Schedule A.
A vacant piece of land is not eligible for the mortgage interest deduction. However, if a taxpayer
constructs a house that meets the requirements of a qualified home once it is ready to be lived in, they
can deduct mortgage interest for a period of up to 24 months from when construction begins.
Example: Spencer owns an empty lot, which he inherited from his grandfather. He plans to build his
dream home on the lot. He borrows $175,000 from the bank and begins construction on February 1,
2024. Spencer can treat the home under construction as a qualified home once the construction has
started. At that point, the interest he pays may qualify as deductible mortgage interest. 156
Late fees and pre-payment penalties incurred on a mortgage loan are also deductible as mortgage
interest on Schedule A.
Example: Fergus owns his home and pays his mortgage monthly. During the year, he fell behind on his
mortgage payments and sent in his house payment late on two occasions. The mortgage company
charges Fergus a $35 fee for each late payment. The late fees are deductible as mortgage interest on
Schedule A.
A second home can include any other residence a taxpayer owns and treats as a home, but the
taxpayer does not have to actually use the second home during the year to deduct the mortgage
interest paid on the related loan.

156Some interest may be deductible on a construction loan once construction begins. A taxpayer can treat a home under
construction as a qualified home for a period of up to 24 months, but only if it becomes their qualified home at the time it’s ready
for occupancy. Construction loans are covered in detail in Publication 936, Home Mortgage Interest Deduction.
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Note: Although a taxpayer can potentially deduct real estate taxes on more than two properties, a
taxpayer cannot deduct mortgage interest on more than two personal homes.
Example: Ellery owns three homes. None of the homes are rental properties. He has a $150,000
mortgage on his main home in Boise, ID, where he lives most of the time. He also has a $75,000
mortgage on a beach cottage in North Carolina and a $90,000 mortgage on a ski condo in Utah. Ellery
can deduct the mortgage interest on his main home and on the ski condo, but he cannot deduct the
mortgage interest on the beach cottage because the mortgage interest deduction is limited to two
homes. He is allowed to deduct the property taxes on all three homes. However, the property taxes are
limited to the $10,000 SALT cap.

Points and Prepaid Mortgage Interest

Points are interest charges a borrower pays up-front to obtain a loan. Points generally represent
prepaid interest a borrower pays at closing to obtain a lower interest rate. Points may also be called
loan origination fees, premium charges, loan discount points, or prepaid interest. In order to deduct
points, the following requirements must be met:
• The mortgage must be secured by the taxpayer’s main home, and the mortgage must have been
used to buy, build, or improve the home.
• The points must not be an excessive or unusual amount.
• The points paid must not be more than the amount of unborrowed funds.
• The points must be computed as a percentage of the loan principal, and they must be listed on
the closing disclosure.
If all these requirements are met, the taxpayer can deduct points in connection with the acquisition
or construction of the home either in the year paid or over the life of the loan. Tax law treats “purchase”
mortgage points differently from “refinance” mortgage points. Points paid to refinance a mortgage are
generally not fully deductible in the year paid and must be deducted over the life of the loan unless the
proceeds are used to improve a main home. A second home or vacation home would not qualify for
this exception.
Example: Tammy refinanced her home mortgage on January 1, 2024, in order to get a lower interest
rate than the rate she currently had. She paid $1,500 in points for a 15-year refinance of her existing
home mortgage. She is entitled to deduct only $100 per year on her Schedule A ($1,500 ÷ 15 years, the
life of the loan).

Investment Interest Expense

The Tax Cuts and Jobs Act suspended all the miscellaneous itemized deductions subject to the 2%-
of-AGI floor, including the deduction for investment expenses such as safe deposit fees, trustee fees,
and investment advisor fees. However, the TCJA did not suspend the deduction for investment interest
expense.
Investment interest expense is defined as any interest paid on loans used to purchase taxable
investments. A common example of this is margin interest, where investors borrow funds from
brokerage houses, also known as margin accounts, to purchase stocks and bonds without needing to
invest the full cash amount.

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Example: Anton likes to invest in stocks using his online brokerage account. He applies for a margin-
approved brokerage account in order to buy more stock. At the beginning of the year, Anton has
$100,000 in cash and stocks in his existing brokerage account. His brokerage firm approves him for a
20% margin loan. This means that Anton can purchase an additional $20,000 worth of marginable
stock. The extra $20,000 is granted to him in the form of a margin loan, for which he will have to pay
interest. The interest would be potentially deductible on Schedule A as an itemized deduction (subject
to limitations, as detailed below).
If a taxpayer takes out a loan to purchase investment property, such as stocks, the interest paid on
that loan can be considered as investment interest expense and may be eligible for deduction. The
deductible amount is limited to the net investment income earned in a given year, but any unused
portion can be carried over to the following year.
Example: Thurston borrows money from a bank to buy $30,000 worth of short-term corporate bonds.
The bonds mature during the year, and Thurston makes $900 of investment interest income. He also
has $510 in investment interest expense, which he paid on the loan originally taken out to buy the
bonds. Thurston must report the full amount of $900 as investment interest income. He can deduct the
$510 of investment interest expense on Schedule A.

Example: Sully borrows money from a brokerage firm to buy $8,500 worth of stock as an investment.
During the year, the stock loses value, and he does not sell them. He has no other investment income.
Sully paid $326 of interest expense on the loan he used to buy the stock. He may not take a deduction
for the investment interest expense because he has no investment income, but he may carry over to
the next tax year the investment interest expense he could not deduct.
The deductible amount of investment interest expense and any disallowed amount that may be
carried over to the following year are calculated on Form 4952, Investment Interest Expense Deduction.
A taxpayer cannot deduct interest related to passive activities or incurred to produce tax-exempt
income (such as state and local bonds that generate tax-exempt interest income) as investment
interest expense.
Example: Melvin borrowed $15,000 to purchase municipal bonds. The tax-free municipal bonds yield
5% in interest income, and Melvin paid 3% in investment interest expense on the loan. Since muni
bond interest is exempt from federal tax, Melvin cannot deduct any of the interest he paid on the loan.
Nondeductible Interest and Investment Expenses: The following expenses cannot be deducted
as investment interest:
• Interest on personal loans, such as car loans
• Fees for credit cards and finance charges for non-business credit card purchases
• Loan fees for services needed to get a loan
• Interest on debt the taxpayer is not legally obligated to pay
• Service charges (such as monthly account fees, ATM fees, and foreign transaction fees).
• Interest to purchase or carry tax-exempt securities
• Late payment charges paid to a public utility
• Expenses relating to stockholders’ meetings or investment-related seminars
• Interest expenses from single-premium life insurance and annuity contracts
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• Interest incurred from borrowing against a life insurance policy
• Fines and penalties paid to any government entity for violations of the law

Example: Tyler and Magdalena file a joint return. During the year, they paid:
1. $3,180 of home mortgage interest reported to them on Form 1098
2. $400 of interest paid on personal credit card expenses
3. $1,500 for an appraisal fee on their personal residence
4. $2,000 of interest on a personal car loan
5. $45 late fee for paying their electricity bill one month late
Tyler and Magdalena can deduct only their home mortgage interest ($3,180). None of the other costs
are allowable as a tax deduction.
Charitable Contributions
2024, individuals can deduct up to 60% of their adjusted gross income in cash contributions.
Different AGI limits apply to contributions of property (covered next). A donation can only be deducted
in the year it was actually made. A donation charged to a credit card before the end of 2024 counts for
2024, even if the credit card bill is not paid until the following year. Similarly, a check sent in 2024 will
count towards deductions for 2024, even if it is not cashed until the following year by the charity.
Contribution Limits
In 2024, taxpayers can elect to deduct cash contributions up to 60% of adjusted gross income. The
60%-of-AGI limit applies to cash contributions only—not real estate, not stocks, not furniture, or any
other type of noncash donations.157 The 60% limit only applies through 2025. A property contribution
may be limited to 50%, 30%, or 20% of AGI, depending on the type of property donated and the type
of organization the donor gives it to. In 2024, there are four major AGI limits:
• The 60% limit: In 2024, a 60%-of-AGI limit applies to cash contributions to a public charity,
specifically, 501(c)(3) organizations. These are called “qualified cash contributions.”
Contributions of noncash property do not qualify for this limit.
• The 50% limit: This limit applies to most noncash contributions to public charities. Examples
of noncash contributions include furniture, clothing, and housewares. This limit also applies to
gifts of inventory and depreciable property, such as machinery and vehicles. This limit also
applies to most conservation easements.158
• The 30% limit: This limit applies to donations of most appreciated capital gain property
(property that would have resulted in a long-term capital gain if sold instead of donated) where
the donor can claim the FMV as a deduction. Common examples include stock, cryptocurrency,
land, or other real estate that has appreciated in value.
• The 20% limit: This limit applies specifically to gifts of appreciated capital gain property to
most private nonoperating foundations and certain other non-public charities.

157 Cash contributions include those paid by cash, check, electronic funds transfer, debit card, credit card, payroll deduction, or a
transfer of a gift card redeemable for cash.
158 A conservation easement, also called a qualified conservation contribution (QCC) is subject to unique rules. This is the

contribution of real property to a qualified organization exclusively for conservation purposes. For qualified farmers or ranchers,
a conservation easement can be as high as 100% of their AGI (under IRC 170(b)(1)(E)(iv)).
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Charitable contributions cannot generate a net operating loss. Excess contributions that exceed a
taxpayer’s AGI may be carried over and deducted over a 5-year period. Carryovers are subject to the
same percentage limits in the year to which they are carried.
Example: Trinidad donated $6,800 in cash to his church during the year. He also donated several large
pieces of furniture to Goodwill. The furniture had a fair market value of $500. The cash contribution
would be limited to 60% of his AGI, while the property donation to Goodwill would be limited to 50%
of his AGI. Trinidad’s AGI is $42,000, and he plans to itemize his deductions. His donations would not
be limited; he could deduct the full amounts on Schedule A.
Be aware that a 50% limit applies to most noncash charitable contributions, and only cash
donations are subject to the higher 60% of AGI limit. The 60%-of-AGI contribution limit applies to cash
contributions made to 501(c)(3) charities, including:
• Churches, mosques, synagogues, and similar religious organizations,
• Hospitals, and most schools and colleges,
• State or federal government entities,
• Nonprofits organized solely for charitable, religious, educational, scientific, or literary purposes
or for the prevention of cruelty to children or animals,
• Organizations that foster youth sports, or national or international amateur sports
competitions (examples include: Little League Baseball, the Olympics, Special Olympics, and
the Paralympic Games).
A taxpayer’s deductible contributions to certain other types of nonprofit organizations are limited
to either 30% or 20% of AGI. The 30% limit applies to organizations that include the following:
• Certain private nonoperating foundations,159
• Veterans’ organizations and fraternal benefit societies (such as the Knights of Columbus, Odd
Fellows, and the Shriners),
• Nonprofit cemeteries.
• In addition, a separate 30% limit applies in the following cases:
• Gifts for use by the charitable organization (such as the donation of a vehicle the organization
uses for itself),
• Gifts of appreciated capital gain property.
The 20% limit applies to contributions of capital gain property to organizations subject to the 30%
limit (such as most private nonoperating foundations).
Example: Cooper’s income for the year is $40,000, all of which comes from his wages. He decided to
donate 100 shares of appreciated stock with a current value of $11,000 to the Knights of Columbus, a
fraternal benefit society, which is a 30%-of-AGI limit organization. However, because the gift is in the
form of appreciated property, there is an additional restriction - only 20% of AGI can be deducted
based on the nature of the organization. Therefore, Cooper’s deduction is limited to $8,000 (20% ×
$40,000 = $8,000), and the remaining amount of $3,000 will need to be carried over to future years
($11,000 - $8,000 = $3,000 carryover).

159A private nonoperating foundation grants money to other charitable organizations. Private foundations usually are established
with funds from a single source, such as a single wealthy family or corporate money.
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To the extent a taxpayer’s deductions for contributions are limited; they may be carried over to
subsequent years. The carryover period is generally limited to five years. Any carryover amounts that
cannot be deducted within five years due to AGI limits are lost.
Any contributions made by the taxpayer and carried over to future years retain their original
character. For example, contributions made to a 30% organization continue to be subject to the 30%-
of-AGI limit in future years.
Example: Regina’s adjusted gross income is $50,000 for the year. In March, she gave her church a plot
of land with a fair market value of $28,000 and a basis of $22,000 that she held for more than five years.
Regina has a qualified appraisal for the property. Regina did not make any other charitable gifts during
the year. Regina’s allowable charitable contribution for the land would be its fair market value of
$28,000. Although the church is a 501(c)(3) organization, the land donation is a gift of appreciated
property, which means that Regina’s deduction is limited to 30% of her AGI. Her current-year
deduction for the land is limited to $15,000 (30% × $50,000 AGI). The unused part of the contribution
($13,000) can be carried over to future years. In addition, Regina does not pay capital gains tax on the
$6,000 of appreciation built into the land.

Qualified Charitable Gifts

In most cases, a donor may claim a deduction for the fair market value of a property. Donated
clothing, furniture, or household items must be in usable condition. No deduction is allowed for items
that are in poor or unusable condition. Deductible contributions may include:
• Unreimbursed expenses that relate directly to the services the taxpayer provided for the
organization.
• The amount of a contribution in excess of the fair market value of items received, such as
merchandise and tickets to a charity ball.
• Transportation expenses, including bus fare, parking fees, tolls, and either the actual cost of gas
and oil or a standard mileage deduction of 14 cents per mile in 2024.
Volunteer Expenses: Volunteer hours cannot be assigned a monetary value for tax purposes.
However, individuals can claim deductions for any out-of-pocket expenses related to their volunteer
work for eligible organizations.
A taxpayer can deduct expenses incurred while traveling to perform services for a charitable
organization only if there is no significant element of personal pleasure in the travel. However, a
deduction will not be denied simply because the taxpayer enjoys providing the services.
Example: Maya is an attorney who donates time to her local homeless shelter for its legal needs. This
year, she spent ten hours drafting legal documents for the shelter, which is a qualified charitable
organization. She also had $200 of out-of-pocket expenses because she purchased several boxes of
printer paper for the shelter’s administrative office. The paper was delivered directly to the shelter for
its use. Maya can take a charitable deduction for $200, the amount she spent on behalf of the shelter.
She cannot deduct the value of her time.

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Example: Odessa regularly volunteers at her local animal shelter, a qualified animal rescue
organization. She uses her own car to travel to and from the shelter. She is not reimbursed for mileage.
Odessa also fosters kittens on behalf of the shelter. She pays for cat food for the foster kittens and other
supplies out-of-pocket. She receives an annual statement from the animal shelter substantiating her
donations. Odessa can deduct her mileage and her unreimbursed expenses as a charitable contribution
but cannot deduct the value of her time.

Qualified Charitable Distributions (QCDs)

In 2024, donors age 70½ or older may also donate up to $105,000 per tax year directly from a
traditional IRA.160 This is called a “Qualified Charitable Distribution” or QCD. If a taxpayer is already
taking RMDs, they can also choose to make a QCD in lieu of taking an annual required minimum
distribution (RMD) from their IRA. If a taxpayer makes a QCD, the amount of the distribution from a
traditional IRA will not be included in taxable income. However, the taxpayer will not be able to claim
a charitable deduction for the amounts given via the QCD to a qualified charity (QCDs are covered in
more detail in a later unit).
Nonqualifying Organizations
Not all nonprofit organizations qualify as “charitable” organizations for donors to claim tax
deductions. An organization may qualify for nonprofit status so that its own activities are not subject
to income tax, but this designation does not automatically provide qualification for purposes of
deductible contributions. The following are examples of gifts that do not qualify as deductible
charitable contributions:
• Gifts to civic leagues, social and sports clubs, and Chambers of Commerce,
• Gifts to political groups, candidates, or political organizations,
• Gifts to homeowner’s associations,
• Donations made directly to individuals,
• The cost of raffle, bingo, or lottery tickets, even if the raffle is part of a qualified organization’s
fundraiser,
• Dues paid to country clubs or similar groups,
• Dues to labor unions,
• Blood donated to a blood bank or to the Red Cross (although the mileage incurred to donate
blood may be deductible),
• Any part of a contribution that benefits the taxpayer, such as the FMV of a meal eaten at a
charity dinner.
Donors who purchase items at a charity auction may claim a charitable contribution deduction only
for the excess of the purchase price paid for an item over its fair market value.
Example: Chavo goes to a nonprofit hospital fundraiser that includes a bingo game. Chavo spends $200
on bingo cards but does not win anything. Even though the $200 went directly to the hospital, the cost
of the bingo game is not considered a charitable gift (because it is a wagering activity).

160Under the SECURE Act 2.0, the yearly QCD limit is now adjusted for inflation. In 2024, the limit stands at $105,000, an increase
from last year's $100,000 limit. In 2025, it will rise to $108,000.
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Example: Tonya participates in a charity auction for her church. All the auction proceeds go to the
church. She bids on a $100 gift certificate to a popular restaurant in town. She pays $135 for the gift
certificate. The FMV for the gift certificate is $100, so her qualifying donation is $35 ($135 amount paid
- $100 FMV of the certificate).
Example: Scarlett paid the Sacramento Chamber of Commerce a $30 entry fee to run in a half marathon
it was sponsoring on behalf of a cancer-related charity. The Chamber is not a qualifying charitable
organization, so none of Scarlett’s entry fees are tax-deductible as a charitable contribution. If the race
had been organized by the charity itself, part of her entry fee might have been deductible.

Substantiation Requirements for Charitable Gifts

Those who claim deductions for charitable contributions must adhere to strict recordkeeping
requirements. These guidelines include recordkeeping and substantiation rules for donors, as well as
disclosure and reporting requirements for the charities themselves. Here are the basic rules for ALL
charitable gifts:
• At a minimum, the donor must have at least a bank record or a written receipt (or written
acknowledgment) from a charity for any cash contribution before the donor can claim a
charitable deduction.
• For single contributions of $250 or more, the donor must obtain a written receipt from the
charity before claiming a charitable deduction.
Rules for Cash Donations
Cash Donations of LESS than $250: Cash contributions include those paid by cash, check, debit
card, credit card, or payroll deduction. If the value of an individual donation is less than $250, the
taxpayer must keep a reliable written record, such as the following:
• A bank, credit union, or credit card statement that shows the name of the qualified organization,
the date of the contribution, and the amount of the contribution
• A receipt (or a letter or other written communication) from the qualified organization showing
its name, the date of the contribution, and the amount of the contribution
• For payroll deductions, a pay stub, or Form W-2, plus a pledge card or other document showing
the name of the qualified organization
• For text donations, a telephone bill, as long as it shows the name of the qualified organization,
the date of the contribution, and the amount given
Donors should not attach an acknowledgment or a receipt to their tax return, but must retain
copies to substantiate their contributions.
Example: Sandy donates $125 a month to her local public library, a qualified 501(c)(3) organization.
She sends her donation via credit card, on the library’s website, then saves a copy of the credit card
transaction details in her records. At the end of the year, she has made a total of $1,200 in donations
to the library. Since each of her individual donations were less than $250, and she has a record of each
one, she has complied with the substantiation requirements for her donations.

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Example: Langley donates $25 per month to the Humane Society. Langley always pays by check, and
he keeps the canceled check as a record of his contribution. This is a valid method of recordkeeping for
donations under $250. He does not need to have an additional receipt from the organization to
substantiate his deduction.
Cash Donations of $250 or MORE: For cash donations of $250 or more, the donor must have a
receipt or a written acknowledgment from the organization that includes:
• The amount of cash the taxpayer contributed,
• The date of the contribution,
• The receipt must include a statement specifying whether any goods or services were given in
return for a contribution, (with the exception of token items and membership benefits). Failure
to include this required statement has led to legal disputes over large donations, resulting in
some donations being disallowed.
• If applicable, a description and a good faith estimate of the value of goods or services provided
by the organization as a result of the contribution (if applicable).
A single, annual statement from the charitable organization may be used to substantiate multiple
contributions. These are also commonly called “donor acknowledgment letters.” There is no specific
IRS form for the acknowledgment.
Example: Trudy donates $300 a month to her local Baseball Little League, which is a qualified
501(c)(3) charity. Sometimes she pays with cash, and sometimes with a check. She does not keep a
record of her individual gifts, but at the end of the year, the Little League mails out an annual donor
acknowledgment letter, listing all her donations, including the dates and specific amounts she
contributed during the year, and stating she received no goods or services for the donations. The
annual statement will suffice to substantiate Trudy’s deduction.

Rules for Noncash Donations (Gifts of Property)

Noncash Contributions of Less than $250: For each noncash contribution of less than $250, the
taxpayer must obtain a receipt from the receiving organization and keep a list of the items donated.
Example: Weston generously gave away twenty of his shirts to Goodwill. As a responsible donor, he
made sure to keep track of the items he donated and received a receipt from the organization upon
dropping off his clothing. In Weston’s town, the thrift shop values dress shirts at approximately $5
each. Based on this valuation, Weston has made a charitable contribution of $100 (20 shirts × $5 fair
market value per shirt). He must keep the Goodwill receipt, but he does not need to attach it to his tax
return. He may claim $100 as a charitable deduction on Schedule A without any additional
documentation.
Noncash Donations between $250 and $500: For each contribution of at least $250, but not
exceeding $500, the donor must have the same documentation for noncash contributions less than
$250. In addition, the organization’s written acknowledgment must definitively state whether the
taxpayer received any goods or services in return and included a description and a good faith estimate
of the fair market value of any such items.

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Noncash Donations Over $500: If a taxpayer’s total deduction for all noncash contributions for
the year is more than $500, the donor must also file Form 8283, Noncash Charitable Contributions, and
attach this form to their individual tax return.
Example: Amelia donated a significant amount of property to her church this year for its annual
rummage sale. All the proceeds from the rummage sale go to the church. Amelia estimates that she
donated $950 worth of clothing, housewares, and other furniture. Amelia received an acknowledgment
letter from her church. Since her noncash donations exceed $500, Amelia would need to file a Form
8283 and include the name and address of the donee organization (her church) and description of the
items she donated on the form.
Noncash Donations Over $5,000: If any single donation or a group of similar items is valued at
more than $5,000, a qualified appraiser is required to make a written appraisal of the donated
property. The donor must also complete Form 8283, Section B, and attach the form to their tax return.
The donor generally does not have to attach the appraisal itself but must retain a copy for their records.
However, if the donation includes artwork valued at more than $20,000 or any other property valued
at more than $500,000, the appraisal itself must be submitted along with the tax return.161
Example: Michelle has an AGI of $125,000. She decides to donate a plot of farmland to her church, a
qualified 501(c)(3) organization. The land is worth over $5,000, so Michelle hires a qualified appraiser
to give her a written appraisal for the property before she donates it. The appraiser values the land at
$18,000. She also requests a receipt for the donation from her church. When she files her tax return,
she claims a charitable deduction of $18,000 on her Schedule A. She also attaches Form 8283 to her
return. She is not required to attach the actual appraisal, but she must keep a copy of it for her records.
Michelle has complied with all the recordkeeping requirements for her property donation.
Example: Ratcliffe is a wealthy industrialist who likes to donate to many different causes. During the
year, he donates 100,000 shares of Ford Motor Co. stock to the Special Olympics, a qualifying 501(c)(3)
nonprofit organization. The value of the stock on the date of the donation is $1,150,000. Since the stock
is from a publicly-traded corporation, Ratcliffe does not need to obtain a qualified appraisal. He will
still be required to obtain an acknowledgment letter from the organization, as well as attach Form
8283 to his tax return.

Special Rules for Donated Vehicles

Different guidelines are in place for donating vehicles, such as boats and airplanes. If the donor
claims a deduction of over $500, they can only deduct the smaller of (1) the total earnings from the
charity’s sale of the vehicle, or (2) the fair market value of the vehicle on the donation date.
The charitable organization should provide Form 1098-C, Contributions of Motor Vehicles, Boats,
and Airplanes, which shows the gross proceeds from the sale of the vehicle donated. If the taxpayer
does not attach Form 1098-C, the maximum deduction that can be taken for the donation is $500.

161Per Publication 526, a qualified appraisal is not required for contributions of certain inventory, publicly traded securities, or
certain intellectual property. See Regulations section 1.170A-16(e)(2). Also, if the taxpayer is required to obtain a qualified
appraisal, they cannot take a deduction for the cost of the appraisal itself (per Publication 526). On January 13, 2023, the IRS
released guidance stating that a charitable contribution of cryptocurrency in excess of $5,000 requires obtaining a qualifie d
appraisal. In Chief Counsel Advice 202302012, the IRS stated that cryptocurrency fails to fall into any category of property
exempted from the qualified appraisal rules of §170(f)(11)(c).
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Example: Porter donates his used motorcycle to his church fundraiser. According to Blue Book values,
the FMV of the motorcycle is $3,500 on the date he makes his donation. The church sells the motorcycle
60 days later at a fundraising auction for $2,700 and sends Porter a Form 1098-C. He can deduct only
$2,700 on his Schedule A (the smaller of the FMV or the gross proceeds from the sale) and must attach
a copy of Form 1098-C to his tax return.
Two exceptions apply to the rules regarding vehicle donations:
• If the charity keeps the vehicle for its own use, the donor can generally deduct the vehicle’s
FMV, or
• If the charity subsequently gives the vehicle directly to a needy person, the donor can generally
deduct the vehicle’s FMV.
Example: Quincy owns a used minivan that is still in good working condition. He donates the minivan
to Meals-on-Wheels, a 501(c)(3) charity that delivers hot meals to disabled people and homebound
seniors. The organization uses the minivan to deliver meals to needy individuals. The FMV of the
minivan is $4,900 on the date of Quincy’s donation. Since the vehicle was put into direct use by the
charity, Quincy may deduct the FMV of the vehicle, as long as he obtains a contemporaneous written
acknowledgment that the charity kept the vehicle for its own use. The deduction is subject to a 30%-
of-AGI limit, and Quincy will be required to attach Form 8283 to his return.

Special Rules for Conservation Easements

Conservation easements are used for land conservation purposes by restricting the future use of
the land in order to protect its conservation values. There are specific regulations that apply to these
donations. Unlike other appreciated property, conservation easements are not limited to 30% of
adjusted gross income. The charitable deduction allowed for conservation easements is generally
limited to 50% of adjusted gross income, but can be as high as 100% for qualified farmers or ranchers.
Also, the carryforward period for a donor to take tax deductions for a conservation agreement is fifteen
years, rather than the usual five years for other types of charitable gifts.
Example: Daryl decides to give a permanent easement of his property to The Nature Conservancy, a
qualifying 501(c)(3) organization. Daryl’s property is 500 acres of wetlands, and his intent is to
preserve the area for fishing and wildlife in perpetuity. Daryl purchased the land twenty years ago for
$1,000,000. The land has appreciated in value. Daryl obtains a qualified appraisal of the easement,
stating that the easement has a current fair market value of $1,400,000. In 2024, Daryl’s AGI is
$400,000. Because of the special threshold that applies to conservation easements, Daryl will be able
to take a charitable deduction of up to 50% of his $400,000 AGI. Therefore, his $1,400,000 gift permits
a deduction of $200,000 ($400,000 AGI × 50% = $200,000) in 2024. He will have a charitable
contribution carryforward of $1,200,000 that he can use in future years to offset his taxable income.
The carryforward is valid for fifteen years, rather than the usual five.

Personal Casualty and Theft Losses

The Tax Cuts and Jobs Act suspended the itemized deduction for most nonbusiness casualty and
theft losses through tax year 2025. Only personal losses derived from federally declared disaster areas
are deductible. Taxpayers who incur disaster-related casualty losses can deduct their losses for the

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year in which the loss occurred, or if elected, in the year prior to the year of the loss.162 Electing to claim
a loss in a prior tax year allows affected taxpayers in a disaster area to quickly obtain the tax benefits
associated with the deduction without having to wait up to a year from the casualty event before filing
their returns to claim the deduction.
In the past, personal casualty and theft losses attributable to a federally declared disaster (FEMA
disaster) were generally subject to a $100-per-casualty and 10%-of-adjusted gross income (AGI) limit.
These limitations only apply to personal casualty losses. However, recent legislation changed these
limits for most presidential disasters through February 10, 2025.
Note: New Special Rules for Certain Disasters: The Federal Disaster Tax Relief Act of 2023 extended
special rules and return procedures for casualty losses attributable to certain major federal disasters.
If Congress designates a disaster loss to be a “Qualified Disaster Loss,” the loss is only reduced by $500,
and the loss amount can be added to the standard deduction. In the Federal Disaster Tax Relief Act of
2023, Congress designated any loss due to a major disaster that was declared by the President during
the period between January 1, 2020, and February 10, 2025 as a “Qualified Disaster Loss.” In addition,
the disaster must have an incident period that began on or after December 28, 2019, and on or before
December 12, 2024, and must have ended no later than January 11, 2025. Qualified Disaster Losses
can be claimed on Form 4684.
The casualty loss deduction on a personal-use asset is the lesser of (1) the decrease in the fair
market value of the property (before and after the casualty event) or (2) the taxpayer’s adjusted basis
in the property at the time of the casualty event. Casualty losses of investment property are treated
differently, and covered in the next section. Business casualty losses are covered in more detail in Part
2, Businesses.
Example: Bridget lives in Florida. On September 26, 2024, Hurricane Helene hit the state. The resulting
storms and flooding destroyed Bridget’s home and car. The county where Bridget lived was designated
a federal disaster area. Bridget immediately files a claim with her insurance company. Bridget assumed
that her insurance would recover the full amount of her losses. Her insurance claim was settled several
months later, on January 2, 2025 (the following year), but Bridget’s insurance company reimbursed
her for only a small portion of her losses. The IRS deems the “disaster year” to be 2025 (not 2024, when
the actual hurricane occurred), because that is when it became certain that Bridget would not be fully
reimbursed by her insurance company. Bridget can either deduct the unreimbursed loss in 2025, or
make an election to deduct the losses on her 2024 tax return.163

Miscellaneous Itemized Deductions

The Tax Cuts and Jobs Act suspended miscellaneous itemized deductions subject to the 2%-of-AGI
floor through 2025, including most unreimbursed employee business expenses. There are still some
miscellaneous itemized deductions that a taxpayer can deduct on Schedule A. These are less commonly
seen, but some of them are still tested on the EA exam. Miscellaneous itemized deductions that are still
deductible in 2024 include:

162IRC section 165(i) allows a special election to deduct losses occurring in a federally declared disaster area in the tax year
immediately preceding the tax year the loss occurred.
163 Scenario modified directly from an example in IRS Instructions for Form 4684, Casualties and Thefts.

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• The amortizable premium on taxable bonds,
• Casualty and theft losses from “income-producing” or “investment” property,
• Losses from Ponzi-type investment schemes,
• Federal estate tax on income “in respect of a decedent” (IRD),
• Gambling losses to the extent of gambling winnings,
• Impairment-related work expenses of persons with disabilities,
• Excess deductions of an estate or trust in the entity’s final tax year,
• Repayments of more than $3,000 under a claim of right,
• Unrecovered investment in an annuity.

The amortizable premium on taxable bonds: If the amount a taxpayer pays for a bond is greater
than its stated principal amount, the excess is called a bond premium. Annual amortization of the
premium is treated as a miscellaneous itemized deduction.
Casualty or theft losses from investment property or “income-producing” property: A
taxpayer can deduct a casualty or theft loss as a miscellaneous itemized deduction if the damaged or
stolen property was income-producing property (meaning property held for investment, such as gold
coins, silver coins, artwork, and vacant lots). The taxpayer must report the loss on Form 4684,
Casualties and Thefts, Section B.
Example: Stewart purchased a plot of coastal land as an investment. He had planned to build a tourist
campground on the site. On June 1, 2024, a severe storm hit the area, and the bluffs were badly
damaged. Two weeks later, his land completely collapsed into the sea. Stewart neglected to purchase
any insurance on the property, so his loss was not covered. Stewart’s loss of valuable waterfront
property is a deductible casualty loss, because it was purchased for investment. He would report the
loss on Form 4684, Section B, Part I, for the loss of his investment property.
Losses from Ponzi investment schemes: Victims of fraudulent investment schemes can claim a
theft loss deduction if certain conditions apply. Under IRS rules, an investor who is a victim of a Ponzi
scheme is entitled to deduct Ponzi losses as a theft loss, instead of a capital loss from an investment.
Ponzi scheme losses are not limited to the $3,000 annual limit that applies to other capital losses. As a
result, Ponzi scheme losses may be offset against ordinary income, including wages, self-employment
income, etc. with no limit. Ponzi scheme losses are deducted on Form 4684, Section C, Theft Loss
Deduction for Ponzi-Type Investment Scheme.
Example: Celeste is a potential investor. She is looking for a financial advisor to help her invest. Bernie
holds himself out to the public as an investment advisor and securities broker. Celeste is persuaded to
invest with Bernie. She opens an investment account with Bernie and contributed $100,000 to the
account and provided Bernie with a power of attorney to use the funds to purchase and sell securities
on her behalf. Unbeknownst to Celeste, Bernie only invests a small amount of her funds and embezzles
the rest into his own personal accounts. Later, it is discovered that Bernie’s purported investment
advisory and brokerage activity was, in fact, a fraudulent investment arrangement known as a “Ponzi”
scheme. Bernie is convicted of securities fraud and sentenced to prison. Celeste is only able to recover
$5,000 of her original $100,000 investment. Therefore, Celeste has a $95,000 deductible Ponzi loss.
She would report the loss on Schedule A as an itemized deduction, and the losses are not limited.

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Federal Estate tax on income in respect of a decedent: Income in respect of a decedent (IRD) is
income owed to a decedent at the time of death. If a decedent’s estate has paid federal estate taxes on
IRD assets, a beneficiary may be able to claim an IRD tax deduction. IRD is covered more extensively
later, in the chapter that covers estate taxes.
Gambling losses to the extent of gambling winnings: The full amount of a taxpayer’s gambling
winnings must be reported on Form 1040. Gambling losses are deducted on Schedule A, up to the total
amount of gambling winnings. Taxpayers must have kept a written record of their losses. Gambling
losses in excess of winnings are not deductible.
Example: Akeem likes to gamble at his local casino. In 2024, he wins $6,200 playing slot machines, but
has $9,500 in gambling losses. He does not keep track of his daily wins and losses. He is required to
report the full amount of the winnings on Form 1040. His deduction for gambling losses is limited to
$6,200 on Schedule A. He cannot deduct the remaining $3,300 in losses. He also cannot carry the losses
forward to future years. If Akeem chooses not to itemize his deductions, then none of his gambling
losses would be deductible.
Impairment-related work expenses for disabled workers: These are expenses that enable a
disabled person to work, such as special equipment or attendant care services at their workplace.
Impairment-related work expenses must be incurred in connection with the taxpayer’s place of work,
or necessary for the taxpayer to be able to work.
In most cases, a disabled taxpayer would be able to deduct these expenses either as (1) medical
expenses or (2) miscellaneous itemized deductions. Taxpayers can generally choose the method that
will give them the best tax result.
Example: Farida has a serious visual disability, macular degeneration. She requires a large screen
magnifier to see well enough to perform her work. Farida purchased her own screen magnifier for
$650. Farida’s employer is a very small company and did not reimburse the cost. Farida plans to
itemize, and she deducts the full cost of the screen magnifier as a miscellaneous itemized deduction on
Schedule A, without any income limitations.
Repayments of more than $3,000 under a claim of right: On occasion, a taxpayer may have to
repay income that was included on a previous year’s tax return because at the time the taxpayer
received it, they thought they had an unrestricted right to it. This is a “repayment under claim of right”
under IRC section 1341. A “claim of right” occurs when a taxpayer reports income in one year, but then
must repay that income back in a future tax year.
An example could be when a taxpayer has to repay the unemployment benefits or wages that they
received in a prior year. If the amount of the repayment is more than $3,000, the taxpayer can elect to
take a deduction or credit in the year the amounts are repaid. If the amount repaid was $3,000 or less,
claim of right under IRC 1341 does not apply. 164

164If the amounts repaid were self-employment income, the taxpayer can deduct the repayment as an expense directly on the
Schedule C or Schedule F. Detailed examples can be found in Publication 525, Taxable and Nontaxable Income.
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Example: Truman is a college professor at a private university. Truman quits his job on November 31,
2024; the day before he receives his year-end bonus. Truman received his Form W-2 from the
university and files his 2024 tax return on February 1, 2025. Approximately two weeks later, on
February 15, 2025, Truman is informed by the university’s payroll department that he was overpaid
$6,500 in wages in 2024. He was not eligible for the year-end bonus because he quit before the end of
the year. Rather than risk a bad employment reference, Truman fully repays the $6,500 requested by
the University on April 30, 2025. In this situation, Truman would not amend his prior-year tax return.
Instead, he is allowed to take an itemized deduction for the $6,500 repayment as an itemized deduction
on his 2025 return (the following year), because that is the year he repaid his employer. Alternatively,
if it results in a larger tax benefit, Truman can elect to take a tax credit under IRC section 1341 on
Schedule 3 based on the tax rate(s) applied on the income in 2024, because the amount of the
repayment exceeds $3,000.
Excess Deductions of an Estate or Trust: If, in its final tax year, an estate or trust has more
deductions than gross income, the beneficiary can claim the excess deductions on their individual tax
return, depending on the type of deduction. These excess deductions are listed on the Schedule K-1
form, which is included in the estate or trust’s final tax return. Each beneficiary receives a copy of the
Schedule K-1 and uses it to report the deductions on their personal Form 1040. The character of these
deductions remains unchanged and they are reported as adjustments to gross income on Schedule 1
(Form 1040), or itemized deductions on Schedule A (Form 1040). Trusts and Estates are covered in
greater detail in Part 2, Businesses.
Itemized Deductions for Nonresident Aliens on Form 1040-NR
Specific limitations on deductions apply to nonresident aliens who are required to file Form 1040-
NR. Nonresident aliens cannot claim the standard deduction. Further, except for certain allowable
itemized deductions, they can claim deductions only to the extent they are connected with income
related to their U.S. trade or business. The following itemized deductions are allowed:
• State and local income taxes,
• Qualifying charitable contributions to U.S. nonprofit organizations
• Casualty and theft losses in a presidentially declared disaster area, and
• Some miscellaneous itemized deductions.
Nonresident aliens filing Form 1040-NR cannot take an itemized deduction for mortgage interest,
and most other itemized deductions are restricted to them. Similar restrictions apply to dual-status
taxpayers. There are special exceptions in the law for tax treaty partners, but the IRS will not test on
any specific tax treaties with other nations.
Example: Ishaan is an international scholar teaching at Gonzaga University on a J-1 Visa. He is
permitted to work on campus for the university because he is doing research under a university grant
program. Ishaan earns $77,000 working for the University. He is FICA-exempt and only had federal
and state income taxes withheld. Ishaan made a charitable gift of $900 in cash to the university’s
scholarship program, which is a qualifying donation. Ishaan cannot take the standard deduction,
because he is a nonresident alien. However, he is allowed to itemize his deductions. He files Form 1040-
NR, and claims an itemized deduction of $900 for the charitable gift that he made, as well as for the
state income taxes withheld from his paychecks during the year.
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Nondeductible Expenses
The IRS has a lengthy list of expenses that individual taxpayers cannot deduct.165 These are just a
sample of personal expenses the IRS lists as nondeductible:
• Lunch with coworkers or meals while working late
• Country club dues, athletic club fees, and gym memberships
• Home repairs, insurance, and rent
• Losses from the sale of a home, furniture, or a personal car
• Brokers’ commissions
• Burial or funeral expenses, including the cost of cemetery lots
• Fees and licenses, such as car license or registration costs (except certain portions that may be
considered deductible property taxes), marriage licenses, and dog tags
• Fines and penalties for breaking the law, such as parking tickets
• Life and disability insurance premiums
• Investment-related seminars
• Lost or misplaced cash or property
• Political contributions
• Expenses of attending stockholders’ meetings
• Voluntary unemployment benefit fund contributions
• Adoption expenses (although a taxpayer may be able to claim an adoption credit)
• Travel expenses for another individual
• Interest on a credit card used for personal expenses
• Expenses of earning or collecting tax-exempt income

165 A basic rule is that most personal, living, or family expenses are not deductible.
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Unit 13: Individual Tax Credits

For additional information, read:
Schedule 8812 instructions
Publication 503, Child and Dependent Care Expenses
Publication 596, Earned Income Credit
Publication 970, Tax Benefits for Education
Publication 5968, Residential Clean Energy Credit
Publication 5866, New Clean Vehicle Tax Credit Checklist

A tax credit directly reduces a taxpayer’s liability on a dollar-for-dollar basis, which means it is
usually more valuable than a tax deduction of the same dollar amount that only reduces the amount of
taxable income. Various types of tax credits are either refundable or nonrefundable.
Nonrefundable Tax Credits
A nonrefundable tax credit reduces a taxpayer’s liability for the year to zero but not beyond that, so
any remaining credit is not refunded to the taxpayer. The most common nonrefundable tax credits
available in 2024 are:
• Child and Dependent Care Credit
• Adoption Credit
• American Opportunity Tax Credit (although the AOTC has a refundable component)
• Lifetime Learning Credit
• Retirement Savings Contributions Credit or, the “Saver’s Credit”
• The Credit for Other Dependents (ODC)
• Child Tax Credit (CTC) (the CTC also has a refundable component)
• Individual Energy Credits
• Foreign Tax Credit (covered later)

Refundable Tax Credits

A refundable tax credit can reduce a taxpayer’s liability to zero and also generate a refund to the
taxpayer for the amount by which the credit exceeds the amount of tax he would otherwise owe.
Refundable tax credits include the following:
• Additional Child Tax Credit (ACTC)
• The Earned Income Tax Credit (EITC)
• Premium Tax Credit (related to the Affordable Care Act, covered later in chapter 14)
• American Opportunity Tax Credit (partially refundable)
• Credit for excess Social Security and RRTA tax withheld
Stringent due diligence requirements apply to tax preparers who prepare returns claiming the
Earned Income Tax Credit, the Child Tax Credit, and the American Opportunity Tax Credit. Due
diligence requirements also apply to the determination of Head of Household filing status. Tax

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preparers must complete Form 8867, Paid Preparer’s Due Diligence Checklist, for each EITC, CTC/ACTC,
or AOTC claim they prepare.166
The American Opportunity Tax Credit, Additional Child Tax Credit, Child Tax Credit, Credit for
Other Dependents, and the Earned Income Tax Credit require the taxpayer, spouse, and qualifying child
to have a valid taxpayer identification number (TIN) assigned on or before the due date (or extended
due date) of the return.
In the past, taxpayers were allowed to amend their returns to claim these credits retroactively after
a valid taxpayer identification number was issued, but this is no longer permitted. This includes filing
an original return past the due date (including extensions) if the taxpayer fails to file it in a before the
deadline.
Example: Blanca is an immigrant from Cuba currently residing in the U.S. She is in the process of
adjusting her residency status via the Cuban Adjustment Act, which allows her to apply for permanent
residency and a green card. Blanca filed her 2024 tax return early, on February 1, 2025, using her ITIN.
She does not file an extension. Three months later, on May 1, 2025, Blanca’s application for U.S.
residency is granted, and she receives a Social Security number (SSN). Her income level would allow
her to claim EITC, but she cannot amend her 2024 return and claim EITC, because she did not receive
her Social Security number by the due date of her tax return, and she did not file an extension. The IRS
would prohibit Blanca from retroactively claiming the EITC by amending her return. If she did attempt
to file a retroactive claim, her claim would be denied.
Example: Samir and Noor are married and file jointly. Samir and Noor are lawfully present in the
United States as visiting scholars, but they are not U.S. residents. Both Samir and Noor apply for
permanent residency on January 1, 2024, and expect to receive their Social Security Numbers soon. On
March 1, 2025, Samir and Noor are granted conditional permanent residency in the United States. They
receive valid green cards and Social Security numbers. Samir and Noor file their 2024 tax return on
April 1, 2025, using their newly-assigned SSNs. They will be eligible for all the refundable credits,
(assuming they otherwise qualify), because they had valid SSNs before the due date of their tax return.

Child and Dependent Care Credit (CDCTC)

The Child and Dependent Care Credit (CDCTC) is not refundable in 2024. This credit equals a
percentage of childcare costs for children under 13 or disabled dependents of any age, while taxpayers
work (or seek work). If childcare is reimbursed through a flexible spending account, the reimbursed
amount must be deducted from qualified expenses for the credit. In 2024, the maximum expense used
to calculate the credit is $3,000 for one dependent or $6,000 for two or more. The credit ranges from
20% to 35% of qualified expenses, with a maximum of 35% for qualifying expenses.
Example: Zane and Shari both work full time and file jointly. They have two children, a daughter who
is four years old, and a son who is two years old. Zane and Shari incur $5,000 of daycare expenses for
their daughter and $4,600 for their son. Their total child care expenses are $9,600 for the year. The
maximum amount of qualifying expenses they can use to figure the credit is $6,000, even though their
actual expenses exceed that amount.

166 Due diligence for tax preparers is covered in more detail in Book 3, Representation.
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Example: Dina and Joseph are married and file jointly. They have one child, Abel, who is 7 years old.
Dina and Joseph both work, so Abel attends after-school daycare. His parents spend $3,200 on daycare
during the year. The maximum amount of daycare expenses that can be used to calculate the credit is
$3,000. Dina and Joseph’s joint AGI is $69,000 in 2024. Based on their AGI, they can claim a 20% Child
and Dependent Care Credit, which results in a $600 credit ($3,000 qualifying daycare expenses × 20%
credit rate = $600).
Qualifying expenses: The following kinds of expenses qualify for the credit.
• Preschool education: Preschool or other programs below the level of kindergarten. Expenses
for enrolling in kindergarten or higher grades are not qualifying expenses.
• After-school care: Daycare services provided before or after school hours. Childcare expenses
during the summer and throughout the year may also be considered qualifying if they are
necessary to allow parents to work.
• Disabled care: Adult daycare or assistance services for a disabled dependent or a disabled
spouse of any age who is unable to care for themselves.167
• Transportation costs: Expenses incurred by the care provider to transport an eligible person
to and from their place of care.
• Fees and deposits: Any payments made to a daycare or preschool for the purpose of securing
childcare services.
• Household services: Any services performed by a full-time nanny or in-home care aide that
benefit and protect an eligible person.
Example: Marina is unmarried and files as head of household. Marina claims her elderly mother, Rosa,
as her dependent. Rosa has mild dementia and is disabled, so she must be in an adult daycare. Marina
pays $12,000 per year for Rosa to be in an adult daycare. Marina may claim the Child and Dependent
Care Credit because Rosa is her dependent, and she is disabled and incapable of self-care. Marina earns
$75,000 in wages in 2024, and has no other income for the year. Based on Marina’s AGI, she can claim
a $600 Child and Dependent Care Credit ($3,000 maximum daycare expenses × 20% credit rate).

167With regards to supportive care for disabled individuals, disabled persons who cannot dress, clean, or feed themselves because
of physical or mental problems are qualifying individuals. This also includes persons needing supervision to prevent harm.
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Eligibility tests: A taxpayer must pass five eligibility tests to qualify for the child and dependent
care credit (CDCTC):
• Qualifying person test
• Earned income test
• Work-related expense test
• Joint return test
• Provider identification test

In 2024, taxpayers may qualify for the CDCTC, even if filing MFS, if they meet certain requirements.
Test #1: Qualifying Person Test
For purposes of the Child and Dependent Care Credit, a “qualifying person” is:
• A dependent child under the age of 13 (at the time the care was provided),
• A spouse who is physically or mentally disabled,
• Any other disabled dependent who is incapable of self-care,
• A disabled person that the taxpayer could claim as a dependent except the disabled person had
gross income of $5,050 or more in 2024 (IRC Section 21(b)(1)(B)).

Example: Conrad is an architect who works full-time. Conrad’s wife, Dacia, is permanently disabled.
The couple has an 8-year-old daughter named Kaylani. Conrad hires an in-home caregiver to look after
his disabled wife and his daughter. Both Dacia and Kaylani are qualifying persons for the Child and
Dependent Care Credit.
Example: Audrey, who files single, has an annual income of $98,500. Her mother, Mildred, who is 62
years old and disabled, lives with her. Due to her physical disability, Mildred is unable to work. Audrey
spends $8,000 each year on an in-home care aide to assist Mildred. In 2024, Mildred received $6,900
in dividend income from investments she acquired long ago. Since Mildred's income surpasses the
$5,050 "deemed exemption" amount in 2024, Audrey cannot claim Mildred as a dependent on her tax
return. Nevertheless, Audrey is eligible to claim the Child and Dependent Care Credit for the expenses
related to Mildred's care, as Mildred meets the criteria for a disabled person whom Audrey could claim
as a dependent if not for the gross income limit.

Test #2: Earned Income Test

If a taxpayer is married, both spouses must have “earned income” during the year to qualify for this
credit. This generally means both spouses must work (if filing a joint return). In the event one spouse
does not work, for purposes of this test the taxpayer’s spouse is treated as having earned income for
any month they are:
• A full-time student, or
• Disabled.
For any month that a spouse has no actual earned income, but has “deemed earned income”
because they were a full-time student or disabled, the amount of “deemed” earned income by the

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nonworking spouse is $250 per month if the couple has one qualifying dependent, or $500 per month
if the taxpayer has two or more dependents.168
Example: Theresa and Jordan are married and have one 5-year-old son named Timmy. Timmy is in
daycare. Jordan works full-time for an accounting firm. Theresa attended college full-time from
January 1 to June 30. She was unemployed during the summer and did not attend school for the rest of
the year, but Timmy continued to stay in daycare, so Theresa could volunteer at her church. Theresa
is treated as having “deemed earned income” only for the six months she attended school full-time. In
other words, they are allowed to take the dependent care credit in the months that Theresa was
attending school. The daycare expenses that were incurred when Theresa was not in school or working
would not be qualifying expenses for the purposes of the credit.
Example: Cheng and Jingyi are married and file jointly. Cheng works full time. His wife, Jingyi, does
not work, because she is disabled. Cheng and Jingyi have one 6-year-old daughter, who is in elementary
school. Cheng pays for after-school care for his daughter, and picks her up at school when he is finished
with his workday. The cost of the after-school care would be a qualifying expense for the Child and
Daycare Credit, even though Cheng’s wife is not working, because Jingyi is disabled.
The amount of qualifying daycare expenses used to calculate the credit cannot exceed the
taxpayer’s earned income for the year (if unmarried at the end of the year) or the smaller of the
spouse’s earned income for the year if married.
Example: Kenny and Selena are married and have one 3-year-old daughter named Poppy. Poppy is in
daycare. The parents spend $4,000 on daycare during the year so both can work. Selena works full-
time as a cashier at a retail store. She earns $40,000 in wages during the year. Kenny is self-employed
as a graphic designer. His business does poorly during the year, and he has an overall loss on his
Schedule C. Since Kenny has no earned income (his business shows a loss), they cannot claim the Child
and Dependent Care Credit.
Example: Tanner and Ursula are a married couple who file their taxes jointly. They have a 7-year-old
son and spend $5,750 on daycare expenses for the year. Tanner’s annual wages are $49,000, while
Ursula only makes $2,000 from a part-time job. Neither of them received any dependent care
assistance from their employers. When calculating their Child and Dependent Care Credit, they can
only consider the lesser of Tanner’s earned income or Ursula’s earned income. Since Ursula’s earnings
were only $2,000, it sets the limit for what can be counted as qualifying expenses towards this credit.

Test #3: Work-Related Expense Test

Child and dependent care expenses must be “work-related” to qualify for this credit, meaning a
taxpayer must be working (or actively searching for work). An exception exists for spouses who are
disabled or full-time students. In addition, any daycare expenses incurred so that a spouse may do
volunteer work or so that a married couple can go on a “date night” do not qualify.

168 If a spouse dies during the year, the deceased spouse’s earned income is not taken into consideration when determining the
eligibility for this credit. This is true even if a joint return is filed with the deceased spouse. See Treas. Reg. Sect. 1.21-2(b)(2).
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Example: Nikita is a stay-at-home mom who volunteers several hours a week for a local suicide
hotline. Her husband works full-time as a custodian. They pay a babysitter to stay with their daughter
during the hours Nikita volunteers. The couple does not qualify for the credit because the babysitting
expense is not “work-related.” Since Nikita does not have a job, is not disabled, and is not a full-time
student, their child care expenses are ineligible for the credit.
Example: Maureen’s four-year-old son attends a daycare center while she works three days a week.
The daycare charges $150 for three days a week and $250 for five days a week. Sometimes Maureen
pays the extra money so she can run errands or go to the doctor on her days off. This extra charge is
not a qualifying expense. Maureen’s deductible expenses are limited to $150 a week, the amount of her
work-related daycare expenses.
Nonqualifying expenses: Examples of child care expenses that do not qualify for the credit
include:
• Tuition for children in kindergarten and above (i.e., private elementary school costs),
• Summer school or tutoring programs,
• The cost of sending a child to an overnight camp (but day camps generally do qualify),
• The cost of transportation not provided by a daycare provider,
• A forfeited deposit to a daycare center (since it is not for care and therefore not a work-related
expense).

Example: Archie’s 7-year-old son, Kanyon, attends a private elementary school, which costs $300 a
week. In addition to paying for school tuition, Archie pays an extra weekly fee of $100 for after-school
daycare so he can be at work during his scheduled hours. Archie can count the cost of the after-school
daycare program when figuring the child care credit, but cannot count the cost of private school tuition.
Example: Lorie is divorced and has custody of her 12-year-old daughter, Bree. In August, Lorie spends
$2,000 to send Bree to an overnight camp (sleepaway camp) for two weeks. She also sends Bree to a
Girl Scout day camp for a week in July. The cost of the Girl Scout camp is $750. Lorie may only count
the $750 toward the credit because the cost of sending a child to an overnight camp is not considered
a qualifying child care expense. Next year, when Bree turns 13, she will no longer be a qualifying child
under the rules for this credit, (unless the child is disabled).
Example: Dominga takes her three-year-old son, Abram, to a nursery school that provides daily lunch
and activities as part of its program, which costs $800 per month. The meals are included in the overall
cost of care, and they are considered incidental and not itemized on her monthly bill. Dominga can
count the total cost of the daycare when she figures her daycare credit.
In the case of divorced or separated taxpayers, only the custodial parent of the child is allowed to
claim the Child and Dependent Care Credit.
The Child and Dependent Care Credit does not apply to child care payments made to a family
member who is the taxpayer’s own dependent under 19 years old, or any other dependent listed on
their tax return.

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Example: Garrison, age 30, pays his 60-year-old mother, Bettie, $300 per month to watch his 5-year-
old son. Bettie watches her grandson while Garrison is at work. Normally, the $300 Garrison pays his
mother would be a qualifying childcare expense. However, in 2024, Garrison claims his mother as a
dependent on his tax return, along with his 5-year-old son. Since Garrison is claiming his mother as a
dependent, the payments made to her for childcare are not qualifying expenses for the purposes of the
Child and Dependent Care Credit.
Taxpayers may combine costs for multiple dependents. For example, if a taxpayer pays daycare
expenses for three qualifying children, the annual limit on qualifying expenses does not need to be
divided equally among them.
Example: Diego has three children, all under the age of 13. All of Diego’s children live with him full-
time. Usually, Diego’s mother, Elena, takes care of his children for free. However, Elena was unable to
take care of his children during the summer, because she went away for two months to visit family
overseas. Diego put his children in daycare during those months, so he could work. His qualifying
daycare expenses are $2,300 for his first child; $1,900 for his second child; and $900 for his third child.
Diego can use the total amount, $5,100, when figuring his credit.

Test #4: Joint Return Test

The joint return test specifies that married couples who wish to take the Child and Dependent Care
credit generally must file jointly. Recently modified rules apply to married taxpayers who file separate
returns. If a taxpayer’s filing status is married filing separately, and all of the following apply, the
taxpayer is still permitted to claim the daycare credit on Form 2441.
• The taxpayer lived apart from their spouse during the last 6 months of the year.
• The taxpayer’s home was the qualifying person’s home for more than half of the year.
• The taxpayer paid more than half of the cost of keeping up the home for the year.
Example: Mirabella physically separated from her husband on March 9, 2024. She has not filed for
divorce or legal separation yet. She does not have any children. Mirabella’s AGI is $95,000. Mirabella
maintains a home for herself and Sebastian, who is her disabled father. Sebastian is 72 years old and
permanently disabled, so Mirabella pays $9,000 for a home-health aide to come in and take care of her
father while she is working. Sebastian has $5,400 in interest income, so Mirabella cannot claim him as
a dependent (his gross income is greater than $5,050, the 2024 gross income threshold for qualifying
relatives). Because Mirabella is not able to claim her father as a dependent and she is still legally
married as of the end of the year, she also cannot use the head of household filing status. Mirabella’s
filing status is married filing separately, but Sebastian is a qualifying person for the Child and
Dependent Care Credit. Because of the following facts, Mirabella is able to claim the credit for the
dependent care expenses she incurred for her father, even though her filing status is married filing
separately.169

Test #5: Provider Identification Test

To qualify for this credit, taxpayers must include the name, address, and identification number of
the caregiver or organization who provided care for their child or dependent. If a daycare provider

169 Example based on scenario in the Form 2441 instructions.

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refuses to provide their tax ID information, the taxpayer can still claim the credit by reporting
whatever information they have (such as the provider’s name and address) and attaching a statement
to Form 2441 explaining the situation. However, foreign daycare providers are exempt from this
requirement, as they do not need a U.S. taxpayer ID.
Example: Edwin is a widowed U.S. citizen. He is working overseas in Saudi Arabia on a multi-year
contract for an international accountancy firm. Edwin worked in Saudi Arabia for the entire taxable
year. Edwin has one 11-year-old daughter named Sadie. Edwin pays a full-time nanny to watch his
daughter, Sadie, while he is working. Since all the care was provided in a foreign country, the nanny is
not required to have a U.S. tax ID, and Edwin is still allowed to claim the Child and Dependent Care
Credit. When Edwin files his individual return, the tax software will automatically enter “LAFCP”
(Living Abroad, Foreign Care Provider) in the space for the care provider’s taxpayer identification
number.

Child Tax Credit and Additional Child Tax Credit

Note: It is important to note that the Child Tax Credit (CTC) is entirely distinct from the Child and
Dependent Care Credit. These are two separate credits, so be careful not to mix them up!
The rules in 2024 for the Child Tax Credit and the Additional Child Tax Credit (ACTC) are as follows:
• The nonrefundable Child Tax Credit is $2,000 per qualifying child
• The refundable Additional Child Tax Credit is a maximum of $1,700 per qualifying child.
• The AGI phaseout for the Child Tax Credit begins at $200,000 ($400,000 for MFJ).170
• The child must have a valid Social Security number to qualify.
• The CTC/ACTC is claimed on Form 8812, Credits for Qualifying Children and Other Dependents.
Example: Joshua and Anika are married and file jointly. They have one 10-year-old child. Joshua has
wages of $195,000. Anika does not work, but she has various profitable investments. Anika has interest
and dividend income of $300,000. Their joint AGI is $495,000. They are not eligible to take the Child
Tax Credit, because their joint AGI is above the phaseout threshold for joint filers ($400,000 is the
phaseout).
Example: Eduardo files as head of household and has two minor children, ages 5 and 7. Both children
qualify for the Child Tax Credit. His MAGI is $79,000, and after figuring his itemized deductions, his
remaining tax liability is $4,680. Eduardo is eligible to take the full credit of $2,000 per child ($2,000 ×
2 children = $4,000) because his MAGI is less than $200,000 and his tax liability is greater than $4,000.
The credit will eliminate most of his remaining tax liability.
Taxpayers with income below certain threshold amounts can claim the Child Tax Credit for each
qualifying child under the age of 17. In order to qualify for the Child Tax Credit, the taxpayer must have
“earned income,” such as wages or income from self-employment.

170If income exceeds the AGI limits, the Child Tax Credit will decrease by $50 for every $1,000 that the AGI exceeds the limit.
Taxpayers whose AGI exceeds $240,000 or $440,000 (MFJ) in 2024 are ineligible to claim the Child Tax Credit or the Additional
Child Tax Credit.
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Note: Unlike the Child and Dependent Care Credit or Earned Income Credit, the Child Tax Credit is not
affected by a child’s disability. The main factor in determining a dependent’s eligibility for the credit is
the child’s age.
A taxpayer whose tax liability is zero cannot take the Child Tax Credit because there is no tax to
reduce. In addition, the Child Tax Credit is limited to the amounts of regular income tax and any
alternative minimum tax owed. However, a taxpayer with zero tax liability may be able to take the
Additional Child Tax Credit, (which is covered in the next section).
Qualifying Child for the CTC: To be eligible to claim the Child Tax Credit, the taxpayer must have
at least one qualifying child, and the child must meet the following tests:
• Age Test: The child must have been younger than 17 on December 31.
• Relationship Test: The child must be the taxpayer’s child, stepchild, foster child, sibling, step-
sibling, half-sibling, or a descendant of any of them. For example, qualifying child could include
grandchildren, nieces, and nephews. Adopted children always qualify as the taxpayer’s own
child.
• Support Test: The child must not provide more than half of their own support.
• Dependency Test: To receive the child tax credit, the taxpayer must claim the child as a
dependent. If a noncustodial parent is eligible to claim the child as a dependent and meets all
other qualifications, then they may claim the child tax credit for their child.
• Joint Return Test: The child cannot file a joint return for the year unless the only reason they
are filing is to claim a refund, and otherwise the child would not have a tax liability.
• Citizenship Test: The child must be a U.S. citizen or U.S. resident alien with a valid Social
Security Number. An ITIN or ATIN is not acceptable.
• Residency Test: In most cases, the child must have lived with the taxpayer for more than half
of the year (over six months). Exceptions exist for temporary absences and children who are
born or die within the year.171

Example: Adelbrand and Esme recently emigrated to the U.S. They are married and plan to file jointly.
They have two dependent children under the age of 10. Adelbrand became a green card holder the
prior year. He works full time and has a valid Social Security Number. Esme and the children have
applied for permanent residency but their application is still pending with U.S. immigration (USCIS).
As of January 1, 2024, Esme and the children only have ITINs. If Adelbrand and Esme attempt to file
their return early, they cannot claim the Child Tax Credit because Esme and the children do not have
valid SSNs. Adelbrand and Esme should consider extending their tax return, in order to give them as
much time as possible to submit a timely return: if Esme and the children receive valid Social Security
numbers before the extended due date, they will qualify to claim the Child Tax Credit.

171Temporary absences include: school, vacation, medical care, military service, or incarceration in a juvenile facility. There are
special rules for children of divorced or separated parents, as well as children of parents who never married. In some cases, the
noncustodial parent may be entitled to claim the child as a dependent and thus the Child Tax Credit. In addition, there is an
exception for an infant who is born during the tax year.
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Example: Viviana is unmarried and has a 16-year-old son, named Cesar. Viviana and Cesar do not have
Social Security numbers, but both of them are U.S. residents for tax purposes. They both have valid
ITINs. Viviana cannot claim the Child Tax Credit for Cesar, because her child must have an SSN that is
valid for employment in order to qualify.
Example: William is unmarried and files head of household. William’s son, Elijah, is a full-time student
who turned 17 on the last day of the year: December 31, 2024. William and Elijah are both U.S. citizens
and have valid Social Security numbers. Elijah is William’s qualifying child. However, Elijah is not a
qualifying person for the Child Tax Credit because he was not under age 17 at the end of the year.
Example: Lissette adopted a son named Myron, who is 14 years old. His adoption was finalized on
November 1, 2024, but before that date, he lived with Lissette all year as her foster child. Myron is a
U.S. citizen. Lissette provided all her son’s support. Myron is a qualifying child for the Child Tax Credit
because: (1) he was under age 17 at the end of the tax year; (2) he meets the relationship requirement;
(3) he lived with Lissette for more than six months of the year, and (4) he did not provide more than
half of his own support.
Example: Victoria is a legal U.S. resident (a green card holder) and she has a valid Social Security
number. Her two nieces, Rosalie, age 15, and Juana, age 16, live with Victoria all year long. The children
do not have valid Social Security numbers, they only have ITINs. Victoria can claim her nieces as
dependents, but she cannot claim the Child Tax Credit for either of them, because they do not have
valid SSNs. She may be able to claim the Credit for Other Dependents for her nieces, instead.

Additional Child Tax Credit (ACTC)

The Additional Child Tax Credit is the refundable component of the Child Tax Credit. A taxpayer
must be eligible to claim the Child Tax Credit in order to claim the Additional Child Tax Credit, even if
the taxpayer does not qualify for full refundability.
Example: Mendel and Jada file jointly and have two children who qualify for the Child Tax Credit. Their
MAGI is $47,000, and their tax liability is $954. They can offset the $954 in tax using the Child Tax
Credit, reducing their tax to zero. Since their tax liability is zero, Mendel and Jada cannot claim the
maximum Child Tax Credit of $2,000 per child, but they may be eligible for the Additional Child Tax
Credit, which is a refundable credit.
Unlike the nonrefundable Child Tax Credit, the Additional Child Tax Credit is refundable, and it can
produce a refund even if the taxpayer does not owe any tax. The additional child tax credit allows
eligible taxpayers to claim up to $1,700 for each qualifying child in 2024. The ACTC is based on the
lesser of:
• 15% of the taxpayer’s taxable earned income that is over $2,500 or,
• The amount of unused Child Tax Credit (caused when the tax liability is less than the allowed
Child Tax Credit)

Note: A special rule that applies to the ACTC, but not to the CTC, states that a taxpayer that claims the
foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction on
Form 2555, cannot claim the refundable Additional Child Tax Credit, but they can still qualify for a
nonrefundable Child Tax Credit (up to the amount of income tax that they owe).

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Example: Maisie files as head of household and claims her 12-year-old daughter, Ruby, and her 9-year-
old son, Daniel, as dependents on her return. Maisie and her children are U.S. citizens and have valid
Social Security numbers. Maisie’s only income is from wages, from a part-time job where she earns
$19,900. She does not owe any income tax, because the standard deduction for her filing status exceeds
her wages. Since she does not owe any income tax, she is not eligible for the nonrefundable Child Tax
Credit. However, she is eligible for the refundable, Additional Child Tax Credit, which can produce a
refund even if Maisie does not owe any tax. The maximum ACTC she can receive is $1,700 per child in
2024. Since she has two qualifying children, she would be eligible for a maximum credit of $3,400
($1,700 × 2 children).
Schedule 8812 is used for figuring and reporting the Additional Child Tax Credit as well as the Child
Tax Credit and the Credit for Other Dependents.
Credit for Other Dependents (ODC)
The $500 "Credit for Other Dependents" applies to dependents who do not qualify for the Child Tax
Credit, such as college-age children and elderly parents. To claim the Credit for Other Dependents, the
dependent must have a valid identification number (ATIN, ITIN, or SSN) by the due date of the return
(including extensions).
Taxpayers can only claim this credit for dependents listed on their return who are U.S citizens,
nationals, or residents. The AGI phaseout is the same as the Child Tax Credit, at $200,000 for unmarried
taxpayers and $400,000 for joint filers, with a $50 reduction for every $1,000 above these thresholds.
Example: Finlay and Hazel file a joint return and they both have valid SSNs. They have two qualifying
dependents. Amber is their 22-year-old daughter. Amber is a full-time student, she has an SSN, and she
meets the qualifying child test. Finlay’s mother, Esther, is 75 years old, has a valid SSN, and meets the
“qualifying relative” test. Amber and Esther are not qualifying dependents for the Child Tax Credit,
because they are both over the age of 17, but they are qualifying dependents for the Credit for Other
Dependents.
Example: Rosario’s AGI in 2024 is $62,000. She financially supports her elderly father, Orlando, who
is age 79, and her disabled cousin, Pedro, who is age 16. Orlando and Pedro live with Rosario in her
home all year, and neither one has any taxable income. Rosario cannot claim the Child Tax Credit for
Orlando, because Orlando is her father and not a child. Pedro is not a qualifying child for the Child Tax
Credit, because he is Rosario’s cousin, which means he cannot be claimed as her qualifying child. Pedro
and Orlando are both Rosario’s qualifying relatives, and she can claim a $500 ODC for both of them.

Adoption Credit
In 2024, a nonrefundable credit of up to $16,810 per child can be taken for qualified expenses paid
to adopt a child. An eligible child must be under the age of 18 years of age, or physically or mentally
disabled (regardless of age). The credit is claimed on Form 8839, Qualified Adoption Expenses.
Taxpayers who file MFS cannot claim the adoption credit.
Unlike most other tax credits, the adoption credit has the same phaseout range for all filing
statuses. The MAGI phaseout range is $252,150 – $292,150 for all filing statuses that are allowed to
take the credit. If a taxpayer’s MAGI is higher than $292,150 in 2024, they cannot claim the adoption
credit. Although the adoption credit is nonrefundable, any unused credit may be carried forward for
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up to five years. Qualified adoption expenses must be directly related to the adoption of the child.
Qualifying expenses may include:
• Attorney fees, adoption fees and court costs,
• Travel expenses related to the adoption, including meals and lodging,
• Costs of an unsuccessful adoption of a U.S. citizen or U.S. national,
• Re-adoption expenses to adopt a foreign child.
Special Needs Adoptions: A special rule allows adoptive parents to claim the maximum credit
amount for special needs children, even without adoption expenses. For the purposes of the adoption
credit, a child with special needs is defined as a U.S. citizen or U.S. resident (foreign adoptions do not
qualify for this special rule)172 when the adoption began, and the government determines the child:
• Cannot or should not be returned to their parents’ home, and
• Is not likely to be adopted without assistance to the adoptive family.
When determining special needs, the state may consider factors such as the child’s ethnicity and
age, whether they are a minority or part of a sibling group, and if they have any physical, mental, or
emotional handicaps. The child does not necessarily have to be disabled to qualify as "special needs.”
Example: Olympia adopts two special-needs children from the U.S. foster care system in 2024. She
incurs only $2,100 in adoption expenses; however, because both children are considered special needs,
Olympia is allowed an adoption credit of $33,620 ($16,810 × 2 children).
Example: Esther is 62 and is employed full-time as an accountant, earning $159,000 per year. Three
of her nieces were put into the U.S. foster care system because their mother (Esther’s sister) was
arrested and later incarcerated. Esther adopts her three nieces from foster care, and the government
paid all the legal fees. The children were considered endangered and receive monthly adoption
assistance benefits from the government and thus are considered special needs. Esther can claim the
full adoption credit of $16,810 per child for a total of $50,430 in 2024. Any unused credit can be carried
forward for 5 years.
Example: In 2024, Andrew and Noreen finalize the adoption of a disabled child from China. They pay
$7,500 in expenses for the adoption, but they are only eligible to claim these actual expenses as a tax
credit. Despite their child’s disability, foreign adoptions do not qualify as “special needs” adoptions, for
the purposes of the adoption credit. Their income tax liability for the year is $6,000 so the adoption
credit will reduce their tax liability in 2024 to zero. They can carry forward any unused adoption credit
($1,500 carryover) for up to five years.
Unsuccessful Adoptions: A taxpayer who has attempted to adopt a child in the U.S. and been
unsuccessful is still eligible for the adoption credit. Eligible expenses may include those related to
unsuccessful attempts to adopt as well as an adoption attempt that is ultimately successful. However,
if the eligible child is from a foreign country, the taxpayer cannot take the credit or exclusion unless
the adoption becomes final. A foreign child is defined as a child who was not a citizen or resident of the
United States at the time the adoption effort began.

172With regards to foreign children, if the child is not a U.S. citizen or U.S. resident, they are not considered to be “special needs”
for purposes of the adoption credit.
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Qualified adoption expenses do not include: any illegal adoption expenses, any surrogate parenting
arrangement, or the adoption of a spouse’s child.
Example: Tabitha and Edison are married and file jointly. This year, Tabitha takes the necessary legal
steps to adopt Layla, Edison’s 16-year-old daughter from his previous marriage. The total cost for the
adoption is $7,600, but unfortunately, none of these expenses can be deducted on their tax return. This
is because the costs associated with adopting a spouse’s child do not count as qualifying expenses for
the purpose of the adoption credit.

The Timing of the Payment: Adoption expenses are generally includible for the credit in the year
the adoption becomes final, with a few exceptions.
• Domestic adoptions: With the adoption of a domestic child, qualified expenses paid before the
year in which the adoption becomes final may be claimed in the year after the expenses were
paid. This rule applies even if the adoption is unsuccessful.
• Foreign adoptions: For a foreign adoption, expenses paid before or during the adoptive
process are only includible for the credit once the adoption actually becomes final.
• Post-adoption expenses: Any additional expenses paid after an adoption becomes final (for
example, additional legal fees related to the adoption) are included in the tax credit calculation
in the year paid, regardless of whether the adoption was foreign or domestic.

Example #1 (domestic adoption): Alicia is going through the process of adopting a 3-year-old child
named Lorena from the U.S. foster system. The child is a U.S. citizen and was legally placed in her home.
Alicia’s AGI is $89,000 for the year. The adoption process takes 3 years. Alicia pays legal fees related to
the adoption of $3,000 in 2022, $4,200 in 2023, and $5,000 in 2024. On February 1, 2024, Lorena’s
adoption becomes final. The $3,000 of expenses she paid in 2022 are includible for the credit in 2023
(the year after the year the costs were incurred) and may be claimed towards the credit on Alicia’s
2023 tax return. Since the adoption became final in 2024, Alicia can claim both the $4,200 she paid in
2023 and the $5,000 she paid in 2024 as a credit on her 2024 tax return.
Example #2 (foreign adoption): Veronica and Charles are attempting to adopt a foreign child named
Manuel, who is 4 years old and a citizen of Colombia. The couple pays qualified adoption expenses of
$4,000 in 2022, $6,000 in 2023, and $2,000 in 2024. On January 27, 2024, the adoption becomes final.
Veronica and Charles may claim all $12,000 in qualified adoption expenses ($4,000 paid in 2022,
$6,000 paid in 2023, and $2,000 in 2024) on their 2024 tax return, because it is a foreign adoption, and
2024 is the year in which the adoption became final.173

Education Credits
Two education credits are available based on qualified expenses a taxpayer pays for post-
secondary education:
• American Opportunity Tax Credit (also called the AOC or AOTC)
• Lifetime Learning Credit

173 Examples modified from scenarios in IRS Tax Topic 607, Adoption Credit at: https://www.irs.gov/taxtopics/tc607.
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There are general guidelines that apply to both types of credits, as well as specific rules for each
one. A taxpayer can receive education credits for themselves, their spouse, and any dependents who
attended an eligible educational institution during the previous tax year. Form 8863, Education Credits,
is used to figure and claim both education credits.
Eligible institutions include colleges, universities, vocational schools, and community colleges.
Payments made in advance for an academic term beginning within the first three months of the next
calendar year can also be claimed.
Example: Fahad is 25 years old and single. On December 28, 2024, he prepaid $2,800 for his college
tuition for the spring semester that begins on January 9, 2025. Fahad can use the $2,800 of educational
expenses towards an education credit on his 2024 return (in the year he actually paid the costs), even
though he will not start college until 2025.
Education credits are not available to taxpayers who: can be claimed as a dependent on another
person’s tax return, married individuals filing separately, and those with incomes above the 2024
phaseout limits ($80,000-$90,000 for unmarried individuals and $160,000-$180,000 for married
couples).
Example: Natalia, age 52, has a 21-year-old son named Raul who is a college student. Natalia and Raul
do not have enough money to pay for Raul’s college tuition. As a gift, Raul’s grandmother pays his
$4,500 in tuition costs directly to the college. The amounts are treated as a gift, so for purposes of
claiming an education credit, either Natalia or Raul can be treated as receiving the gifted money, and
paying for the qualified tuition and related expenses. If Natalia claims Raul as a dependent, she can
claim an education credit. Alternatively, if Raul’s mother cannot claim him as a dependent, Raul can
claim the credit.174
A taxpayer cannot claim both the American Opportunity Credit and the Lifetime Learning Credit
for the same student in one year. However, if a taxpayer incurs education expenses for multiple
students, the taxpayer may be eligible to take the American Opportunity Credit for one student and the
Lifetime Learning Credit for another student on the same tax return.
Example: Armando is 49 and pays college expenses for himself and his dependent daughter, Sarah,
age 18. Armando is attending graduate school to earn his doctorate degree. Armando qualifies for the
Lifetime Learning Credit. Sarah is an undergraduate student in her first year of college. She qualifies
for the American Opportunity Credit. Armando can take both credits on his tax return for each eligible
student—Sarah and himself.
Qualified education expenses include tuition and related fees, textbooks and other course materials
required as a condition of enrollment. Any course involving sports, games, or hobbies is not a
qualifying expense unless the course is part of the student’s degree program (or if taken to improve job
skills, in the case of the Lifetime Learning Credit). Tuition expenses are reported to the student on
Form 1098-T, Tuition Statement, issued by the school.

174Example from Publication 4491, under the section for “education expenses.”
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Qualified education expenses must be reduced by the amount of any tax-free educational
assistance received, such as Pell grants, tax-free portions of scholarships, and employer-provided
educational assistance.
Example: Casper is age 26 and an Air Force veteran who receives the GI Bill. His total college tuition
and textbooks cost $8,900 for the year. He receives $4,000 of his GI Bill to help cover his tuition. He
also receives a gift of $1,900 from his mother to help pay for his textbooks. Casper’s qualified higher
education expenses for the purposes of calculating an education credit are $4,900 ($8,900 - $4,000)
because his veterans’ assistance benefits must be subtracted. The gift from his mother does not have
to be subtracted.
Certain college expenses cannot be used to claim an education credit, such as: the cost of room and
board (even if on-campus housing is required by the college), medical fees (including student health
fees), insurance expenses, transportation costs (like bus fare or on-campus parking fees), and any
other personal, living, or family expenses.

Example: Blakely is an undergraduate student attending Chico State University in California. She
received Form 1098-T, Tuition Statement. It shows that her tuition was $8,100 and that she received a
$1,500 tax-free scholarship. She also paid an additional $800 for required textbooks, which was not
reported on the Form 1098-T. Blakely’s maximum qualifying expenses for an education credit is $7,400
([$8,100 + $800] - $1,500 scholarship).
Example: Everly is 27 years old and single. She is a graduate student attending Fayetteville State
University, NC. She paid $9,200 for tuition and $7,000 for room and board at the university. She was
awarded a $5,000 tax-free tuition scholarship. She also applied for a $4,000 student loan. To qualify
for an education credit, she must first subtract the tax-free scholarship from her tuition, her only
qualified expense. Everly has $4,200 of qualified educational expenses ($9,200 tuition - $5,000
scholarship). The student loan is not considered in this calculation, because it must be paid back.

American Opportunity Tax Credit (AOTC)

The American Opportunity Tax Credit (also referred to as the AOTC or AOC) allows taxpayers to
claim a maximum credit of up to $2,500 for each eligible student. The credit covers 100% of the first
$2,000 and 25% of the second $2,000 of eligible expenses per student. Qualified expenses include
tuition and required fees, books, supplies, equipment, and other required course materials (but not
room and board or student health fees).
Example: Efren is a junior in college studying to be a mechanic. He pays $6,500 in tuition to his college.
This year, in addition to tuition, he pays a $550 fee to the school for the rental of the automotive
equipment he is required to use in his training program. Efren’s equipment rental fee is also a qualified
education expense.

The American Opportunity Tax Credit has a refundable portion. Up to 40% of the credit can be
refunded, allowing taxpayers to receive a maximum of $1,000 even if they do not owe any tax. To
qualify for the AOTC, students must meet these requirements:

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• Degree requirement: The student must be enrolled in a program that leads to a degree,
certificate, or other recognized educational credential. Taking classes merely for recreation or
personal interest will not qualify.
• Minimum course load: The student must be enrolled at least half-time for at least one
academic period beginning in the tax year.
• No felony drug conviction: The student cannot have any felony convictions for possessing or
distributing a controlled substance.
• Four years of postsecondary education: The credit can be claimed only for expenses related
to a student’s post-secondary education and only for a maximum of four years.

Example: Celeste has not yet completed her first bachelor’s degree, but it took her five years to get all
the credits she needed to graduate. She expects to graduate with her bachelor’s degree on December
19, 2024. Celeste properly claimed the American Opportunity Tax Credit in 2020, 2021, 2022, and
2023. Since the credit has already been claimed for the first four years of her undergraduate education,
she cannot claim the AOTC on her 2024 return. She may be able to claim the nonrefundable Lifetime
Learning Credit for the tuition costs that she incurred, instead.
For 2024, the AOTC phases for unmarried taxpayers with MAGIs between $80,000 and $90,000
($160,000 -$180,000 MFJ). Taxpayers who file MFS cannot claim the credit.
Example: Bella, age 26, and Callen, age 33, are married and always file jointly. Bella is a full-time
student working towards her first bachelor’s degree. Bella incurs $13,000 in qualifying tuition
expenses during the year. Callen works full time and has $220,000 of taxable income. Their joint AGI
is over the phaseout threshold, so they cannot claim the American Opportunity Credit. They are
phased-out because of their high income level.
Note: Taxpayers claiming the American Opportunity Credit must have a valid taxpayer identification
number by the due date of the tax return (including extensions). Further, the student claimed for the
credit must also have a valid identification number by the due date (including extensions). Taxpayers
cannot file an amended return to claim the credit for a year that the taxpayer and/or student did not
originally have a valid identification number by the return due date.

If a student does not meet all the conditions for the American Opportunity Tax Credit, the student
may still qualify to take the Lifetime Learning Credit.
Lifetime Learning Credit
The Lifetime Learning Credit is a nonrefundable tax credit of 20% of qualified tuition, fees, and any
amounts paid directly to the educational institution for required books, supplies, and equipment, up
to $10,000, paid during the tax year. The maximum credit is $2,000 per tax return, not per student. A
family’s maximum credit is the same regardless of the number of qualified students.
The Lifetime Learning Credit is phased out at $80,000-$90,000 for unmarried filers and $160,000–
$180,000 for joint filers. Taxpayers who file Married Filing Separately cannot take the credit. The
requirements for the Lifetime Learning Credit differ from those for the AOTC as follows:

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• No degree or workload requirement: There are no specific degree or workload requirements
for eligibility. Part-time students can also qualify, and non-degree courses are eligible. A
student who is taking a course merely to enhance their job skills is eligible.
• All levels of postsecondary education: A student may be an undergraduate, graduate, or
professional degree candidate. The courses can also be just for professional development.
• An unlimited number of years: There is no limit on the number of years for which the credit
can be claimed for each student.
• Felony drug convictions permissible: A student can be convicted for a felony drug conviction
and still qualify.

Example: Brent attends Creek Community College after spending twelve months in prison for a felony
cocaine conviction. He paid $4,400 for the course of study, which included tuition, equipment, and
books required for the course. The school requires that students pay for books and equipment when
registering for courses. The entire $4,400 is an eligible education expense under the Lifetime Learning
Credit. Although he meets all the other requirements for the American Opportunity Credit, Brent does
not qualify for the AOTC because he has a felony drug conviction. He may claim the Lifetime Learning
Credit instead.
Example: Karina works full-time as a paralegal at a lawyer’s office. She takes a few night courses at a
local junior college. Some of the courses are not for credit, but she is taking them to advance her
knowledge of her career. She is not pursuing a degree. The education expenses may qualify for the
Lifetime Learning Credit, but not for the American Opportunity Credit, because the Lifetime Learning
Credit does not have a degree requirement.

Earned Income Tax Credit (EITC)

The Earned Income Tax Credit (EITC), also commonly known as the Earned Income Credit (EIC), is
a refundable tax credit for lower-income people who work and have earned income and adjusted gross
income under certain thresholds. Taxpayers who claim EITC must have valid Social Security numbers
by the due date of the return (including extensions).175 Refunds for taxpayers claiming the EIC will not
be issued prior to February 15.
There are strict rules176 and income guidelines for the EITC. To claim the EITC, a taxpayer must
meet all of the following tests:
• Have a Social Security number that is valid for employment.
• Have “earned income” from wages, combat pay, or self-employment, etc.
• The investment income limit in 2024 is $11,600. The investment income limitation is now
indexed for inflation.
• Investment income includes: interest payments, dividends, capital gains, and passive rental
income.
• Not be claimed as a dependent by another taxpayer,

175 Taxpayers cannot file an amended return to retroactively claim EIC for any year in which they did not have a valid Social Security

number by the due date of the return (including extensions).

176 Among the EITC rules is a requirement that practitioners make reasonable inquiries to determine that the information the

taxpayer is giving is correct. We cover the due diligence for the EITC, CTC, and other credits in Book 3, Representation.
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• Be a U.S. citizen or legal resident all year (a nonresident alien married to a U.S. citizen or
resident alien filing jointly can still qualify under some narrow circumstances).
• Cannot file Form 2555 (related to the foreign earned income exclusion).

Example: Amadeo is a U.S. citizen with a valid Social Security number. He claims his 18-year old
daughter, Cassandra, as his dependent. His daughter is a full-time student and a qualifying child for
EITC. Amadeo also qualifies for head of household filing status. In 2024, he received $39,500 in interest
and dividends for the year. Amadeo does not work, and he relies on his investments as his main source
of income. Amadeo would not qualify for the EITC because he does not have any earned income. Also,
his investment income exceeds the maximum limits set for the EITC.

Earned Income and AGI Limits

The amount of the credit varies based on a taxpayer’s earnings and how many children are claimed
as dependents on the return. Both a taxpayer’s earned income and their AGI must be less than the
following limits:

2024 Income limits for EITC

Maximum AGI Maximum AGI
Children Claimed (MFJ filers) (All other filing statuses)
Zero (“childless EITC”) $18,591 $25,511
One $49,084 $56,004
Two $55,768 $62,688
Three or more $59,899 $66,819

2024 maximum amount of the EITC:

• No qualifying children: $632 (the “childless EITC”)
• 1 qualifying child: $4,213
• 2 qualifying children: $6,960
• 3 or more qualifying children: $7,830
• Taxpayers whose investment income is more than $11,600 in 2024 cannot claim EITC.

Example: Seren and Gilroy are married and their joint AGI is $59,900 in 2024. Normally, they would
not qualify for EITC because of their income level. However, Seren becomes pregnant at the beginning
of the year, and gives birth to triplets on December 30, 2024. Now Seren and Gilroy have 3 children.
They qualify to claim EITC in 2024, because their AGI is now below the threshold for taxpayers with
three or more qualifying children.
Example: Chelsea is unmarried and is 32 years old. She has one 7-year-old child and files as head of
household. She earns $14,900 in wages during 2024. Her wages would normally qualify her for the
Earned Income Tax Credit, but she also has $11,950 of investment income during the year, from a
passive rental property that she inherited from her grandmother. A taxpayer with $11,600 or more of
investment income in 2024 does not qualify for the EITC, regardless of their earnings, so Chelsea would
not qualify for EITC.
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Qualifying Income for the EITC: Only “earned” income, such as: wages, tips, combat pay, union
strike benefits, and net earnings from self-employment qualifies for the EITC. For EITC purposes,
“earned income” does not include the following income:
• Social Security benefits, Supplemental Security Income (SSI), or welfare payments,
• Alimony (even if taxable to the recipient) or child support,
• Pensions or annuities,177
• Unemployment benefits,
• Inmate wages, including work release programs,
• Income from investments, passive rental activities, or other passive sources.
Income that is excluded from tax is generally not considered earned income for the EITC.
Nontaxable combat pay and qualified Medicare waiver payments are a notable exception. A taxpayer
can choose to include this nontaxable pay in their earned income if it gives them a better tax result.
Example: Roshan and Mandy are married and file jointly. They are both age 27. Mandy does not work;
she stays home and takes care of their 2-year-old daughter. Roshan is on active duty in the military
and served in a combat zone the entire year. He earned $36,900, which can all be excluded as combat
pay. They have no other income. Military personnel have the option of treating excludable combat pay
as earned income for purposes of the EITC. Roshan and Mandy elect to file a return, claiming their
daughter, and treating Roshan’s nontaxable combat pay as earned income to qualify for the Earned
Income Tax Credit. In addition to the EITC, they will also qualify for the refundable Additional Child
Tax Credit. This will produce a nice refund for them.

Qualifying Children for EITC Purposes

The definition of a “qualifying child” for purposes of the EITC is stricter than it is for being able to
claim someone as a dependent. The taxpayer’s qualifying child must meet all the following tests:
• Relationship test
• Age test
• Joint return test
• Residency test
Relationship Test: The child must be related to the taxpayer in one of the following ways:
• Son, daughter, stepchild, eligible foster child, adopted child, or descendant of any of them (for
example, a grandchild), or
• Brother, sister, half-brother, half-sister, stepbrother, stepsister, or descendant of any of them
(for example, a niece or nephew).

Example: Ronan is 37 and financially supports his younger sister, Genevieve, who is age 16 and still in
high school. Ronan has taken care of his sister since their parents died three years ago. She lives with
him all year. Ronan earns $31,900 in wages. Ronan can file as head of household, and Genevieve is
Ronan’s qualifying child. He is eligible for the Earned Income Tax Credit.

177 Although uncommon, some disability retirement benefits qualify as earned income to claim the EITC.
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Example: Barbara’s niece, Aimee, is 22 and attending college full time. Aimee lives with Barbara all
year. Barbara made $30,400 in wages in 2024 and is filing as Head of Household. She is claiming Aimee
as her dependent. Aimee meets the rules for a qualifying child. Barbara can claim the EITC.
Any qualifying child listed on Schedule EIC also must have a valid SSN. An ITIN or an ATIN is not
sufficient for EITC purposes, although in some situations, the parents may still qualify for EITC even if
their child does not have an SSN.
Note: Taxpayers who have valid Social Security numbers can claim the EITC, even if their children do
not have SSNs. In this instance, they would get the smaller credit available to taxpayers without
children (the “childless EITC”). In the past, these filers did not qualify for the credit.
Example: Lupita is a legal U.S. resident with a valid green card. She has an SSN that is valid for
employment. She earned $14,900 in wages in 2024. Lupita’s nephew, Mateo, is 18 years old and has
lived with his aunt all year. Mateo is a citizen of Mexico and does not have a valid SSN, but he does
qualify as a U.S. resident for tax purposes, because he meets the substantial presence test. Mateo has
lived with his aunt continuously since his parents died two years ago, but he only has an ITIN. Lupita
may claim Mateo as a dependent on her tax return, and also claim the EITC for herself. Lupita will
qualify for the smaller “childless EITC,” because Mateo is not a qualifying child for EITC purposes.
A foster child can also be an eligible child for EITC purposes. The child must be placed in the
taxpayer’s home by an authorized placement agency or by the courts in order to be eligible.
Age Test: To qualify for the EITC, the child must be:
• Age 18 or younger,
• A full-time student, age 23 or younger, or
• Any age, if permanently disabled.
In addition, a qualifying child must be younger than the taxpayer claiming them, unless the child
(dependent) is permanently disabled.

Example: Harriet, 40 years old, has never been married and made $40,400 in wages for the year. Her
brother Chester, who is 50 and also unmarried, has lived with her since their parents passed away a
decade ago. Chester has Down’s syndrome and earns $9,100 working in a sheltered workshop for
disabled workers. This income does not count towards Chester’s gross income when determining
dependency. Despite being older than Harriet, and due to his disability, Chester is Harriet’s qualifying
child (not qualifying relative). Harriet can claim Chester as her dependent and file as head of
household. She is eligible for EITC.
Joint Return Test: The qualifying child (dependent) cannot file a joint return with a spouse, except
to claim a refund.
Example: Todd and Sophie are both 18 years old and got married right out of high school. They both
live with Clara, Todd’s mother. Clara supports the young couple and they live in her home. Todd only
had $3,010 of wage income from a part-time job. Neither Todd nor Sophie are required to file a tax
return. Taxes were taken out of Todd’s wages, so Todd and Sophie file a joint return only to get a refund
of the income taxes withheld. The exception to the joint return test applies, so Clara may claim her son
and daughter-in-law as her qualifying children, if all the other tests are met.

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Residency Test: The child must have lived with the taxpayer in the United States for more than
half the year (although there are exceptions to this test for temporary absences). 178 Only a custodial
parent can claim the EITC (or, in the case of another family member that claims the child, the child
must have lived with that family member for more than half the year). A child who was born or died
during the year would meet the residency test for the entire year if the child lived with the parent the
time the child was alive.
Example: Catherine gave birth to a baby girl on March 3, 2024. The infant was born sickly and died
two months later. The child is still a qualifying child for purposes of the EITC because she meets the
other tests for age and relationship.
Example: Cassidy has one son, named Kiernan, who is 18 years old and attends college full-time in
another state. Cassidy provides all her son’s financial support and pays for his tuition. Kiernan lives in
the on-campus dorms and only comes home for the holidays. Cassidy can claim Kiernan as her
qualifying child, and file as head of household. He meets the residency test for EITC purposes because
college attendance is considered a temporary absence.

“Childless EITC”: A taxpayer with a qualifying child can claim the EITC without any age limitations,
but a taxpayer without a child can only claim the EITC if all of the following tests are met:
• Must be between the age of 25 and 65. On a joint return, only one spouse must meet the age
requirement.
• Must not qualify as a dependent of another person
• Must live in the United States for more than half the year.
• Cannot file Form 2555 (related to the foreign earned income exclusion).179

Example: Cornelius is 23 years old. He moved out of his parents’ home three years ago, and lives in his
own apartment. He is unmarried and provides all his own financial support. He is not a student and
has no dependents. In 2024, Cornelius earns $16,000 in wages working in a restaurant. He has no other
income. Even though his income is below the threshold to claim EITC, Cornelius is not eligible for the
credit because he is under the age of 25, and therefore does not meet the age requirement for the
“childless EITC.”
Example: Ruth and Alfred are married and file jointly. They do not have any dependents. Alfred is 67
and Ruth is 60 years old. Ruth works as a church secretary in 2024, earning $16,500 in wages. Alfred
has a small amount of Social Security income, $3,900, in 2024. All of Ruth’s and Alfred’s children are
grown up and they do not have any dependents. Based on their joint AGI, Ruth and Alfred are eligible
for the “childless EITC” in 2024. If all other rules are met, they would qualify for the EITC, because for
a couple filing a joint return, only one taxpayer has to meet the age requirement, and Ruth is under the
age of 65, so they qualify.

178 For purposes of the EITC, U.S. military personnel stationed outside the United States on extended active duty are considered to
live in the U.S. during that duty period, so their children meet the residency test. There are also exceptions for temporary absences,
including: college attendance, vacations, military service, and detention in a juvenile facility.
179 The mere act of earning foreign income would not automatically disqualify a taxpayer from claiming EITC. A taxpayer who elects

not to exclude foreign income from their gross income may still be eligible for the EITC.
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EITC Fraud and Penalties: If the IRS audits a taxpayer’s return and disallows all or part of the
EITC, the following consequences may occur:
• The taxpayer will be required to repay the amount with interest.
• The taxpayer might have to file Form 8862, Information to Claim Earned Income Credit after
Disallowance.
• The taxpayer will not be able to claim the EITC for two years if the error was due to reckless or
intentional disregard of the rules.
• The taxpayer will not be eligible for the EITC for ten years if the error was caused by fraudulent
activity.180
Retirement Savings Contributions Credit (Saver’s Credit)
The credit is 10%–50% of eligible contributions to IRAs and other qualifying retirement plans up
to a maximum credit of $1,000 ($2,000 MFJ), depending on a taxpayer’s adjusted gross income. Eligible
contributions must be made to an IRA or an employer-sponsored retirement plan.181 Form 8880, Credit
for Qualified Retirement Savings Contributions, is used to calculate the amount of the credit.
ABLE account designated beneficiaries may be eligible to claim the Saver’s Credit for a percentage
of their contributions. The amount of the credit is the eligible contribution multiplied by the applicable
credit rate, which is based on filing status and AGI.
Note: In past exams, the IRS referred to this credit as either the “Retirement Savings Contributions
Credit” or the “Saver’s Credit.” Either term may be used on the EA exam since both terms are currently
used on the IRS website and in IRS publications. Do not be confused by this—they are the same credit.
To be eligible for this credit, the taxpayer must fulfill all the following requirements:
1. Be at least age 18 or older;
2. Not be a full-time student; and
3. Not claimed as a dependent on another person’s return.
The income limitations in 2024 are as follows:
2024 Retirement Savings Contribution Credit Phaseouts
Credit Rate MFJ HOH Single, QSS, MFS
50% of the contribution AGI not more than AGI not more AGI not more than
$46,000 than $34,500 $23,000
20% of the contribution $46,001- $50,000 $34,501 - $37,500 $23,001 - $25,000
10% of the contribution $50,001 - $76,500 $37,501 - $57,375 $25,001 - $38,250
No Credit Allowed more than $76,500 more than $57,375 more than $38,250

180 Tax preparers may also face consequences for disallowed credits on their clients’ returns. This can include monetary fines,
suspension or expulsion from IRS e-file, disciplinary action, or even criminal penalties for filing fraudulent returns. Due diligence
requirements for tax preparers are covered in more detail in Part 3, Representation.
181 Eligible contributions include those to both traditional IRAs and Roth IRAs, elective deferrals to 401(k) or other qualified

employer-sponsored retirement plans, and voluntary employee contributions to other qualified retirement plans.
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Most workers who contribute to traditional IRAs already deduct all or part of their contributions.
The Saver’s Credit is in addition to these deductions. In essence, a taxpayer could potentially deduct
their contribution to a traditional IRA, and then also receive the Saver’s Credit in the same year.
Example: Paisley works at a restaurant. She is married and earned $41,000 in 2024. Paisley’s husband,
David, is permanently disabled and did not have any earnings. Paisley contributed $2,000 to her IRA
for the year. After deducting her traditional IRA contribution, the adjusted gross income shown on her
joint return is $39,000. Paisley may claim the maximum 50% Saver’s Credit of $1,000 for her $2,000
IRA contribution on her 2024 tax return.
Example: Alonzo is 24 and earns $39,500 during the year. He is single and contributes $3,000 to his
401(k) plan at work. Alonzo is not eligible for the Retirement Savings Contribution Credit because his
income exceeds the threshold limit for single filers.
Example: Edith works at a grocery store. She is married and earned $36,000 in wages during 2024.
Edith’s husband, Anthony, is on a religious sabbatical and didn’t have any earnings for the year. Edith
contributed $1,000 to her traditional IRA during the year. After deducting her IRA contribution, the
adjusted gross income shown on their joint return is $35,000. Edith may claim a 50% Retirement
Savings Contribution Credit, or $500, for her $1,000 IRA contribution.
Example: Rory works as a cashier at a retail store. He is married and earned $31,000 in wages during
the year. Rory’s wife, Natasha, has a part-time job at a pet food store. She earned $8,000 in wages. Their
combined wage income is $39,000 ($31,000 + $8,000) before making any IRA contributions. Rory
contributes $1,000 to his traditional IRA for 2024, and Natasha contributes $1,000 to her IRA. After
deducting their IRA contributions, their adjusted gross income is $37,000 ($39,000 wages - $2,000 IRA
contributions). Rory and Natasha may claim a 50% Saver’s Credit ($2,000 contributions × 50% =
$1,000 credit). Their allowable credit is $1,000 on their jointly-filed return.
However, when figuring the credit, taxpayers generally must subtract the amount of distributions
received from their retirement plans:
• In the two years before the year the credit is claimed;
• The year the credit is claimed; and
• The period after the end of the credit year but before the due date, including extensions, for
filing the return for the credit year.
Also, note that foreign income cannot be included in the taxpayer’s adjusted gross income to
calculate this credit. This credit is claimed on Form 8880, Credit for Qualified Retirement Savings
Contributions.
Credit for Excess Social Security and RRTA Tax Withheld
This credit is for workers who overpay their tax for Social Security, which usually happens when
an employee is working two jobs, and both employers withhold Social Security tax. Each year, a limit
is set as to how much Social Security tax an individual should have withheld from his earnings.
If the taxpayer’s withholding for Social Security tax exceeds the annual maximum, the taxpayer can
request a refund of the excess amount (the maximum earnings subject to Social Security tax is
$168,600 in 2024). This also applies to overpaid Railroad Retirement taxes. This credit is fully
refundable. If a single employer overwithheld too much social security (or RRTA tax), that is the
employer’s error and the employer should adjust the excess for the employee.
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Example: Zachary is a medical doctor. In 2024, he works for two different hospitals as an employee.
His first employer pays him $120,000 in wages during the year. The second hospital pays him $50,000.
His total wages were $170,000, and the entire amount was subject to Social Security tax, because each
of his employers is required by law to withhold Social Security tax from the entire amount. His total
wages for the year exceed the 2024 Social Security contribution limit of $168,600. When Zachary files
his tax return, his overpayment of Social Security tax is calculated automatically by his software, by
adding up the combined Social Security tax withheld from all his wages. He will receive a credit for any
overwithheld amounts.
If a single employer refuses to refund the over-collection, the employee can file a claim for refund
using Form 843, Claim for Refund and Request for Abatement.
Example: Grover works for a large corporation. He typically earns a $175,000 salary. In the middle of
the year, he is transferred to a new location, and the human resources department accidentally
registers him as a new employee, rather than a transferred employee. As a result, Grover gets two Form
W-2’s from the same employer. Both his W-2 forms show withheld Social Security taxes. He doesn’t
notice the issue until late April, and when he contacts his employer for a refund of the excess FICA
taxes withheld, the company refuses to correct the issue, saying that it is too late. Since Grover’s
employer would not correct the error, he can file Form 843 with the IRS to claim a refund, along with
copies of his two Form W-2s.

Individual Energy Credits

In an effort to promote the adoption and utilization of renewable energy by individuals, Congress
implemented several personal energy credits. Below is a brief explanation of the four types of
renewable-energy credits available for 2024.
A taxpayer may not claim these credits until the year the property is installed or, in the case of a
vehicle, in the year the vehicle is received. The residence credits are claimed on Form 5695, Residential
Energy Credits, while the vehicle credits are claimed on Form 8936, Clean Vehicle Credits.
Residential Clean Energy Credit
This credit is available for property installed on a taxpayer’s main home (generally where one lives
the majority of the time), on either an owned or rented home. This credit was previously named the
“Residential Energy Efficient Property Credit.” Qualified improvements include: solar panels, solar
water heaters, wind turbines, geothermal heat pumps, fuel cells, and battery storage technology. The
credit is equal to 30% of the costs for new energy property (including certain labor and installation
costs) installed in 2024. Taxpayers may claim this energy credit for:
• Solar panels, wind turbines, and geothermal power generation equipment
• Solar water heaters
• Fuel cells
• Battery storage
The Residential Clean Energy Credit can be applied to new construction. There are no annual or
lifetime dollar limits, except for fuel cell property, which has specific limitations. The adjusted basis of
the property installed is reduced by the amount of the credit.

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Example: Dante owns a home in Texas and decided to install solar panels and a geothermal heat pump
in 2024 to make his home more energy-efficient. He spent $15,000 on the solar panels and $6,000 on
geothermal power equipment. Both installations were completed and operational by December 15,
2024. The solar panels and geothermal power equipment both qualify for the Residential Clean Energy
Credit at a rate of 30% of the cost. The maximum credit on the solar panels is $4,500 (30% × $15,000).
The maximum credit on the geothermal equipment is $1,800 (30% × $6,000). Dante adds the credits
for both installations: $4,500 (solar panels) + $1,800 (geothermal heat pump) = $6,300. When filing
his taxes for the year, Dante uses Form 5695 to claim the residential energy credits.
Example: In 2024, Jamila decides to make her primary residence more energy-efficient by installing
solar panels. The panels were installed and operational during the year. The solar panels cost $18,000,
including installation costs. The Residential Clean Energy Credit allows her to claim 30% of her total
qualified expenses, allowing her a credit of $5,400 ($18,000 × 30%).
Individual taxpayers may claim the Residential Clean Energy Credit regardless of income level, but
the credit is nonrefundable. A taxpayer can carry forward any unused credit and apply it to reduce
their tax in future years.
Energy Efficient Home Improvement Credit
This credit was previously named the “Nonbusiness Energy Property Credit.” Qualified
improvements include: home insulation materials, exterior doors, windows, skylights, central air
conditioners, water heaters, furnaces, boilers, heat pumps, biomass stoves, and home energy audits.
The credit is equal to 30% of the total improvement expenses, up to the following annual limits:
• $1,200 per year for energy efficient property and energy efficient home improvements.
Installation and labor costs do not qualify for this part of the credit
o Exterior doors (30% of costs up to a maximum credit of $250 per door, up to a total of
$500);
o Exterior windows and skylights (30% of costs up to a maximum credit of $600); and
o Insulation materials and air sealing materials or systems (30% of costs).
o Home energy audits, which must include an inspection of the taxpayer’s main home
located in the U.S. (includes renters) and written report by a Qualified Home Energy
Auditor (30% of costs up to a maximum credit of $150).
o Other Qualifying property: Residential energy property installed in a home located in
the U.S. and used as a residence by the taxpayer, including renters and second homes
(30% of costs, including labor, up to a maximum credit of $600 for each of these four
line items) satisfying the energy efficiency requirements:
▪ Central air conditioners;
▪ Natural gas, propane, or oil water heaters;
▪ Natural gas, propane, or oil furnaces and hot water boilers; and
▪ Improvements to or replacements of panelboards, sub-panelboards,
branch circuits, or feeders.
• $2,000 per year for qualified heat pumps, water heaters, biomass stoves or biomass
boilers.

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There is no lifetime limit for the credit, so it could potentially be claimed several years in a row.
The credit is nonrefundable, and the taxpayer cannot carryover any excess credit to future tax years.
To receive the Energy-Efficient Home Improvement Credit, the property must be installed in an
existing residence in the United States; some categories of property are limited to the primary
residence only. Newly-constructed homes do not qualify. The adjusted basis of the property installed
is reduced by the credit.
Example: In 2024, Adeel installed energy-efficient windows on his main home for a total cost of
$2,200. The windows met the necessary energy efficiency requirements to qualify for a credit. 30% of
the $2,200 of expenditures for windows is $660, but the Energy Efficient Home Improvement Credit
imposes a $600 annual limit for windows and skylights. Thus, Adeel’s expenditures for windows will
tentatively qualify him to claim a credit of $600.
Example: Delphine installed a new central air conditioner in her home for $5,000. 30% of the $5,000
cost paid for the central air conditioner is $1,500, but a $600 per-item limit for the air conditioners
applies, to limit Delphine’s credit for this expenditure to $600. She also installed insulation materials
at a cost of $4,200. 30% of the $4,200 cost paid for the insulation materials is $1,260. Adding these
credit amounts yields a sum of $1,860 ($600 + $1,260). However, the aggregate annual limit of $1,200
applies, so this will limit Delphine’s total energy efficient home improvement credit to $1,200 for the
year.

Clean Vehicle Credit

The Clean Vehicle Credit provides a nonrefundable credit as an incentive to buy new electric
vehicles for primary use in the United States. The credit is either $3,750 or $7,500, depending on
whether the vehicle meets the critical minerals requirement ($3,750), the battery component
requirement ($3,750), or both ($7,500). The taxpayer claims the credit in the tax year they receive the
vehicle. Here are the key elements to claim this credit:
• The final assembly of the vehicle must occur in North America.
• The manufacturer’s suggested retail price cannot exceed $55,000, or $80,000 for a pick-up
truck, SUVs, or van.
• The taxpayer’s modified adjusted gross income cannot exceed $300,000 MFJ/QSS, $225,000
HOH, or $150,000 single/MFS. The taxpayer uses the lesser of their MAGI in the current or prior
tax year when determining eligibility.
Starting in tax year 2024, a taxpayer can elect to transfer their credit to the dealer at the time of
purchase. If they choose to make this election, the credit is not limited by their tax liability, effectively
making the credit refundable. The taxpayer will recapture the credit on their tax return if they made
the election but are not eligible for the credit (e.g., their income is too high).

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Example: In July 2024, Joshua purchased a Tesla Model 3 Long Range All-Wheel Drive vehicle for
$54,999 (which is below the $55,000 MSRP limit). Per the federal government’s website, the vehicle
qualifies for a $7,500 credit:182

Joshua elects to transfer the credit to the dealer at the time of sale and gets a $7,500 price reduction.
He receives a “time of sale report” from the dealer, which is necessary to complete his 2024 tax return.
Joshua takes this report to his enrolled agent, Marian, who completes Form 8936, Clean Vehicle Credit,
with the seller’s report to determine Joshua’s eligibility for the credit and to report that it was
transferred to the dealer at the time of sale. Form 8936 must be attached and submitted with his Form
1040.

Used Clean Vehicle Credit

The Used Clean Vehicle Credit provides a nonrefundable credit as an incentive to buy used electric
vehicles. The credit is the lesser of 30% of the cost, or $4,000. The taxpayer claims the credit in the tax
year they receive the vehicle. Here are the key elements to claim this credit:
• The vehicle must be purchased from a dealer at a cost of $25,000 or less.
• The vehicle must meet certain battery requirements.
• The vehicle year must be at least two years earlier than the current year.
• The taxpayer’s modified adjusted gross income cannot exceed $150,000 MFJ/QSS, $112,500
HOH, and $75,000 single/MFS. The taxpayer uses the lesser of their MAGI in the current or
prior tax year when determining eligibility.
Like the Clean Vehicle Credit, starting in tax year 2024, a taxpayer can elect to transfer Used Clean
Vehicle Credit to the dealer at the time of purchase. If they choose to make this election, the credit is
not limited by their tax liability, effectively making the credit refundable. The taxpayer will recapture
the credit on their tax return if they made the election but are not eligible for the credit (e.g., their
income is too high).

182Image and vehicle information from U.S. Department of Energy and the U.S. Environmental Protection Agency website for
Federal Tax Credits for New Plug-in Electric and Fuel Cell Electric Vehicles: https://fueleconomy.gov/feg/tax2023.shtml
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Unit 14: The ACA and the Premium Tax Credit

For additional information, read:
Publication 5187, Health Care Law: What’s New for Individuals and Families
Publication 974, Premium Tax Credit (PTC)

The Affordable Care Act (ACA)183 is a comprehensive health care reform law first enacted in March
2010. The IRS administers the Affordable Care Act tax provisions. The Tax Cuts and Jobs Act
permanently eliminated the penalty under the Affordable Care Act’s individual mandate (i.e., the
penalty for an individual for failing to have health insurance). 184
However, even though the individual healthcare penalty has been reduced to $0, most of the other
Marketplace provisions are still active. Taxpayers can still purchase health insurance through the
Marketplace and receive the Premium Tax Credit (PTC), which is designed to cover a percentage of
their health insurance costs. This credit is essentially a subsidy.
Taxpayers can receive the Premium Tax Credit in advance to lower their monthly insurance
payments when they enroll in a Marketplace plan. The amount of Advance Premium Tax Credit (APTC)
received by consumers is based on their estimated annual household income.
However, if taxpayers underestimate their annual income and receive more APTC than they are
eligible for, they will have to repay all or some of the credit when filing their federal tax return for that
year. This repayment amount is referred to as “excess APTC” and is the difference between the
taxpayer’s advance credit payments and the premium tax credit they are entitled to for that year. For
2024, the repayment caps range from $400 to $3,150, depending on the taxpayer’s income and filing
status.

2024 Repayment Caps for APTC

Income (as % of the federal
poverty line) Single Filers All other filing statuses
Under 200% $375 $750
200%-299% $950 $1,900
300%-399% $1,575 $3,150
400% and above No limit (full repayment) No limit (full repayment)

The Inflation Reduction Act extended larger PTCs to qualifying households through the 2025 plan
year. The law extends eligibility to taxpayers with household income above 400% of the federal
poverty line and lowers premium contribution percentage at all levels of household income.
The two taxes that were instituted to help fund the ACA are the Additional Medicare Tax and the
Net Investment Income Tax. Both of these taxes will be covered in this unit.

183 The actual name of the health care law is the “Patient Protection and Affordable Care Act,” often shortened to the Affordable
Care Act, or ACA.
184 Some states have their own individual health insurance mandate, requiring taxpayers to have health coverage or pay a fee with

the state.
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Note: In this book, we will cover the ACA from the individual taxpayer’s perspective. The ACA from the
employer’s perspective is covered in detail in Book 2, Businesses. All of the employer-shared
responsibility provisions remain in place, which means that employers with 50 employees or more
must offer qualifying health coverage to their employees or face the prospect of severe penalties.

Premium Tax Credit

The Premium Tax Credit is a refundable federal tax credit to help eligible taxpayers pay for health
insurance premiums. The credit is based on a taxpayer’s income and is only available for taxpayers
who purchased their insurance through a federal or state healthcare exchange. There are two ways to
get the Premium Tax Credit:
1. If the taxpayer qualifies for advance payments of the Premium Tax Credit, they can choose to
have the amounts paid directly to the insurance provider to help cover their monthly insurance
premiums. This is also called the “Advance Premium Tax Credit” (APTC) because the taxpayers
receive the credit in advance to lower their monthly health insurance premiums.
2. The taxpayer can choose to pay full price for their insurance through the Marketplace, then
receive the PTC as a refundable credit on their individual tax return.
The amount of the Premium Tax Credit is based on a sliding scale, so the higher the household
income, the lower the amount of the credit.
Note: The Premium Tax Credit is only available to taxpayers who purchase their insurance from the
federal exchange (i.e., the “Healthcare Marketplace”);185 it is not available to taxpayers who obtain
insurance through their employer, or purchase their health insurance directly from an insurance
provider.

To be eligible for a Premium Tax Credit or the Advance Premium Tax Credit, a taxpayer must
generally meet all of the following requirements:
• Purchase health insurance through the Healthcare Marketplace,
• Be a U.S. citizen or legal U.S. resident,
• Be unable to get coverage from an employer or the government (i.e., cannot be enrolled in
Medicare, Tricare, Medi-Cal, or Medicaid),
• Not be claimed as a dependent on anyone else’s tax return,
• If married, the couple must generally file a joint tax return. 186 Taxpayers who file separate
returns will not qualify for the credit, although some exceptions exist.
• The taxpayer must meet certain household income requirements. For purposes of the Premium
Tax Credit, a taxpayer’s household income is the total of the taxpayer’s modified adjusted gross
income (MAGI), the taxpayer’s spouse’s MAGI (if filing jointly), and the MAGI of all dependents
that are required to file a federal income tax return.

185 The Health Insurance Marketplace, also called simply the Marketplace, is the place where you will find information about private

health insurance options, purchase health insurance, and obtain help with premiums and out-of-pocket costs if you are eligible.
The Department of Health and Human Services (HHS) administers the requirements for the Healthcare Marketplace.
186 In the case of married taxpayers who file separately (MFS), certain eligibility exceptions exist for victims of domestic abuse or

spousal abandonment.
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Example: Ambrose and Vidalia are married and file jointly. They have two dependent children. Vidalia
works part-time and does not receive health insurance through her employer. Ambrose was
unemployed at the beginning of 2024 before starting a new job on April 20, 2024. His employer-
sponsored health insurance started on May 1, 2024. From January through April, the family purchased
health insurance through the Marketplace. Ambrose and Vidalia can claim the Premium Tax Credit for
the four months that they had Marketplace coverage, assuming they meet the income guidelines.
If a worker voluntarily enrolls in an employer-sponsored plan, (including retiree coverage or
COBRA coverage), the worker is not eligible for the premium tax credit, even if the employer plan is
unaffordable or fails to provide minimum value. However, the taxpayer may be eligible for a premium
tax credit for coverage of another member of the family who enrolls in Marketplace coverage, if that
family member is not enrolled in an employer plan.
Example: Shelly is single and 32 years old. She works for a small hardware store that does not offer
health coverage, so she obtains her health insurance through the Marketplace. On June 1, 2024, Shelly
started a new job with a bank. The bank offers Shelly full health coverage, including medical and dental.
Shelly enrolled in her new employer’s coverage at the end of June, but she forgot about her Marketplace
policy and did not cancel it. For June through December, Shelly is enrolled in her employer plan as well
as her Marketplace plan at the same time. Since Shelly enrolled in an employer-sponsored plan, she is
not eligible for the PTC for her Marketplace coverage for the months of June through December.
Example: Weston is 45, unmarried, and has one 25-year-old daughter named Debbie. Debbie is a full-
time student and has no income, so Weston claims her as a dependent. Weston is self-employed at the
beginning of the year, and he has a Marketplace policy for himself and his daughter Debbie. On May 5,
2024, Weston gets a full-time job working for a construction firm. The firm offers health insurance to
Weston, but not to his 25-year-old daughter. Weston cancels his Marketplace policy, but he does not
cancel his daughter’s Marketplace coverage. Weston’s income for 2024 is 300% of FPL. He is eligible
for a premium tax credit for the months he was self-employed and did not have employer coverage for
himself. Weston also qualifies for a credit for the full year of his daughter’s coverage, because she is
not enrolled in his employer’s plan and is not eligible for any other health insurance.

Advance Premium Tax Credit and Repayments

When a taxpayer first applies for a Marketplace plan, the amount of the credit is estimated using
information the taxpayer provides about family size and projected household income. Since it can be
difficult to know exactly how much income a taxpayer will earn in any given year, and family
circumstances can change during the year, the actual amount of the credit can vary from the estimated
amount.
Note: A taxpayer who received Advance Premium Tax Credit (APTC) payments must file a tax return,
to reconcile the advance credit payments with the actual Premium Tax Credit earned. This is called
“reconciling” the advance payments of the Premium Tax Credit and the actual Premium Tax Credit the
taxpayer actually qualifies for based on their annual income. The calculation for this reconciliation can
be found on Form 8962, Premium Tax Credit. If an individual received advance payments and files their
taxes electronically without including Form 8962, the IRS will reject their return.

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At the end of the year, if the taxpayer has taken more Premium Tax Credit in advance than they are
due based on their final income, the taxpayer may have to pay back the excess when they file their
federal tax return. If the taxpayer has taken less than they qualify for, they will get the difference back
as a refundable credit when they file their tax return.
Example: Mariano is a self-employed individual whose income varies significantly from year to year.
Upon enrolling in a state exchange health insurance plan, he estimated his earnings for the upcoming
year based on his previous year’s income. Based on his estimated income, he was eligible for the
Premium Tax Credit, which he chose to receive as advance credit payments. However, Mariano’s
business did much better than he expected in 2024, resulting in a higher income than the prior year
and disqualifying him from the Premium Tax Credit. He must reconcile the amounts received through
advance credits using Form 8962, where he discovers that he received $4,000 in excess advance
premium tax credits that he must repay. As he does not qualify for the credit, this amount is added to
his overall tax liability.
If a taxpayer fails to file a tax return to reconcile advance payments of the premium tax credit on
Form 8962, the taxpayer could be prevented from applying for Marketplace premium tax credits in the
following calendar year.
Changes in family size due to marriage, death, divorce, birth, or adoption can affect the amount of
the credit. A taxpayer is supposed to report changes in circumstances to the Marketplace so the amount
of the advance credit payments can be recalculated during the year. A taxpayer should also report
changes in eligibility for government-sponsored or employer-sponsored health coverage, a move to a
new address, an increase or decrease in the number of dependents, and other factors that may affect
eligibility for the Premium Tax Credit.
The IRS may use full collection actions, including levies and liens, against a taxpayer who does not
repay excess advance premium tax credits.
Note: Remember, the Premium Tax Credit is a refundable credit. If the amount of the credit is more
than the amount of the tax liability of the return, a taxpayer may receive the difference as a refund. If
no tax is owed, a taxpayer can receive the full amount of the credit as a refund.
Example: Adelaide was enrolled in a qualified health plan through the Marketplace. She turned 65 on
July 1, 2024, and became eligible for Medicare. Adelaide applied for Medicare in September and
became eligible to receive Medicare benefits beginning on December 1, 2024. Adelaide can get the
Premium Tax Credit for her healthcare coverage that she received from January through November.
Beginning in December, Adelaide cannot get the Premium Tax Credit for her coverage in the qualified
health plan, because she is enrolled in Medicare. She should cancel her Marketplace coverage as soon
as possible.

Important Forms
The IRS has created a group of forms to help handle the employer reporting requirements of the
ACA. Taxpayers who are covered by health insurance will most likely receive one of the forms listed
below. Taxpayers must use the information from these statements when preparing their taxes. The
forms are provided to different groups of people.

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• Form 1095-A, Health Insurance Marketplace Statement: This form is for individuals who enroll
in Marketplace coverage. This form reports basic information about the insurance company
that issued the taxpayer’s policy and the exchange where they are enrolled, and it documents
the taxpayer’s coverage for each month.
• Form 1095-B, Health Coverage: This is for employees or taxpayers whose insurance comes
from a source other than the Marketplace.
• Form 1095-C, Employer-Provided Health Insurance Offer and Coverage: Individuals who work
for applicable large employers will typically get this form (employees will also get this form if
they enroll in self-insured coverage provided by an applicable large employer).
Some taxpayers may receive multiple forms in the same year. For example, if a taxpayer purchased
health insurance through the Healthcare Marketplace at the beginning of the year, and then started a
new job in the middle of the year that offered health coverage, the taxpayer may receive a Form 1095-
A from the Marketplace, as well as Forms 1095-B or 1095-C.
Example: At the start of the year, Ghalib was a self-employed bookkeeper who had purchased his
health insurance through the Healthcare Marketplace. In June he was offered a full-time position at a
law firm that provided group health insurance after 30 days. He quickly signed up for his employer-
provided coverage and cancelled his individual Marketplace policy immediately thereafter. When tax
season arrives, Ghalib received two forms: a 1095-A for the months he had Marketplace insurance and
a 1095-C for the insurance from his employer.

Net Investment Income Tax (NIIT)

One of the many taxes imposed by the Affordable Care Act is the 3.8% Net Investment Income Tax
(NIIT). This tax may apply to individuals, estates, and trusts. For individuals, a 3.8% tax is imposed on
the lesser of: the individual’s net investment income for the year, or any excess of the individual’s
modified adjusted gross income for the tax year over the following thresholds:
Filing Status Threshold Amounts
MFJ or QSS $250,000
MFS $125,000
Single or HOH $200,000

These threshold amounts are not indexed for inflation.

Example: Lamar is single and earned a salary of $175,000 during the year. He also had $19,000 of
income from dividends, for a total MAGI of $194,000. This amount is less than the $200,000 threshold
for single filers, so it doesn’t matter how much investment income Lamar has, he is not subject to the
Net Investment Income Tax.
Example: Irfan is married to Mahira, and they file jointly. Irfan earns $210,000 in wages during the
year. Mahira, his wife, does not work, but she is an avid collector of antique jewelry. In 2024, she sells
an antique gold brooch online for a hefty $45,000 profit. The couple’s joint AGI is $255,000 ($210,000
wages + $45,000 capital gains from the sale of the collectible). This is $5,000 above the threshold for
their filing status ($250,000 for MFJ). They will owe the NIIT on the excess ($5,000 × 3.8% = $190),
since $5,000 is less than their net investment income ($45,000) for the year.
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The NIIT is imposed only on U.S. citizens and U.S. resident aliens. Nonresident aliens are not subject
to the NIIT, even if they have U.S. source investment income. 187 Investment income that is subject to
the tax includes:
• Interest income, unless it is tax-exempt, (like municipal bonds),
• Dividends and capital gains,
• Rental and royalty income (if passive),
• Income from trading of financial instruments or commodities,
• Income from businesses that are passive activities for the taxpayer (such as passive income
from a limited partnership interest).
To the extent that gains are not otherwise offset by capital losses, the following are common examples
of income that is included in computing a taxpayer’s net investment income:
• Capital gains from the sale of stocks, bonds, and mutual funds,
• Capital gain distributions from mutual funds,
• Gains from the sale of real estate, collectibles, or other capital assets,
• Gains from the sale of interests in partnerships and S corporations, to the extent the partner or
shareholder was a passive owner.
Net investment income does not include earned income or pension income. The NIIT does not
apply to: wages, self-employment income, Social Security benefits, veterans’ benefits, unemployment
compensation, taxable alimony payments, or distributions from IRAs or certain qualified retirement
plans.
Example: Adara is single and earned a salary of $175,000 for the year. She also received $80,000 of
dividend income, for a total MAGI of $255,000, which exceeds the threshold for single filers by $55,000.
The NIIT is based on the lesser of $55,000 (the amount by which her MAGI exceeds the threshold for
single filers) or $80,000 (her total “net investment income”). Adara owes NIIT $2,090 ($55,000 × 3.8%
= $2,090).
Example: Wahid is unmarried. In 2024, he earns $180,000 of self-employment income, and $99,000
in passive income from a limited partnership interest. He also has ($9,000) in losses from a residential
rental for the year. The rental loss is netted against the passive partnership income, and Wahid’s
modified adjusted gross income is $270,000 ($180,000 + [$99,000 - $9,000]). His income exceeds the
threshold for his filing status by $70,000. His Net Investment Income (NII) is $90,000. The Net
Investment Income Tax is based on the lesser of (1) $70,000 (the amount that Wahid’s MAGI exceeds
the $200,000 threshold for single filers) or (2) $90,000 (his investment income). Wahid will owe NIIT
of $2,660 ($70,000 × 3.8%).
The NIIT does not apply to any gains or investment income that is excluded from gross income for
regular income tax purposes. For example, municipal bond interest is exempt from federal tax, so it is
not included in the calculation for the NIIT.

187A dual-status alien, who is a resident of the United States for part of the year and a nonresident alien for the other part of the
year, is subject to the NIIT only with respect to the portion of the year during which the individual is a United States resident. The
threshold amount is not reduced or prorated for a dual-status resident.
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Example: Tavish is age 34 and claims his 64-year-old mother, Moreen, as his dependent parent. Tavish
qualifies to file as head of household. In 2024, Tavish has $395,000 of wage income and $40,000 of
interest income. All his interest income is from municipal bonds. Although his total income is $435,000
for the year, he is not subject to the NIIT, because all his investment income is from tax-exempt
municipal bonds.
Net investment income also does not include any gain on the sale of a personal residence that is
excluded from gross income (such as the Section 121 exclusion on the sale of a main home).
Example: Deborah is single. She earns $45,000 in wages during the year. In 2024, she sells her main
home that she has owned and lived in for the last 10 years. The sale price was $1 million, and Deborah’s
cost basis in the home was $600,000. She is allowed to exclude $250,000 of the gain under section 121.
$1,000,000 sales price - $600,000 basis = $400,000 realized gain
$400,000 - $250,000 section 121 exclusion = $150,000 recognized gain
$45,000 wages + $150,000 recognized gain = $195,000 MAGI
After subtracting her allowable exclusions, her modified adjusted gross income is $195,000, which is
below the threshold amount of $200,000, so she does not owe any Net Investment Income Tax.
A gain from the sale of a second home, rental property, or a vacation home would not be eligible
for section 121 exclusion and therefore, would be subject to the NIIT.
Example: Brandon and Christine are married and file jointly. Brandon earns $75,000 in wages for the
year, and Christine does not work or have any earned income. In 2024, Brandon and Christine also
have $225,000 of capital gains from selling their vacation home. None of the gain from the sale of the
home can be excluded from income. After adding in the wages from Brandon’s job, their joint modified
adjusted gross income is $300,000 ($75,000 wages + $225,000 in capital gains). Their MAGI exceeds
the threshold amount by $50,000 (the threshold is $250,000 for joint filers). Brandon and Christine
are subject to NIIT on the lesser of $225,000 (their Net Investment Income) or $50,000 (the amount of
their modified adjusted gross income that exceeds the $250,000 MFJ threshold). Brandon and
Christine owe Net Investment Income Tax of $1,900 ($50,000 × 3.8%).
Example: Ruskin is unmarried and earns $180,000 in wages. He also earned $90,000 in capital gains
from selling a plot of land. Ruskin’s modified adjusted gross income is $270,000 ($180,000 + $90,000).
Ruskin’s modified adjusted gross income exceeds the threshold of $200,000, so he will owe Net
Investment Income Tax. Ruskin’s investment income is $90,000 for the year (the capital gains). His
NIIT is based on the lesser of $70,000 (the amount that Ruskin’s modified adjusted gross income
exceeds the $200,000 threshold) or $90,000 (his investment income). Ruskin owes NIIT of $2,660
($70,000 × 3.8%).
Investment interest expense can be deducted to determine gross investment income, which is used
to arrive at net investment income. The NIIT is subject to estimated tax provisions, so taxpayers may
need to adjust their withholding or estimated payments to avoid underpayment penalties. Individuals,
estates, and trusts must compute the tax on Form 8960, Net Investment Tax.

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Example: Aster, a single filer, typically earns approximately $200,000 in wages during the year. Wages
are not subject to the NIIT. However, he plans to sell a large block of cryptocurrency during the year,
and he knows that his normal withholding will not cover the additional tax from the cryptocurrency
sale. Aster can request that his employer increase his withholding by filling out a new Form W-4,
Employee’s Withholding Certificate. This way, additional taxes will be taken out with each paycheck.
Aster can also choose to make estimated payments directly to the IRS to cover the additional taxes that
he anticipates to owe.

Additional Medicare Tax

The Additional Medicare Tax was also legislated to help fund the Affordable Care Act. The tax only
applies to earned income, like wages. The Additional Medicare Tax is withheld at a rate of 0.9% and
computed on Form 8959, Additional Medicare Tax. The tax is assessed only on earned income in excess
of the following thresholds:
Filing Status Threshold Amounts
MFJ $250,000
MFS $125,000
Single, HOH, or QSS $200,000

Filing status determines the threshold amount, and these thresholds are not adjusted for inflation.
A taxpayer’s earned income (including wages, taxable fringe benefits, bonuses, tips, commissions, and
self-employment income) that is subject to regular Medicare tax is also subject to the Additional
Medicare Tax to the extent it exceeds the applicable threshold amount for their filing status.
Unlike regular Medicare taxes, there is no “employer share” of the Additional Medicare Tax. Self-
employed taxpayers also cannot deduct one-half of the 0.9% Additional Medicare Tax. It is imposed
entirely on the employee (or the self-employed taxpayer). An employer is required to withhold the
Additional Medicare Tax if an employee is paid more than $200,000, regardless of an employee’s filing
status or whether the employee has wages paid by another employer. The Additional Medicare Tax
applies, even if the amounts are not withheld from a taxpayer’s wages.
Example: Montgomery and Lucy are married and file jointly. Montgomery earned $120,000 in salary
working as a physician, and Lucy earned $190,000 working as a scientist. Neither of their employers
withholds amounts for the Additional Medicare Tax, because neither earned wages above $200,000.
However, their combined earned income is $310,000, which exceeds the $250,000 threshold for joint
filers by $60,000. Montgomery and Lucy will owe $540 of Additional Medicare Tax on their income tax
return ($60,000 × 0.9% = $540). They must calculate the tax and attach Form 8959, Additional
Medicare Tax, to their tax return.
Example: Vivian is single. She earns $350,000 in wages during the year, all from one employer. The
additional 0.9% tax will be calculated on her earnings above $200,000. This means that $150,000 will
be subject to Additional Medicare Tax ($350,000 wages - $200,000 threshold amount). She will pay
$1,350 in Additional Medicare Tax on her tax return ($150,000 × 0.9% = $1,350). This additional tax
will be withheld from Vivian’s wages automatically by her employer.

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Example: Sasha is unmarried with one dependent son. She files as head of household. She earns
$130,000 in self-employment income from an online business, and $23,000 in wages during the year.
Sasha is not liable for the Additional Medicare Tax because her combined self-employment income and
wages is $153,000, which is less than the $200,000 threshold for her filing status.
Couples who are married and file a joint return must combine all their wages, compensation, or
self-employment income to figure the amount of tax. The next two examples show how marital status
can affect the calculation of the Additional Medicare Tax.
Extended Example #1: David is single and earned $145,000 in wages. Because his earnings are below
the $200,000 threshold for single filers, his company did not withhold any amount for the Additional
Medicare Tax. He also had $85,000 of self-employment income from a side job as a web designer.
David’s total earned income is $230,000, so he will be required to pay Additional Medicare Tax on the
$30,000 of earned income that exceeds the $200,000 threshold. David will owe $270 in Additional
Medicare Tax on his income tax return ($30,000 × 0.9% = $270). He must calculate the tax and attach
Form 8959, Additional Medicare Tax, to his tax return.
Extended Example #2: David gets married on December 31, 2024, to Patty, who only earned $7,000
in wages during the year. Because they are married as of the last day of the year and file jointly, their
threshold for the Additional Medicare Tax is now $250,000. Their combined earned income is now
$237,000, which is below the $250,000 threshold for MFJ. David and Patty do not owe the Additional
Medicare Tax.
If an employer withholds amounts for a married employee who earns more than $200,000, but the
combined earnings of the employee and their spouse are less than the $250,000 MFJ threshold, the
taxpayers can apply the overpayment against any other type of tax that may be owed on their joint tax
return.
Example: Herman and Katherine are married and file jointly. Herman makes $225,000 in wages
during the year. Herman’s employer is required by law to withhold the Additional Medicare Tax on
Herman’s wages (because he earns more than the $200,000 threshold for when mandatory
withholding becomes necessary). Katherine has a small part-time job at a local church. She only earns
$8,000 in wages. When they file their joint return, their combined wages total $233,000, which is under
the threshold amount for joint filers. They do not owe any Additional Medicare Tax. This means that
the Additional Medicare Tax that was withheld on Herman’s paycheck will be treated as an
overpayment on their individual return, and will be applied as an automatic credit against any other
taxes they might owe for the year.

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Unit 15: Additional Taxes and Credits

More Reading:
Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad
Publication 926, Household Employer’s Tax Guide
Publication 514, Foreign Tax Credit for Individuals
Tax Topic 556, Alternative Minimum Tax
Form 5405, Repayment of the First-Time Homebuyer Credit (Instructions)

In this unit, we cover a variety of other taxes and credits, including the taxation and reporting of
foreign income, the “nanny tax,” and the “kiddie tax.” We start with a look at the Alternative Minimum
Tax (AMT).
Alternative Minimum Tax
The Alternative Minimum Tax (AMT) gives an alternative set of rules to calculate an individual’s
taxable income. For this reason, the AMT is sometimes called a “parallel tax” system. Congress adopted
the AMT in 1969 in an attempt to ensure that individuals and corporations paid at least a minimum
amount of tax. What this translates into, is that for some higher-income taxpayers, some deductions
can be disallowed, and certain types of income that might be tax-exempt under the normal income tax
system (like municipal bond interest) may be subject to income tax under the AMT regime. The Tax
Cuts and Jobs Act made a number of significant changes to the individual AMT. First, the AMT
exemption was increased substantially and is now indexed for inflation every year.
The AMT exemption amount for 2024 is $85,700 for those filing as single or head of household,
$66,650 for those filing as married filing separately, and $133,300 for those filing as a qualifying
surviving spouse and couples filing jointly.
AMT exemptions are reduced by 25 cents for every dollar earned once a single or head of household
taxpayer's Alternative Minimum Taxable Income (AMTI) reaches $609,350 or above ($1,218,700 or
above for those filing as a qualifying surviving spouse and married couples filing jointly).
This means that taxpayers who have Alternative Minimum Taxable Income (AMTI) below these
exemption thresholds will not be subject to AMT, regardless of how many tax deductions or credits
they may have. AMT exemption amounts are reduced 25 cents for every dollar the taxpayer’s AMTI
exceeds the phaseout thresholds detailed above. Certain situations may “trigger” the AMT tax. Some
scenarios when a taxpayer may have to pay the AMT tax include:
• Having a high income coupled with high itemized deductions,
• The exercise of incentive stock options,
• A large sale of capital assets that results in long-term capital gains,
• Tax-exempt interest from private activity bonds.
Individual taxpayers compute AMT on Form 6251, Alternative Minimum Tax—Individuals. As
described in the preceding units, federal tax law provides special treatment for certain types of income
and allows deductions and credits for certain types of expenses. These tax benefits can significantly
reduce the regular income tax liabilities for some taxpayers.

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AMT “Tax Preference” Items

The AMT limits the extent to which deductions and credits can be used to reduce the total amount
of income tax paid by higher-income taxpayers. These are called “tax preference” items. When
calculating the AMT, many common items considered in the computation of the regular income tax
liability are either adjusted downward or eliminated entirely.
For taxpayers who itemize, only state and local taxes and foreign income taxes need to be adjusted
when figuring alternative minimum taxable income. In addition, the following tax preference items
may also be eliminated when calculating the AMT:
• Depletion
• Excess intangible drilling costs
• Interest on private activity bonds
• Accelerated depreciation on property placed in service before 1987
• Exclusion of gain on qualified small business stock (QSBS)
Example: Florence is unmarried and files single. She earns a high salary as a physician. She also invests
in a profitable copper mine, for which she receives royalties yearly. Florence had taxable income before
exemptions of $700,000. She also reported $65,000 in depletion deductions from her copper mine
investment on Schedule E. Under the AMT rules, her taxable income must be recalculated without
certain deductions allowed under the regular tax system. Florence’s AMTI is computed by taking her
taxable income before exemptions of $700,000, and adding back the “preference item” of $65,000 in
depletion to arrive at AMTI of $765,000. After applying the AMT rates to the recalculated taxable
income, Florence’s AMT liability is determined to be higher than her regular tax liability. Therefore,
she is required to pay the higher AMT amount instead of the regular tax amount.
The AMT is the excess of the tentative minimum tax over the regular income tax. Thus, the AMT is
owed only if the tentative minimum tax is greater than the regular tax. In general, the tentative
minimum tax is computed by:
1. Starting with AGI minus itemized deductions, if any, for regular tax purposes,
2. Eliminating or reducing certain adjustments and preferences (the exclusions, deductions, and
credits that are allowed in computing the regular tax, such as those mentioned above), to derive
alternative minimum taxable income (AMTI),
3. Subtracting the AMT exemption amount,
4. Multiplying the amount computed in (3) by the applicable AMT rate(s) of 26% and 28%, and
5. Subtracting the AMT Foreign Tax Credit.
The AMT exemption in step 3 is an amount that is deducted from alternative minimum taxable
income before calculating the tentative minimum tax. Most tax preparation software will automatically
compute whether a taxpayer owes the AMT. Taxpayers who received or claimed any of the following
items in the tax year, are required to complete, (but may not necessarily need to file), Form 6251,
Alternative Minimum Tax, Individuals, Estates, and Trusts:
• Accelerated depreciation,
• Stock received through incentive stock options that were not sold in the same year,
• Tax-exempt interest from private activity bonds,

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• Intangible drilling, circulation, research, experimental, or mining costs,
• Amortization of pollution-control facilities or depletion,
• Income (or loss) from tax-shelter farm activities or passive activities.

Credit for Prior Year Minimum Tax

A nonrefundable credit may be available to individuals, estates, and trusts for alternative minimum
tax paid in prior years to the extent that a taxpayer’s regular tax in the current year is greater than
their tentative minimum tax. If applicable, the credit is calculated on Form 8801, Credit for Prior Year
Minimum Tax-Individuals, Estates, and Trusts.
The AMT is caused by two types of adjustments and preferences: “exclusion” items and “deferral”
items. Exclusion items are those that affect only a single tax year and therefore cause a permanent
difference between regular taxable income and alternative minimum taxable income (AMTI).
For individual taxpayers, an example of an “exclusion item” is the deduction for state and local
income taxes. These taxes are never deductible for AMT purposes, and they are added back into AGI in
the calculation of AMTI in the year they are paid. Deferral items are adjustment and preference items,
such as depreciation, that affect more than one tax year.
Because they affect the difference between regular taxable income and AMTI in multiple tax years,
they generally do not cause a permanent difference in taxable income over time. The minimum tax
credit is allowed only for the portion of AMT caused by deferral items, which may generate a credit for
future years.
Note: A taxpayer can only claim the AMT credit in a year when they do not have to pay AMT. In other
words, even though the AMT credit is triggered by the payment of the alternative minimum tax, the
credit is a regular tax credit and a taxpayer cannot use it to offset alternative minimum tax.
Example: Brandon and Stacy are married and file jointly. They are high-income earners, but also have
high itemized deductions on Schedule A. They had an AMT liability in the previous year because their
taxable income exceeded $1.9 million after they exercised some incentive stock options. They use Form
8801 to calculate how much of their AMT was related to that and other deferral items and discover
they have a $112,000 AMT credit. They can use their AMT tax credit to reduce their regular tax, but
they cannot reduce it below the tentative minimum tax amount. Any unused AMT credit balance can
be carried forward and used in a future year.

Kiddie Tax on Investment Income

Years ago, wealthy families could transfer investments to their minor children and save tax dollars
because the investment income would be taxed at the children’s lower rates. Congress closed this tax
loophole, and now investment income earned by dependent children may be taxed at the parent’s rate.
This law became known as the “kiddie tax.”
The kiddie tax never applies to earned income (such as wages or self-employment income); it
applies only to unearned income and investment income, such as interest, dividends, and capital gains
distributions. The kiddie tax also applies to unemployment income. Part of a child’s investment income
may be subject to the kiddie tax if:

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• The child’s investment income is more than $2,600 (in 2024);
• The child is (1) a dependent under age 18, (2) under the age of 19 and does not provide more
than half of their support with their own earned income, or (3) a full-time college student under
age 24 and does not provide more than half of their support with their own earned income;
• The child is required to file a tax return for the tax year; and
• At least one of the child’s parents was alive at the end of the year (if both of the child’s parents
are deceased, then the kiddie tax does not apply, regardless of how much unearned income the
child has).
Remember, the kiddie tax only applies when a dependent child’s investment income exceeds
$2,600 in 2024. The first $1,300 in investment income is tax-free; the second $1,300 is taxed at the
child’s marginal rate. If this unearned income threshold ($2,600 in 2024) is not exceeded, then the
kiddie tax does not apply. If this threshold is exceeded, only the child’s unearned income in excess of
the threshold is subject to the kiddie tax. All the child’s investment income in excess of the kiddie tax
threshold is then taxed at the parent’s tax rate. There are two ways to report the kiddie tax:
• Child’s return: The child can file their own return, and report the tax by attaching Form 8615,
Tax for Certain Children Who Have Unearned Income, to their Form 1040. This is the most
common method.
• Parent’s return: Alternatively, the parents can report their child’s unearned income on Form
8814, Parent’s Election to Report Child’s Interest and Dividends, on their Form 1040, rather than
having the child file a separate return. To use this method, the child can only have income from
interest, dividends, or capital gain distributions. However, if the child’s gross income is $13,000
or more in 2024, Form 8814 cannot be used, and the child must file their own return to report
the income.
Example: Emily Johnson, 16 years old, inherited many investments when her wealthy grandfather
died. She is claimed as a dependent by her parents and does not provide more than one half of her own
financial support. In 2024, Emily received: $5,000 in interest income, $4,500 in qualified dividends,
and $6,000 in capital gain distributions. Her total unearned income is $15,500 in 2024, so her parents
cannot report Emily’s income on their return using Form 8814. Instead, Emily must file her own tax
return and attach Form 8615 to calculate the kiddie tax.

A child’s investment income may also be subject to the net investment income tax, which is
calculated using only the child’s income. However, the NIIT applies only if the child’s net investment
income exceeds the $200,000 threshold for single filers (this scenario would be very rare, and would
only apply if a dependent child had more than $200,000 in taxable income).
Example: Rochelle is 14 years old. Both of her parents died in a car accident three years ago, and she
inherited several valuable investments from them. Rochelle lives with her grandmother, Pearl, all year.
Pearl has sole custody of her granddaughter and claims her as a dependent. Rochelle has $17,600 in
investment income in 2024. Most of this income goes into Rochelle's college savings account. Rochelle
is not subject to the kiddie tax rules because both of her parents are deceased (i.e., she does not have
a living parent). In this case, Rochelle’s income would not be subject to the kiddie tax, even if Pearl
claims her granddaughter as a dependent. Rochelle must file her own tax return, but none of her
income is subject to the kiddie tax.

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Example: Marcus and Renee are married and have a 16-year-old son named Tony. In 2024, Tony
received $3,150 of interest income from a CD his grandmother gave him. Tony does not have any other
taxable income. The first $1,300 of investment income is not taxable. The next $1,300 is taxed at the
10% income tax rate (which is the child’s marginal rate). The remainder, $550, is subject to the kiddie
tax. Tony may choose to file his own tax return and attach Form 8615, or Tony’s parents can choose to
report their son’s income on their joint return by attaching Form 8814.
Example: Javier is a 17-year-old high school student who is claimed as a dependent on his parents’ tax
return. He worked as a pizza delivery driver 10 hours a week and earned $6,200 of wages in 2024. He
also had $2,950 of interest income from a certificate of deposit that his wealthy aunt gave him last
Christmas. Javier is required to file a tax return because his unearned income exceeded the filing
threshold for a dependent, and he is subject to the kiddie tax. If Javier did not have any interest income,
he would not be required to file a return; his investment income is what triggers his filing requirement.
Example: Contessa has a 17-year-old son named Franco. Contessa files as head of household and
claims her son as a dependent. Franco earns $9,300 in wages at a part-time job. He also has an
additional $5,000 in capital gains from the sale of a collectible toy, which he sold at a tidy profit to a
private collector. Franco must file his own tax return and attach Form 8615. Contessa cannot use Form
8814, because Franco has a mix of wages and investment income, plus the total amount of his income
exceeds the maximum threshold to use the Form 8814.
Note: The kiddie tax does not apply to a child who is married and files a joint return with their spouse.
This applies whether the child is a minor, under age 19, or a full-time college student under age 24.
Example: At 19 years old, Angelica is a full-time college student who relies on her parents for financial
support. She received $3,950 in qualified dividends from a mutual fund gifted by her grandfather when
she graduated high school. Because she would normally be claimed as a dependent by her parents, her
investment income would be subject to the kiddie tax. However, during the year, Angelica meets
Harrison, age 26, in one of her college classes. They fall in love and get married on December 15, 2024.
She will file a joint tax return with her new husband. As a result, she is no longer considered a
dependent and is not subject to the kiddie tax.

First-Time Homebuyer Credit Repayment

First-time homebuyers who claimed a special tax credit in 2008189 are required to repay a portion
of the funds received over a 15-year period starting in tax year 2010. The First-Time Homebuyer Credit
took the form of a loan in 2008, and there are still taxpayers who are repaying that loan on their tax
returns (tax year 2024 will be the final year for taxpayers who claimed this credit and are still paying
it back).
A homebuyer who claimed the maximum credit of $7,500 must repay $500 per year as an
additional tax. The repayment amount is entered on Schedule 2, Form 1040.

189The credit was optional and applied to first time home purchases after April 8, 2008, and before July 1, 2009. The repayments
began in 2010 and have a 15 year repayment period.
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Example: Melinda purchased her home in 2008 and claimed the full amount of the First-Time
Homebuyer Credit. She still lives in the home and continues to use it as her main residence. She is
required to pay back her credit in equal yearly installments of $500 over a period of 15 years. When
she files her tax return, the repayment is listed on her Form 1040 (Schedule 2, Line 10) as an additional
tax.
A taxpayer who claimed the credit and sells the home (or who no longer maintains it as their
primary residence, including a conversion to rental property) must complete Form 5405, Repayment
of the First-Time Homebuyer Credit.190
In the case of a sale (including through abandonment or foreclosure), the taxpayer must repay the
credit with the tax return for the tax year in which the sale is completed. The following are exceptions
to the repayment rule:
• Involuntary conversion: If the home is destroyed or condemned, and the taxpayer does not
acquire a new home within the 2-year replacement period, the repayment owed with the
taxpayer’s return for the year in which the 2-year period ends is limited to the gain on the
disposition. The amount of the credit in excess of the gain doesn’t have to be repaid. If the
taxpayer does not have a gain on the involuntary conversion, they do not have to repay any of
the credit, unless they sold the home under threat of condemnation to a related party.
• Transfers incident to divorce: If the home was transferred to a spouse (or ex-spouse as part
of a divorce settlement), the spouse who received the home is responsible for repaying the
credit (regardless of which spouse purchased the home) if none of the other exceptions apply.
• The person who claimed the credit dies: If a person who claimed the credit dies, repayment
of the remaining balance of the credit is not required unless the credit was claimed on a joint
return. If the credit was claimed on a joint return, then the surviving spouse is required to
continue repaying their half of the credit if none of the other exceptions apply.
Example: Giuliana and Arturo purchased a home together in 2008, and claimed the full amount of the
First-Time Homebuyer Credit. They use the home as their primary residence. On December 1, 2024,
Arturo dies. Giuliana must continue repaying half of the credit, but Arturo’s portion of the credit does
not have to be repaid (it is considered forgiven).

Nanny Tax (Tax on Household Employees)

When employing household workers, taxpayers are responsible for paying employment taxes, also
known as the "nanny tax." A worker is deemed an employee if the taxpayer has control over their work
and hours. Examples include babysitters, housekeepers, and chauffeurs. Employers must withhold
Social Security and Medicare taxes if they pay cash wages of $2,700 or more in 2024. If the wages paid
to an employee during the year are less than this threshold, no Social Security or Medicare taxes are
owed.
Individuals who withhold taxes for a household employee are required to file Schedule H, which is
used to report household employment taxes along with their Form 1040. To do so, the employer must

190The repayment is limited to the amount of gain on the sale if the sale is to an unrelated taxpayer. A similar, $8,000 credit was
also available in 2009 and 2010 but did not have to be repaid. A taxpayer who purchased his home and received the credit in either
2009 or 2010 did not have to repay the credit unless the home was sold within a three-year period following the purchase.
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request an employer identification number (EIN). The employer also must file Form W-2, Wage and
Tax Statement, and furnish a copy of the form to the employee (unless wages paid were less than
$2,700 for 2024 and no taxes were withheld).
Example: Vance hires Sally as full-time nanny, to care for his two toddlers while he is at work. Sally
also does housework in his home. Vance sets Sally’s schedule and gives specific directions about
household and childcare duties. Vance also provides all the equipment and supplies Sally needs to do
her work. Sally is Vance’s household employee and subject to the nanny tax rules. Vance must file a
Schedule H.
However, self-employed individuals such as daycare providers who care for multiple children from
different families in their own home are not considered household employees.
Example: Yelena runs a licensed daycare in her own home. Yelena cares for seven children from
different families in her home. Draco brings his 5-year-old son to Yelena’s daycare and pays $600 per
month for ongoing daycare. Yelena is not Draco’s household employee, because she operates her own
daycare business.
Example: Wagner hires Jorge to do weekly yard maintenance and cut his grass. Jorge runs his own
lawn care business called Gonzalez Landscaping Services, and he provides gardening services to many
other commercial and residential clients. Jorge advertises his business online and in the local
newspaper. Jorge provides his own tools and supplies. Jorge is self-employed and not considered
Wagner’s household employee.
Note: An employer is not required to withhold income tax from a household employee’s wages.
However, income tax may be withheld at the employee’s request. Even if the employer is not required
to pay FICA (Social Security and Medicare) taxes, the employee’s wages may be subject to income tax.
Example: Randall is a widowed single taxpayer with infant twin boys. Randall hires Hilda to take care
of his twin boys while he is at work. Hilda usually works Monday through Friday, 9 AM to 6 PM. She is
an experienced nanny, and she also cleans Randall’s home during the day. Hilda is a household
employee. Randall pays Hilda $33,000 in wages during the year. He is required to file Schedule H with
his Form 1040. He must also file a Form W-2 to report the wages he paid to Hilda, and provide her with
a copy of her W-2.
An employer of household employees may need to increase the federal income tax withheld from
their earnings, or make estimated tax payments to avoid an estimated tax penalty resulting from their
liability for employment taxes in connection with household employees, (as shown on Schedule H).
The taxpayer has several options. The employer can:
• Increase federal income tax withheld on other types of income;
• Increase their federal income tax withheld by giving the payor of their Social Security or
pension a new Form W4-P, Withholding Certificate for Pension or Annuity Payments;
• Make estimated tax payments by filing Form 1040-ES, Estimated Tax for Individuals.
Estimated taxes must be withheld or paid as the tax liability is incurred, so employers cannot wait
until they file their tax return (and Schedule H) to pay household taxes owed.

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Wages paid to a taxpayer’s spouse, parent, or child under the age of 21 are exempt from the nanny
tax rules. In that case, the taxpayer would not have to withhold FICA tax.
Example: Geraldine hires her own mother, Enola, to take care of her children during the week. In this
case, since Geraldine has hired her mother, the payments are exempt from the nanny tax rules. No
Social Security and Medicare taxes will be owed by either Geraldine or her mother. No Federal
Unemployment Tax (FUTA) would be owed. However, Enola would owe income tax on the amounts
that she earned, and she would need to report the income on her individual tax return.
A taxpayer cannot claim a household employee as a dependent, even if the employee lives with the
taxpayer all year long.

Section 199A Qualified Business Income Deduction

This provision, also known as the “Section 199A Deduction” or the “QBI deduction,” allows a
deduction of up to 20% of qualified business income for owners of some businesses. The deduction is
available, regardless of whether an individual itemizes their deductions on Schedule A or takes the
standard deduction. This deduction expires after 2025, unless Congress decides to extend it.
The deduction only applies to individuals and estates/trusts who own interests in businesses taxed
as sole proprietorships, partnerships, or S corporations.
Income earned by a C corporation is not eligible for the 199A deduction for its shareholders. The
deduction allows eligible taxpayers to deduct up to 20% of their qualified business income on their
own 1040 (or, in the case of an estate or trust, Form 1041), subject to an overall deduction limit of 20%
of taxable income (less any net long-term capital gains, qualified dividends and any QBI deduction for
the year).
QBI Deduction: Modified Taxable Income Threshold Amounts
For taxpayers with taxable income that exceeds the threshold amounts, the deduction is subject to
two limitations based on the type of trade or business generating the qualified business income. The
two limitations are based on: (1) the amount of W-2 wages paid by the qualified trade or business and
(when applicable) the unadjusted basis immediately after acquisition (UBIA) of qualified property held
by the trade or business, and, as mentioned previously, (2) 20% of the amount of the taxpayer’s
modified taxable income
The modified taxable income thresholds where the W-2 wages (and potentially the UBIA of the
qualified property of the business) come into play are indexed for inflation. In 2024, the modified
taxable income threshold amounts are as follows:
• Married Filing Joint: $383,900 to $483,900
• All other filing statuses: $191,950 to $241,950
The Section 199A deduction only applies to domestic income (U.S. business activities only). Only
taxable income is counted. A taxpayer’s “QBI component” (i.e., the maximum potential QBI deduction)
is generally 20% of the taxpayer’s QBI from qualifying trades or businesses. QBI is the net amount of
qualified items of income, gain, deduction and loss from any qualified trade or business.
Only items included in taxable income are counted. In addition, the items must be effectively
connected with a U.S. trade or business. In other words, the business income must be generated by

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domestic business activity. Items such as capital gains and losses, certain dividends and interest
income are excluded.
Example: Abigail is married and files jointly with her husband, Chester. They take the standard
deduction for the year. Abigail operates a medical billing service as a sole proprietor. Her business has
one employee, a secretary who is paid $50,000 annually. The business has no significant assets. After
figuring out her allowable deductions, Abigail’s business generates $200,000 in net qualified business
income. Chester earns $15,000 in wages during the year. Chester and Abigail’s modified taxable income
(before applying the QBI deduction) is $185,800 ($215,000 AGI - $29,200 standard deduction for MFJ
filers in 2024). Abigail is entitled to a QBI deduction of $37,160. While the tentative QBI deduction is
$40,000 ($200,000 net qualified business income × 20%), they will only be able to claim the lower
$37,160 figure (based on 20% of their modified taxable income) as the actual QBI deduction on their
joint tax return. The wage and UBIA limitations do not apply because Abigail and Chester’s joint
modified taxable income is less than $383,900 in 2024.
“Qualified Business Income,” or QBI, does not include:
• Employee wages, (except wages earned by a statutory employee),
• Reasonable compensation, (i.e., salary, wages) earned by a shareholder-employee of an S
corporation;
• Any guaranteed payment from a partnership for services rendered with respect to the trade or
business;
• Investment income, such as capital gains or interest and dividend income,
• Hobby income,
• Non-taxable income, (such as municipal bond interest)
• Rental real estate income where the real estate activity does not rise to the level of a
trade/business. This does not mean that the taxpayer has to be a “real estate professional” in
order to get the QBI deduction. The rental of real property may constitute a trade or business,
even if the rental activity is reported on Schedule E.
Example: Warren operates three businesses as a sole proprietor. One is a cupcake bakery with
$10,000 in taxable income. The second business is a farming business that has a ($4,000) loss for the
year. The third business is a fishing tour company that operates in Cancun, Mexico. The tour company
has $20,000 in profits. Since the tour company is not a domestic business, that particular income is not
QBI. Based on this information, Warren’s §199A deduction is based on the Schedule C net income from
the bakery and farming businesses of $6,000, ($10,000 - $4,000).
Individuals claim the QBI deduction, so S corporations and partnerships cannot take the deduction
at the entity level. However, all S corporations and partnerships must report each shareholder’s or
partner’s share of QBI on Schedule K-1, so the shareholders or partners may potentially claim the 199A
deduction on their individual tax returns. 191

191 The rules to determine whether or not real estate rental activity rises to the level of a trade/business is complex. However, to
help partially alleviate this issue, the IRS issued guidance that provides a safe harbor where a real estate rental activity will be
treated as a trade/business. In addition to other requirements, the safe harbor provides for trade/business status when a taxpayer
(either themselves, through employees or independent contractors) provides at least 250 hours of qualifying services in the activity
for at least three of the past five years (including the current tax year), or 250 hours every year if the activity has been operated for
less than four years. A number of additional rules apply when a taxpayer owns and rents multiple properties.
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Note: The determination of whether a business qualifies for the 199A QBI deduction occurs at the
entity level. The deduction then “flows through” to the individual owners to be claimed on the
taxpayer’s individual returns. The QBI deduction is listed on the official Prometric test specs, so you
may see a question on this topic on either Part 1 or Part 2 of the exam. The QBI deduction is covered
in more detail from a business’ perspective in Book 2, Businesses.
Eligible individuals may also be entitled to a special deduction of up to 20% of their combined
qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP)
income. The total Section 199A deduction is the lesser of:
• 20% of qualified business income plus 20% of their qualified real estate investment trust
(REIT) dividends and qualified publicly traded partnership (PTP) income, or
• 20% of taxable income (before any QBI deduction) minus any net long-term capital gains and
qualified dividends.
An overall qualified business loss results in no QBI deduction for the taxable year. The loss carries
over to subsequent years and reduces the section 199A deduction for QBI in the following years.
Foreign Earned Income Exclusion
All income of U.S. citizens and U.S. resident aliens is subject to tax by the United States, regardless
of where the individual lives and even if the income is earned outside the United States. “Foreign
earned income” is income received for services performed in a foreign country while the taxpayer’s tax
home is also in a foreign country. It does not matter whether the income is paid by a U.S. employer or
a foreign employer. The tax home of the taxpayer (where the taxpayer resides) is the main determining
factor.
Example: Candice is a U.S. citizen living in Canada. She is legally present in Canada, but works online
for a U.S. company. She has lived continuously in Canada for the last five years, only coming back to the
U.S. on sporadic short visits of less than a few days. Her tax home is in Canada, and therefore, her
income is considered “foreign earned income.” The taxpayer’s tax home is what matters, not the
physical location of the employer.
The exclusion does not apply to investment income, such as dividends, interest, or passive income
from rental activities. It also does not apply to pension or retirement income.
Example: Wayne is a U.S. citizen who lives and works in Serbia. He has lived continuously in Serbia for
several years, working as a consultant for a multinational company. He earns $70,000 in foreign wages
during the year. He also has additional interest income of $37,000, which is from a CD that he has
invested in a U.S. bank. His $70,000 foreign wages can be excluded from taxable income, but the
interest income cannot be excluded using the foreign earned income exclusion.
For 2024, the maximum foreign-earned income exclusion is $126,500. For married couples, the
exclusion is applied on a per spouse basis, whether filing MFS or MFJ. In other words, if married
taxpayers file jointly (or separately) and both individuals live and work abroad, each can claim the
foreign earned income exclusion, for a total exclusion amount of $253,000 in 2024.

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Example: Sophia and Abe are married and live abroad. In 2024, they were both living and employed
in Peru for the entire taxable year. Sophia earned $82,000 and Abe earned $96,000. Each qualifies for
the foreign earned income exclusion, and they can exclude all their wages from federal income tax.
Each spouse must file their own Form 2555, whether they file MFJ or MFS.
Example: Donnie and Sherri are a married couple, both 55 years old. They have chosen to make Belize
their permanent home and live there year-round. Donnie is self-employed and works online as a
financial planner, earning $160,000 in self-employment income. Sherri is a teacher, and she also works
online for a tutoring company, tutoring students in English. Sherri earns $35,000 in wages. While
Sherri can exclude her entire wage earnings, Donnie can only exclude $126,500 of his self-employment
income, because that is the maximum foreign earned income exclusion per individual in 2024. Both
Donnie and Sherri must individually file Form 2555, regardless of whether they file jointly or
separately.
The foreign earned income exclusion is not automatic. Eligible taxpayers must file a U.S. income tax
return each year, with a Form 2555 attached, if they wish to claim the exclusion. All of the normal filing
thresholds for U.S. taxpayers apply, regardless of where the taxpayer works or resides. If the election
is made to exclude foreign earned income, the election remains in effect for subsequent years, unless
it is formally revoked.192
A taxpayer must be either a U.S. citizen or a legal resident alien of the United States 193 who has
foreign earned income, a foreign tax home, and passes one of two tests to claim the exclusion:
• Bona Fide Residence Test: A U.S. citizen or U.S. resident alien who is a bona fide resident of a
foreign country for an uninterrupted period that includes an entire tax year.
• The Physical Presence Test: A U.S. citizen or U.S. resident alien who is physically present 194
in a foreign country or countries for at least 330 full days during twelve consecutive months.
A taxpayer may qualify under the physical presence test, and the income may span a period of
multiple tax years. If so, the taxpayer must prorate the foreign earned income exclusion based
on the number of days spent in a foreign country.

Note: The foreign earned income exclusion generally does not apply to the wages and salaries of
members of the Armed Forces and government employees of the United States. However, citizens or
residents of the U.S. working in a combat zone as civilian contract workers may qualify as having a tax
home in a foreign country, even if the taxpayer retains a residence in the U.S.195

192 it is not necessary to affirmatively revoke the election if the taxpayer does not have any foreign earned income for the year. For
example, if the taxpayer lived overseas and had foreign earned income in the prior year, but returned to the United States in 2024
and did not have any foreign earned income in 2024, then the taxpayer does not need to revoke the election.
193 Nonresident aliens do not qualify for the foreign earned income exclusion.
194 The physical presence test, within the meaning of Internal Revenue Code section 7701(b)(1)(A), is based only on how long a

person stays in a foreign country or countries. This test does not depend on the kind of residence established, a person’s intentions
about returning to the United States, or the nature and purpose of a person’s stay abroad.
195 The Bipartisan Budget Act changed the tax home requirement for certain eligible taxpayers, specifically contractors or

employees of contractors supporting the U.S. Armed Forces in designated combat zones, who may now qualify for the foreign
earned income exclusion.
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Foreign Housing Exclusion or Deduction

In addition to the foreign earned income exclusion, a taxpayer can claim an exclusion (or a
deduction) for foreign housing costs.
The foreign housing exclusion applies only to amounts paid by an employer, while the foreign
housing deduction applies only to amounts paid with self-employment earnings. Qualified housing
expenses include reasonable expenses paid for housing in a foreign country. Only housing expenses
for the part of the year that the taxpayer actually qualified for the foreign earned income exclusion are
considered. Housing expenses do not include the cost of meals, or expenses that are lavish or
extravagant.
Example: Wilmer is a U.S. citizen who lived in Ecuador all of 2024 and was employed by a foreign
company as an advertising representative. He lived rent-free in an apartment provided by his
employer. Wilmer received a salary of $95,000, and the fair rental value of his housing was $12,000,
for a total of $107,000. He qualifies for the foreign earned income exclusion as well as the foreign
housing exclusion. He can exclude all his income using Form 2555.
The foreign housing exclusion and/or deduction will reduce regular income tax, but will not reduce
self-employment tax (for taxpayers who are self-employed).
Example: Claire is a well-known American artist who lives and works in Bogota, Colombia. She runs
her art gallery in Colombia and qualifies for the foreign earned income exclusion. Her gross income is
$95,000, her business deductions total $27,000, making her net profit $68,000 on Schedule C. She can
use the foreign earned income exclusion to exclude all her business income from income tax, but she
must still pay self-employment tax on all her net profits.

The Foreign Tax Credit and Foreign Income Taxes

Generally, income taxes paid to a foreign country can be deducted as an itemized deduction on
Schedule A or as a credit against U.S. income tax. A taxpayer can choose between a foreign tax deduction
or a foreign tax credit; they can use whichever one results in the lowest tax. The foreign tax credit
usually produces a better tax result, but not always. In this chapter, we will talk mainly about foreign
tax credit.
U.S. citizens and U.S. resident aliens are eligible for the Foreign Tax Credit, which is designed to
relieve taxpayers of the double taxation burden that occurs when their foreign source income is taxed
by both the U.S. and a foreign country.196 Nonresident aliens are not eligible for this credit. Four tests
must be met to qualify for the credit:
• The tax must be imposed on the taxpayer.
• The taxpayer must have paid the tax.
• The tax must be a legal and actual foreign tax liability.
• The tax must be an income tax (not an excise tax, sales tax, etc.).
Although taxpayers can choose between taking the deduction or the credit for all foreign taxes paid,
in most cases, it is to their advantage to take the Foreign Tax Credit, since a credit directly reduces tax

196 For foreign tax credit purposes, a “foreign country” includes: any foreign country, its political subdivisions, and U.S. possessions.

U.S. possessions include Puerto Rico and American Samoa.

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liability. Taxpayers cannot claim the Foreign Tax Credit for taxes paid on any income that has already
been excluded using the foreign earned income exclusion or the foreign housing exclusion.
Unlike the foreign earned income exclusion, which applies only to income that is earned while a
taxpayer is living and working abroad, the Foreign Tax Credit applies to any type of foreign income,
including investment income. Foreign tax paid may be reported to the taxpayer by a financial
institution on Form 1099-INT or Form 1099-DIV.
If the amount of foreign tax that the taxpayers incur is small, then taxpayers can claim the credit
directly on Schedule 3 if, among other conditions, all foreign income is specified passive income,
reported on an information return (such as a 1099-DIV or 1099-INT) and total taxes paid do not exceed
$300 ($600 MFJ).
Example: Josephine and Walter are both age 65, married, and file jointly. They both receive Social
Security, as well as other pension income. They own several foreign stocks, and their Form 1099-DIV
for the year shows foreign tax paid of $590. They have no other foreign income. The couple is not
required to complete Form 1116 because their foreign taxes are less than $600 on their joint return.
They can take a foreign tax credit of $590 directly on their Form 1040.
If the foreign tax paid exceeds $300 ($600 MFJ), a taxpayer must file Form 1116, Foreign Tax Credit,
in order to claim the foreign tax credit. Certain taxes do not qualify for the Foreign Tax Credit, including
interest or penalties paid to a foreign country, taxes imposed by countries involved with international
terrorism, and taxes on foreign oil or gas extraction income.
Note: Individuals claim the Foreign Tax deduction on Schedule A (Form 1040) as an itemized
deduction. The Foreign Tax Credit is claimed on Form 1116, Foreign Tax Credit. A taxpayer cannot claim
both—the deduction and the tax credit—on the same return, but may alternate years, taking a credit
in one year and a deduction in the next year, choosing whichever one gives them a better tax result.
A taxpayer is allowed to switch between claiming the Foreign Tax Credit or an itemized deduction
for foreign tax paid. If a taxpayer claimed an itemized deduction for a prior year for qualified foreign
taxes, the taxpayer can also switch to claiming a credit by filing an amended return within ten years
from the original due date of the return. This type of amended return has a much longer statute period
than normal amended returns.
Note: Per IRS Publication 514, the foreign tax credit does not apply to any tax paid to Iran, North Korea,
Sudan, or Syria. These countries are currently sanctioned by the U.S.
Example: Arshad is a U.S. citizen. He lived and worked in Iran until August, when he was transferred
to Greece. Arshad paid taxes to each country on the wages earned in that country. Arshad cannot claim
a foreign tax credit for the income taxes he paid in Iran. Because the income he earned in Iran is a
disallowed category of foreign income, he must fill out a separate Form 1116 for that income. Further,
he cannot take a foreign tax credit for the taxes paid on the income earned in Iran, but all his worldwide
income is still taxable by the United States.

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Unit 16: Individual Retirement Accounts

More Reading:
Publication 590-A, Contributions to Individual Retirement Arrangements
About Publication 590-B, Distributions from Individual Retirement Arrangements
Publication 575, Pension and Annuity Income
Publication 560, Retirement Plans for Small Business

There are a variety of retirement accounts individuals can establish for themselves and retirement
plans that can be established by employers and self-employed individuals.
In this unit, we primarily cover traditional individual retirement arrangements (traditional IRAs)
and Roth IRAs, as they are tested heavily on Part 1 of the EA exam. We will also briefly address other
types of retirement plans.
Traditional IRA: Amounts in a traditional IRA, including contributions and earnings, are generally
not taxed until they are distributed. Typically, a taxpayer can deduct their traditional IRA contributions
as an adjustment to gross income. However, the deduction is phased out at higher income levels, when
a workplace retirement plan also covers the taxpayer (or the taxpayer’s spouse).
Roth IRA: Contributions to a Roth IRA are made with after-tax income and are never deductible.
In contrast to a traditional IRA, withdrawals from a Roth IRA are generally not taxed. Unlike traditional
IRAs, Roth IRAs do not require participants to start taking minimum distributions at a certain age.
Income limits apply in determining who is eligible to participate in a Roth IRA.
However, there is no income limit for taxpayers who wish to convert their traditional IRA to a Roth.
This process is known as a “Roth conversion” and involves paying taxes on the converted amount.
Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs,
Insurance Contracts, etc., is used to report distributions of $10 or more from a retirement plan or an
IRA. In addition, Form 1099-R will reflect a “code G” in Box 7 for any eligible rollover distribution from
a qualified retirement plan that is directly rolled over to an IRA.
IRA Contribution Limits
IRA accounts cannot be held jointly. This means that each person must have their own IRA account,
but in the case of married spouses that file jointly, only one spouse must have qualified compensation.
The limits for contributions to an IRA in 2024 are the lesser of (1) qualifying taxable compensation (as
described next) or (2) $7,000 per taxpayer ($8,000 if age 50 or older).
For those who file as MFJ, under the spousal IRA rules (discussed later), each spouse can potentially
contribute up to these limits for a total maximum contribution (for both spouses) of $14,000 (or
$16,000 if both spouses are age 50 or older).
This yearly IRA contribution limit does not apply to:
• Rollover contributions197 (rolling over from one IRA account to another)
• Qualified reservist repayments198

197Indirect rollovers are limited to one rollover per year, but trustee-to-trustee rollovers are not limited.
198If a taxpayer was a reservist in the Armed Forces and was called to active duty, the taxpayer can contribute (repay) any IRA
amounts equal to any qualified reservist distributions received. The taxpayer can make these repayment contributions even if the
payments would cause the total yearly contributions to exceed the general limit on IRA contributions.
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• Repayments of qualified disaster distributions (QDDs)199. In general, participants may repay all
or part of the distribution within three years. The repayment is treated like a rollover.
Repayments are reported on Form 8915-F.

Example: Ambrose, age 51, was affected by a qualified disaster loss, which destroyed his home in a
FEMA disaster area. He needed money for living expenses, so he received a qualified disaster
distribution from his traditional IRA in the amount of $90,000 on September 30, 2023. Ambrose
elected to recognize all the income from the IRA distribution on his 2023 tax return. Since it was a
qualified disaster distribution, the amount was not subject to a penalty, but it was subject to income
tax, which he paid when he filed his return. In 2024, Ambrose regrets withdrawing the money from his
IRA and wants to pay it back. On May 3, 2024, Ambrose makes a qualified repayment of $45,000. He
must file an amended return to report the repayment. He reports the entire $45,000 as a repayment
on Form 8915-F, Qualified Disaster Retirement Plan Distributions and Repayments, which he attaches
to an amended tax return (Form 1040-X) for the 2023 tax year, to reduce the amount of income
originally reported by $45,000. The repayment is permitted because it was made within the 3-year
period for repayment.
Traditional IRA Rules
To make contributions to a traditional IRA, the taxpayer must have qualified taxable compensation,
such as wages, salaries, commissions, tips, bonuses, or self-employment income.200

Example: Connie is 17 years old and has a part-time job working in a retail shop. She is claimed as a
dependent on her parents’ tax return. She earns $4,350 in wages during 2024. She also has $2,050 in
dividend income. Connie may contribute to an IRA in 2024 because she has qualifying earned income
(her wages). Her IRA contribution would be limited to $4,350, the amount of her wages. The
investment income is not qualifying compensation for IRA purposes. Connie would be allowed to take
a deduction for her IRA contribution on her individual tax return, even if she is claimed as a dependent
by her parents.
This also includes taxable alimony (but not child support), allowing individuals who rely on
alimony for financial support to save for retirement through an IRA. This allows taxpayers to build
retirement savings in IRAs even if they rely on alimony income for support.

Example: Sandra is 45, and divorced her ex-husband in 2016. Her ex-husband was ordered by the
court to pay her $5,000 a month in alimony for 10 years following the date of the divorce. Her divorce
decree is “grandfathered” and Sandra’s alimony is taxable. She receives $60,000 per year in taxable
alimony, which she properly reports on her tax return. She does not have any other sources of income.
Sandra is allowed to contribute to a traditional IRA or Roth IRA if she chooses.

199 The Secure 2.0 Act includes a retroactive provision which includes permanent relief for those impacted by federal disasters.
This provision allows penalty-free disaster distributions of up to $22,000 from a retirement plan per participant. This change is
retroactive and applies to FEMA disasters occurring on or after January 26, 2021 and moving forward. Taxpayers can choose to
recontribute those amounts back into their retirement accounts within three years. Taxpayers can still choose to repay these
withdrawals. A disaster repayment is not considered a “rollover” and the “once-a-year” rollover limits do not apply.
200 For self-employment income, the amount of earned income for purposes of calculating the maximum amount of IRA

contributions is generally the profits of the business, less the deductible (for income tax purposes) portion of any self-employment
taxes paid.
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Example: Dalton is 54 and wants to contribute to a traditional IRA. He received $15,000 of capital
gains from the sale of stock; $18,000 of interest income; and $3,950 of wages from a part-time job. The
capital gains and interest income are not qualifying compensation for the purposes of determining his
IRA contribution. Therefore, the maximum amount he can contribute to a traditional IRA or a Roth IRA
is $3,950, which is the amount of his wages.
Nontaxable combat pay also qualifies as compensation for this purpose. Also, difficulty-of-care
payments (also called “qualified Medicare waiver payments”) to home healthcare workers, are
considered “qualifying compensation” for IRA contribution purposes. The SECURE Act expanded the
definition of “qualifying compensation” to include certain taxable stipends and non-tuition fellowship
payments received by graduate students.
Example: Charlton is an Army medic serving in a combat zone for all of 2024. He earns $43,000 in
wages. Although none of his combat pay is taxable, it is still considered qualifying compensation for
purposes of an IRA contribution. He is allowed to contribute to a Roth or traditional IRA if he wishes.
Nonqualifying compensation: “Compensation” for purposes of contributing to an IRA does not
include:
• Child support or nontaxable alimony,
• Passive rental income,
• Dividend and interest income,
• Pension or annuity income,
• Deferred compensation,
• Prize winnings or gambling income,
• Sources of income that are not taxed, such as certain foreign earned income and excludable
foreign housing costs (except for nontaxable combat pay and qualified Medicare waiver
payments).
Example: Leroy is single and 67 years old. He received $14,000 of rental income from a residential
rental and $13,000 in Social Security income during the year. All his rental income is passive and
reported on Schedule E, from long-term residential tenants. The rental income and the retirement
income are not qualifying compensation for IRA purposes. Since he does not have any earned income,
Leroy is not permitted to contribute to a Roth IRA or a traditional IRA.
In prior years, there were age limits to contribute to a traditional IRA, but the age limits were
abolished by the SECURE Act. Anyone with qualifying compensation, regardless of age, may now
contribute to a traditional IRA.
If either the taxpayer or their spouse is covered by an employer plan and their taxable income is
too high, their deductible IRA contribution will be phased out. However, as long as taxpayers have
qualifying compensation, they may contribute to a traditional IRA (although they may not be able to
deduct the contribution).
Note: If the taxpayer (or their spouse, if they are married) does not participate in a retirement plan at
work, a traditional IRA contribution is fully deductible up to their allowable contribution limit.
Contributions can be made to a traditional IRA at any time on or before the due date of the return
(not including extensions). For the 2024 tax year, this means that a taxpayer may make an IRA
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contribution up until April 15, 2025. Filing an extension does not give a taxpayer additional time to
contribute to an IRA. This makes an IRA contribution a rare opportunity for late-stage tax planning
because it can occur after the tax year has already ended. A taxpayer can even file their return, claiming
a traditional IRA contribution before the contribution is actually made. However, if a traditional IRA
contribution is reported on the taxpayer’s return, but the contribution is not actually made by the
deadline, the taxpayer must file an amended return.
Example: Inigo is age 62 and earns $56,000 in wages during the year. He files his 2024 tax return early,
on February 28, 2025, and deducts an $8,000 traditional IRA contribution, the maximum that he can
contribute for his age in 2024. Inigo may wait as late as April 15, 2025, the due date of the return, to
actually make his IRA contribution. If Inigo forgets to make his IRA contribution by the deadline, he
will be forced to amend his tax return.

Roth IRA Rules

Roth IRAs and traditional IRAs have many differences, but they are both used for retirement
planning. Unlike a traditional IRA, none of the contributions to a Roth IRA are deductible, but qualified
distributions are generally tax-free at the time of withdrawal. The major differences between a Roth
IRA and a traditional IRA are as follows:
• Contributions to a Roth IRA are not deductible by the taxpayer, and participation in an
employer plan has no effect on the taxpayer’s contribution limits.
• Roth IRA owners are not required to make minimum distributions during their lifetime.
Distributions only become required after the owner’s death.
• Roth IRA contributions can be made at any age.
• Income limits apply, which means high-income earners may be prohibited from contributing
to a Roth IRA.
• If a person files separately from their spouse, they cannot contribute to a Roth IRA if their MAGI
exceeds $10,000 or higher. However, this rule does not apply if the spouses lived apart the
entire year.201 In situations where spouses live apart from each other the entire year, the MAGI
phaseout range is applied using the single filing status range (see below).
Whether or not a taxpayer can make a Roth IRA contribution depends on filing status and modified
adjusted gross income (MAGI). The following income limits apply to Roth IRAs:

Filing Status 2024 Roth IRA Phaseout Ranges

Single, HOH, MFS (did not live with spouse) $146,000 – 161,000
MFJ and QSS filers $230,000 – $240,000
MFS (lived with spouse) $0–$10,000

In general, a taxpayer cannot contribute to a Roth IRA if their income is above the full phaseout
figures shown above. However, a “backdoor” Roth IRA is still possible in 2024. This is accomplished
when a taxpayer (1) opens a traditional IRA, (2) makes a non-deductible IRA contribution, and then
(3) converts the funds to a Roth in the same year. We will cover IRA conversions in more detail later.

201Per IRC Section 408A(c)(3)(C) and IRC Sect. 219(g)(4), for MFS taxpayers who live apart the entire year, the spouses are not
subject to the much lower MAGI limits for Roth IRA contributions, but instead may use the single filing status thresholds.
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If married taxpayers choose to file separately, they must consider only their own qualifying
compensation for IRA contribution purposes, whether they contribute to a Roth or a traditional IRA. 202
Example: Bastien and Danielle are married, but have lived apart for several years. They chose to file
separate tax returns. Bastien is 38, works full-time, and earned $55,000 in wages during the year.
Bastien and Danielle both have a Roth IRA. His wife, Danielle, is 34 and has $47,000 in dividend income,
but she also earned only $3,650 working a small part-time job during the holidays. Because they lived
apart the entire year, they may each use the “single” filing status MAGI phaseout range to determine
their maximum Roth IRA contribution. Danielle is limited to a $3,650 Roth IRA contribution, the
amount of her qualifying compensation. Bastien may contribute up to $7,000 (the 2024 limit for his
age) to his own Roth IRA account. They are both allowed to contribute, even though they file separate
returns, because they lived apart the entire year.
Wages and Self-Employment Losses: If a taxpayer’s only qualifying compensation for the year is
from self-employment and the self-employment activity generates a loss for that year, they cannot
contribute to an IRA. However, if the taxpayer has wages in addition to self-employment income, a loss
from self-employment is not subtracted from the wages when figuring total “qualifying” compensation
income for purposes of determining his IRA contribution. In other words, if you experience a net loss
from self-employment, do not deduct that loss from your salaries or wages when determining your
total compensation.
Example: Florence, age 42, has a profitable rental property netting $33,000 in passive income. The
passive income is not qualifying compensation for an IRA contribution. However, she also works part-
time at a library earning $10,000 in wages. On weekends, she’s self-employed as a wedding
photographer but had a net loss of ($5,400) on her Schedule C business this year. Her earned income
for 2024 is only $4,600 ($10,000 wages - $5,400 loss from self-employment), but her “qualifying
compensation” for purposes of an IRA contribution remains at $10,000; the full amount of her wages.
Thus, Florence can contribute the full amount of $7,000 to her IRA, assuming she has enough available
funds to do so.
Spousal IRA Contributions: IRAs cannot be owned jointly. Therefore, each spouse must have their
own IRA account. However, a married couple filing jointly may contribute to each of their IRA accounts,
even if only one taxpayer has qualifying compensation. This is called a “spousal IRA contribution.”
Example: Derrick, 49, and Elaine, 51, are married and file jointly. Derrick works as a paramedic and
makes $76,000 per year. Elaine is a homemaker and has no taxable income. Even though Elaine has no
qualifying compensation, she may contribute to an IRA account because her husband has enough
earned income to allow her to make a spousal contribution. Their combined maximum contribution
for 2024 is $15,000. Derrick may contribute $7,000 to his IRA, and Elaine may contribute $8,000 to her
IRA because she is over 50 years old. This special rule for “spousal contributions” only applies if
Derrick and Elaine file jointly.

202Other than the exceptions for married couples who file jointly, a taxpayer can never contribute more than their earned income
for the year. Minors who want to start contributing to an IRA must abide by limits based on their own income, not the income of
their parents.
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For married taxpayers filing a joint return, their combined IRA contributions cannot exceed their
combined qualifying compensation.
Example: Carl and Jacqueline are a 60-year-old married couple who typically file their taxes jointly.
This year, Carl has made $53,000 in passive income from his commercial rental property while
Jacqueline earned $28,000 in qualified dividends and an additional $8,000 from a part-time job. These
are the only sources of income for the year. Only Jacqueline’s wages count as “qualifying
compensation” for purposes of an IRA contribution. Together, they can contribute up to $8,500 to their
IRAs if they file jointly. One of them can contribute up to the maximum annual amount of $8,000 in
2024 (for their age), while the other can contribute the remaining $500 (equal to Jacqueline’s
remaining qualifying compensation). Alternatively, they could divide the $8,500 equally between their
respective IRAs ($4,000 each) or split it in any other way they choose. However, regardless of how they
split their contributions, their total combined contributions cannot exceed $8,000.

Deductibility of Traditional IRA Contributions

The deductibility of a traditional IRA contribution is based on income, filing status, and whether
the taxpayer (or their spouse) is covered by an employer retirement plan at work. Any taxpayer with
qualifying compensation is permitted to contribute to a traditional IRA, regardless of whether they are
covered by an employer retirement plan; however, the deductibility of the contribution may be limited.
This rule only applies to traditional IRA contributions, because Roth IRA contributions are never tax-
deductible.
If a taxpayer exceeds the income limits for making a fully deductible contribution to a traditional
IRA, the excess portion can still be made as a nondeductible or after-tax contribution. If a taxpayer
makes nondeductible contributions to a traditional IRA, the taxpayer must file Form 8606,
Nondeductible IRAs. Form 8606 reflects a taxpayer’s cumulative nondeductible contributions, which is
the taxpayer’s “basis in the IRA.”
If a taxpayer does not report nondeductible contributions properly, all future withdrawals from
the IRA may be taxable unless the taxpayer can prove, with satisfactory evidence, that nondeductible
contributions were made. Regardless of whether a portion of the contribution is nondeductible, the
related earnings will grow on a tax-deferred basis. If the taxpayer or spouse are not covered by an
employer plan, there is no limitation on the deductibility of their traditional IRA contributions.
Example: Cressida is single and earned $135,000 in wages in 2024. She is covered by a 401(k)
retirement plan at work. She contributes the annual maximum to her workplace 401(k), but she also
wants to contribute to a traditional IRA. She is phased out for the deduction because her MAGI exceeds
the threshold for single filers covered by an employer plan. If she contributes to a traditional IRA in
2024, she must file Form 8606 to report her nondeductible contribution. She is still allowed to
contribute to a traditional IRA, but the amounts would not be deductible on her Form 1040. Cressida is
responsible for keeping track of her own IRA’s basis, so she should keep copies of her Forms 8606
indefinitely.
Note: Remember, if neither spouse is covered by an employer-sponsored retirement plan, their IRA
contributions are fully deductible on Form 1040 as an adjustment to income. However, if either a
taxpayer or his spouse, (or both,) is covered by (i.e., participates in) an employer retirement plan, the
tax-deductible contribution to a traditional IRA may be phased out.
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Taxpayers that are covered by an employer retirement plan are phased out at the following levels
of modified adjusted gross income (MAGI):
2024 Phaseouts when the Taxpayer (or Spouse) is Covered by an Employer Plan
Filing Status MAGI Range Allowable Deduction
Single, HOH, MFS (did not live $77,000 or less Full deduction
with spouse*) more than $77,000 but less than $87,000 Partial deduction
$87,000 or more No deduction
MFJ (for the covered spouse*), $123,000 or less full deduction
QSS More than $123,000 but less than Partial deduction
$143,000
$143,000 or more No deduction
MFS (lived with spouse*) $0- $10,000 A partial deduction
$10,000 or more No deduction
If neither spouse is a participant in an employer retirement plan, their traditional IRA
contributions are fully deductible.
*Note #1: If the taxpayer files MFS but did not live with their spouse at any time during the year,
their IRA deduction is determined under the “single” filing status.
*Note #2: If filing as MFJ and only one spouse is covered by a retirement plan, for the non-covered
spouse, in 2024, a full deduction is allowed at MAGI of $230,000 or less; a partial deduction for more
than $230,000 but less than $240,000; and no deduction at $240,000 or more (see detailed charts
in Publication 590-A).
Remember, taxpayers can always have a traditional IRA whether or not they are covered by another
retirement plan. However, they may not be able to deduct all of their traditional IRA contributions if
they are also covered by an employer plan.
Example: Leif and Araceli are both age 39, married, and file jointly. Leif is a member of the U.S. House
of Representatives and covered by a retirement plan at work. Araceli is not covered by a workplace
retirement plan, because she is self-employed. Leif’s salary for the year is $269,000. Araceli earned
$45,000 in taxable self-employment income. Araceli makes a $7,000 contribution to her traditional IRA
in 2024. Since Leif is covered by a retirement plan at his work, and their joint AGI exceeds the phaseout
threshold, (The phaseout begins at $230,000 in 2024 if one spouse is covered by a retirement plan at
work) Araceli’s IRA contribution is not deductible. She is still allowed to make a nondeductible
contribution, and the earnings in her IRA account will grow tax-free. Araceli must file Form 8606,
Nondeductible IRAs, to report her nondeductible contribution.
Example: Henrietta, 59, is employed full-time as a manager for a family-owned restaurant. Her
husband, Kirk, 62, is a full-time welder. Neither of them has retirement plans through their jobs, but
they both have traditional IRAs that they contribute to every year. Their joint AGI in 2024 is $145,000.
They can each deduct up to $8,000 each in 2024, as an IRA contribution since they are over 50 years
old. This deduction is not limited and can be claimed on their joint tax return as an adjustment to
income.
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Married taxpayers who file MFS generally have a much lower phaseout range than those with any
other filing status. However, if a taxpayer files a separate return but did not live with their spouse at
any time during the year, the taxpayer is treated as “single” for IRA contribution purposes.
Example: Stefano, age 43, and his wife Emmy are not divorced, but they have lived in separate homes
for the past two years. In 2024, Stefano earned $41,000 in wages during the year and files as MFS.
Stefano is covered by a 401(k) at work, but he also has a traditional IRA. He is nevertheless allowed to
deduct his full IRA contribution of $7,000. This is because he did not live with his spouse during the
year, and therefore is not subject to the lower IRA phaseout limits that normally apply to MFS filers.
Example: Adeline and Brixton are married and live together. Adeline has a 401(k) through her job, so
she is covered by a workplace retirement plan. Adeline wants to save for her retirement, so she usually
makes contributions to a traditional IRA in addition to contributing to her workplace 401(k). Adaline’s
IRA contribution is normally deductible. However, Brixton gets angry at Adeline and refuses to file a
joint return with her this year. Adeline is forced to file MFS. She earns only $32,000 in wages, but she
cannot deduct her IRA contribution because she is filing MFS, and earned more than $10,000 while
living with her husband, while also being covered by a retirement plan at work.

Splitting IRA Contributions Between Multiple Accounts

A person may have IRA accounts with multiple financial institutions and may split their annual
contributions between accounts; their aggregate contributions for the year are subject to the limits
described above. In other words, an individual may own and deposit into multiple IRA accounts, as
long as they do not contribute more than the annual limit. Further, a taxpayer may choose to split
contributions between a traditional IRA and a Roth IRA; again, their combined contributions are
subject to the maximum annual contribution limits outlined before.
Example: Josue is 62. He has a traditional IRA through his credit union and a Roth IRA through an
online investment firm. Josue wants to contribute to both accounts. Josue earns $50,000 in wages. He
can contribute to both of his retirement accounts, but the combined contributions for 2024 cannot
exceed $8,000, the annual maximum for his age (he is allowed a catch-up contribution because he is
over 50). Josue decides to split his contributions and contribute $4,000 to his Roth IRA and $4,000 to
his traditional IRA.
Example: Gaspar is age 48, earns $5,200 in wages and $45,000 in passive rental income. He does not
have any other earnings during the year. His maximum IRA contribution is limited to $5,200 (the
amount of his earned income). Gaspar decides to split his IRA contributions between a traditional IRA
and a Roth IRA. He contributes $4,200 to a traditional IRA and $1,000 to a Roth IRA. The most Gaspar
will be able to deduct as an adjustment to income is the $4,200 contribution to his traditional IRA. Roth
IRA contributions are never deductible.
Example: Inez, 28, has $13,000 of gambling income and no other income in 2024. Inez marries Wilmer
on August 15, 2024. Wilmer is age 32 and has wages of $84,000. He plans to contribute $7,000 to his
traditional IRA. If Wilmer and Inez file jointly, each can contribute $7,000 to a traditional IRA, as long
as they have the available funds to do so. This is because Inez, who has no qualifying compensation,
may use Wilmer’s compensation, reduced by the amount of his IRA contribution ($84,000 - $7,000 =
$77,000), to determine her maximum contribution to a traditional IRA.

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Distributions from a Traditional IRA

Distributions from a traditional IRA are permitted at any time, however, the amounts distributed
are generally taxable in the year they are received, subject to the following exceptions:
• Rollovers to another retirement plan (other than conversions to a Roth IRA),
• Rollovers to a Section 529 plan (if they meet the requirements)
• Qualified charitable distributions (QCDs) directly to a qualified charity (must be a trustee-to-
trustee transfer),
• Tax-free withdrawal of contributions (made in the same year),
• Distributions of nondeductible contributions (these are rare).
In addition, traditional IRA distributions made before age 59½ may be subject to a 10% early
withdrawal penalty, in addition to regular income tax, unless the taxpayer qualifies for an exception.
Exceptions to Early Withdrawal Penalties
Taxpayers have full control and ownership of IRAs, allowing them to withdraw funds at any time
for any reason. However, there may be tax consequences for early distributions made before age 59½,
which is a 10% excise tax in addition to regular income tax. Here are the exceptions to the 10% early
withdrawal penalty for traditional IRA distributions:
• First-time home purchase: Up to $10,000 can be withdrawn penalty-free for buying, building,
or rebuilding a first home.
• Qualified education expenses: Withdrawals used to pay for tuition, fees, books, supplies, and
equipment required for enrollment or attendance at an eligible educational institution.
• Death or disability: If the taxpayer dies or becomes totally and permanently disabled. Also,
terminal illness distributions.
• Terminal illness distributions: Under the SECURE 2.0 Act, distributions made to individuals
who are terminally ill are exempt from the 10% early withdrawal penalty.
• Emergency personal expense distributions. Added by the SECURE 2.0 Act, the maximum
amount that can be claimed under this provision is the lesser of (1) $1,000 or (2) the vested
IRA account balance over $1,000. The first tax year these are available is tax year 2024.
• Domestic abuse victim distributions. Added by the SECURE 2.0 Act, the maximum amount
that can be claimed under this provision is the lesser of (1) $10,000 or (2) 50% of the IRA
account balance) in 2024, but the amount is inflation-adjusted. The first tax year these are
available is tax year 2024.
• Medical expenses: Unreimbursed medical expenses that exceed 7.5% of the taxpayer’s
adjusted gross income (AGI).
• Health insurance premiums: Distributions made to cover the cost of medical insurance while
the taxpayer is unemployed.
• Substantially equal periodic payments (SEPP): Withdrawals taken as part of a series of
substantially equal periodic payments.203

203Under the SEPP exception, the account owner must withdraw substantially equal amounts from the IRA annually. The amount
is determined by dividing the account balance by the taxpayer’s life expectancy. Once a taxpayer starts taking withdrawals under
this exception, substantial penalties exist for canceling the annual plan of distributions. Once you begin, you must continue for at
least five years or until you reach age 59½, whichever is longer, or else be subject to sizable penalties.
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• IRS levy: Withdrawals made to satisfy an IRS levy.
• Qualified Reservist Distributions: The distributions are made to a qualified reservist (an
individual called up to active duty),
• Qualified disaster distributions, or QDDs.
• Qualified birth and adoption distributions: Up to $5,000 per birth or adoption.
Even though these distributions will not be subject to the 10% penalty, they will be subject to
income tax at the taxpayer’s normal rates. Distributions that are properly rolled over into another
retirement plan or account (other than conversions to a Roth IRA) are not subject to either income tax
or the 10% additional penalty. Taxpayers should use Form 5329 to report penalty exceptions.
Note: Emergency personal expense distributions, terminal illness distributions, domestic abuse victim
distributions, qualified birth and adoption distributions, and qualified disaster distributions can all be
repaid by the taxpayer no later than three years from the date after they received the distribution. If
they repay them, they can amend their returns and get a refund of the income tax paid on the
distribution.
Example: Ethan, age 32, and Enya, age 29, are married and file jointly. Enya gave birth to twins on May
3, 2024. Ethan withdraws $10,000 from his traditional IRA a week later. Enya does not own a
retirement account. Ethan’s entire $10,000 distribution is a qualified birth distribution (up to $5,000
is permitted, per child). Ethan should report the SSN of his twins on his 2024 tax return, and check the
exception that applies. Ethan’s IRA distribution will be subject to income tax, but is not subject to a
10% early withdrawal penalty.
Example: On January 2, 2024, Oksana, age 39, takes a $8,000 distribution from her traditional IRA
account in order to buy a car. She does not meet any of the exceptions to the 10% additional penalty
tax, so the $8,000 is an early distribution and is subject to a penalty. Oksana must include the $8,000
in her gross income and pay income tax on the full amount. In addition, she must pay a 10% penalty
tax of $800 (10% × $8,000). This penalty will be added to her overall tax liability.

Required Minimum Distributions (RMDs) from Traditional IRAs

A person cannot keep funds in a traditional IRA account indefinitely. The SECURE 2.0 Act increased
the applicable RMD age from age 72 to age 73 starting back in 2023, and this will increase again to age
75 in 2033. The first RMD distribution can be delayed until April 1 of the year following the year the
taxpayer turns 73. The distribution for each subsequent year must be made by December 31.
For example, if a taxpayer reaches age 73 in 2024, their first RMD is due by April 1, 2025, and their
second RMD is due by December 31, 2025.204 The amount of each RMD is based on IRS tables.
Failure to take a required RMD can result in an excise penalty of the amount that the taxpayer
should have withdrawn but did not. The Secure Act 2.0 reduced the penalty tax for failure to take RMDs
from 50% to 25%. If the failure is corrected in a timely manner (within two years), the penalty is
reduced to 10%.

Roth IRA accounts do not require minimum distributions (RMDs) during a taxpayer’s lifetime, but traditional IRA accounts do.
204

However, beneficiaries of Roth IRAs are subject to RMD rules.

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Example: Shoshana has a traditional IRA that she has contributed to for many years. Shoshana turned
73 on June 1, 2024. Her first RMD is not due until April 1, 2025, the year after she turns age 73. She
must take her first RMD (for 2024) on or before April 1, 2025, and her second RMD (for 2025) by
December 31, 2025. Many times, people will forget to take their required RMDs. If Shoshana forgets to
take her required RMD, but corrects her mistake within two years, her RMD penalty will be 10%. If
Shoshana fails to correct the failed RMD within two years, she will be subject to a 25% penalty.
Shoshana would file Form 5329, Additional Taxes on Qualified Plans, to report the excise tax that
applies because of her failure to take the RMD.

Qualified Charitable Distributions (QCD)

A taxpayer who is 70½ or older may choose to make a qualified charitable distribution (QCD) 205 of
up to $105,000 (in 2024) from a traditional or Roth IRA206 to qualified charitable organizations and
exclude that amount from income. QCD amounts may count toward a taxpayer’s RMD, if the taxpayer
is required to take an RMD, but cannot be claimed as a charitable deduction.
In order to qualify, the funds must come out of the taxpayer’s IRA by the deadline for minimum
distributions (generally December 31). For taxpayers who file jointly, the other spouse can also
contribute up to the annual maximum, assuming the spouse has an IRA, as well.207
Charitable distributions are reported on Form 1099-R for the calendar year the distribution is
made. The IRA trustee must make the distribution directly to the qualified charity; the taxpayer cannot
request a distribution and then donate the money later.
Example: Guadalupe is 77, and she has been taking RMDs from her IRA for many years. Her required
minimum distribution is $9,400 in 2024. Guadalupe always donates a large portion of her income to
her local Methodist church. Instead of taking an RMD, Guadalupe directs her IRA trustee to make a QCD
directly to her church, which is a qualifying 501(c)3 charity. Her IRA trustee transfers a $10,000
qualified charitable distribution from Guadalupe’s traditional IRA account directly to her church’s
bank account before December 31, 2024. In this way, she is able to fulfill her RMD requirement for the
year, as well as contribute to her church tax-free. The distribution is not taxable to her, because she
never has constructive receipt of the funds. Guadalupe cannot deduct the contribution on Schedule A,
because the amounts she donated are already pre-tax.
If a taxpayer over age 70½ makes deductible traditional IRA contributions, that taxpayer must later
recapture those deducted amounts by reducing any potential qualified charitable distribution made in
later years by including those in the taxpayer’s taxable income (no double-dipping!). This is not just
for the year of the contribution—the effect is cumulative and carries forward.

205 The PATH Act made the QCD election permanent. Although the SECURE ACT 1.0 raised the RMD age, the SECURE Act 1.0 did not

change the Qualified Charitable Distribution (QCD) rules. This means that a taxpayer who is 70½ may make a QCD as well as any
future tax years. Employer-sponsored plans (like 401(k) plans) cannot make QCDs, but the participant could potentially rollover
the funds into an IRA and then make a QCD from the IRA once the rollover is complete.
206 Note that RMDs are not required for Roth IRAs and that most distributions from a Roth IRA to the account holder are tax-free,

so Traditional IRAs are the primary focus of QCDs.

207 Beginning in tax year 2024, the cap on the QCD amount is indexed for inflation, under the SECURE Act 2.0. For 2024, the annual

QCD limit increased to $105,000 (from $100,000 in the prior year).

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Example: Norma turned 75 in 2024. She works full-time at the Clydesdale Foundation, a 501(c)(3)
horse rescue organization. She loves her job working with horses, and doesn’t plan to retire. She still
contributes to her traditional IRA every year, and has always deducted the amounts on her tax return.
She wants to make a QCD directly to the Clydesdale Foundation. Her QCD exclusion must be reduced
by all the contributions she made over the age of 70½.
A taxpayer could potentially make a QCD from a Roth IRA, but there would generally be no tax
advantage to doing so, since the amounts in Roth IRAs have already been taxed, and qualified
distributions are normally tax-free anyway.208
Distributions from a Roth IRA
The rules are different for Roth IRA distributions. Distributions from a Roth IRA may be completely
tax-free and penalty-free if they are “qualified” distributions. In order to be a “qualified” distribution,
the account must satisfy a five-year period, and the taxpayer must be at least 59½, although there are
exceptions for disability or death of the IRA owner. A taxpayer can withdraw their regular Roth IRA
contributions (for their basis in the IRA, normally their contributions, but not the earnings) at any time
and at any age with no penalty or tax. Taxpayers over 59½ who have held their Roth accounts for at
least five years can withdraw contributions and earnings with no tax or penalty. However,
withdrawing earnings before age 59½ may result in a 10% early withdrawal penalty on the earnings,
unless an exception applies. Penalty exceptions include death or disability of the IRA owner, and are
covered in more detail in the next section.
Example: Walker is 71 and has held and contributed to his Roth IRA for over fifteen years. He
withdrew $9,000 from his Roth account during the year because he wanted to take a cruise. The entire
withdrawal is tax free and penalty free, because he is over the age of 59½, and he has held the Roth for
more than five years.
Example: Hetta is age 49 and has owned her Roth IRA for fifteen years. In 2024, Hetta dies. The Roth
IRA passes to her adult son, Trevor, who is age 26 and her closest living relative. The Roth IRA includes
$86,000 from Hetta’s contributions over the years, and $14,000 of accumulated investment earnings.
Trevor withdraws the entire balance of the inherited Roth IRA as a distribution. The entire amount is
tax-free to Trevor, because (1) his mother, Hetta, had held the Roth IRA for more than five years, and
(2) the distribution was made by a beneficiary (Trevor) after the death of the original IRA owner.
IRA Rollover Rules
A “rollover” is a transfer from one retirement plan to another retirement plan. If executed properly,
most rollovers are nontaxable events. A taxpayer can make only one indirect rollover from an IRA to
another IRA in any twelve-month period. However, trustee-to-trustee transfers between IRAs are not
limited, and rollovers from a traditional IRA to a Roth IRA are not limited.
With a direct rollover, the funds from the taxpayer’s current retirement account are transferred
directly to a new retirement plan. This is also called a “trustee-to-trustee” transfer. With an indirect
rollover, it is up to the employee to redeposit the funds into the new IRA or another qualifying
retirement account within the mandatory 60-day period to avoid penalty.

208 However, if the Roth IRA has not been held for 5 years, a QCD from the Roth IRA could prevent earnings of the IRA to be subject
to taxable income, as compared to a regular distribution from the Roth IRA that has not been in existence for at least five years.
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60-Day-Rule: If a taxpayer receives an IRA distribution and wishes to make a nontaxable rollover,
they must complete the rollover transaction by the 60th day following the day they receive the
distribution. The “60-day rollover rule” applies to indirect rollovers of a qualified retirement account,
such as an IRA or 401(k). A taxpayer that properly completes an indirect rollover will not owe any
interest or penalties as long as all the funds are redeposited into another qualified retirement account
within 60 days.209
It is not uncommon for employees to roll funds from one retirement plan to another, especially
after a job change. When employees leave a job that had an existing retirement plan, the employee will
often roll over their existing plan (such as an employer’s 401k) into a traditional IRA.
An “indirect” rollover of a retirement account may be requested when an employee changes jobs
or leaves a job to start their own business, but does not want to share information with a former
employer. Indirect rollovers are limited to one rollover per year. With an indirect rollover, the
employer generally withholds 20% of the amount that is pending transfer in order to pay the taxes
due. This withholding is mandatory, even if the taxpayer later intends to roll all the funds over into
another retirement account. If the taxpayer does roll it over and wants to defer tax on the entire taxable
portion, he will be forced to add funds from other sources equal to the amount of tax withheld. This
money is returned as a tax credit for the year when the rollover process is completed.
Example: Lucy, age 31, requested a $10,000 distribution from her traditional IRA on January 3, 2024,
intending to buy a new car. Her IRA trustee properly withholds $2,000 from the distribution. Thirty
days after receiving the money, Lucy talks to her accountant, who informs Lucy that she will be subject
to a substantial early withdrawal penalty. Lucy regrets the distribution, and wishes to recontribute the
amounts. If she decides to rollover the full $10,000, she must contribute $2,000 from her own savings,
and she must complete the rollover within 60 days. On March 2, 2024 (58 days later), Lucy
recontributes $10,000 to a traditional IRA, treating it as an indirect rollover. She made the contribution
by the 60-day deadline, so on her tax return for the year, she may report $10,000 as a nontaxable
rollover and $2,000 as taxes paid. She will not owe a penalty, and will not owe tax on the amounts.
Example: Sheldon quits his old job on September 1, 2024. On October 14, 2024, Sheldon begins a new
job, which happens to be with a competitor of his old employer. He has an existing retirement account
at his old employer. He decides to transfer the balance of his IRA account to his new employer’s
retirement plan. Rather than disclose any information about his new workplace to his former boss,
Sheldon decides to receive a direct distribution from his IRA of $60,000 in cash. The IRA custodian is
required to apply federal income tax withholding to a traditional IRA distribution. Because this was an
indirect rollover, Sheldon was forced to replace the amounts that were withheld with his own savings.
On October 30, 2024, Sheldon deposits the entire amount of $60,000 into his new employer’s
retirement plan, making up the difference with his own funds. Because the transaction is completed
within 60 days, it is completely non-taxable, and any withheld amounts can be claimed when he files
his 2024 tax return. The total rollover must be reported on Form 1040, by including “Rollover” next to
Line 4b, with -0- listed on Line 4b.

209 Revenue Procedure 2016-47 allows eligible taxpayers to request for a waiver of the 60-day rollover limit and avoid early
distribution taxes. Taxpayers submit the self-certification to their plan administrator or an IRA trustee (NOT to the IRS). In the past,
taxpayers who failed to meet the rollover time limit could only obtain a waiver by requesting a private letter ruling from the IRS.
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Note: In order to avoid this mandatory 20% withholding, a taxpayer may request a “direct rollover”
(also called a “trustee-to-trustee” transfer). The distribution is then made directly from the custodian
or trustee for the employer-sponsored plan to the custodian for the employee’s IRA or his new
employer’s retirement plan. Under this option, the 20% mandatory withholding does not apply. Unlike
indirect rollovers, direct rollovers are not limited to one rollover per year.
IRA accounts can hold cash as well as investment property, such as stock or land held for
investment. If a taxpayer sells distributed property (such as stocks distributed from an IRA) and rolls
over all the proceeds into another traditional IRA or qualified retirement plan within the required time
frame, no gain or loss is recognized. The sale proceeds (including any increase in value) are treated as
part of the distribution and are not included in the taxpayer’s gross income.
In the case of a rollover distribution, if a taxpayer is given both property and cash, they have the
option to roll over any portion of the property or cash, or a combination of both. It is also possible for
them to sell the property and utilize the proceeds in a traditional IRA. However, they are not permitted
to keep the property and replace the funds they have received.
Example: Arturo is 60 and has a 401(k) at his current job. At the end of the year, he decides to quit his
position and transfer his retirement funds elsewhere. He receives a distribution from his employer’s
401(k) plan of $20,000 cash and $30,000 of stock. He decides to keep the distributed stock and puts it
in a taxable brokerage account. He will owe income tax on this amount, but not a 10% penalty because
he is over 59½. He can still roll over the $20,000 cash received into a traditional (rollover) IRA, but he
cannot substitute an additional $30,000 in cash in place of the stock and treat this amount as if it had
also been rolled over.

Distributions from Inherited IRAs

Anyone can inherit an IRA, but inherited IRAs are subject to special rules. Following the death of
an IRA owner, the IRA usually passes to a beneficiary. An Inherited IRA is also sometimes called a
“Beneficiary IRA.” This is a retirement account that is opened by the beneficiary of an IRA when the
original owner of the IRA has died. On July 18, 2024, the IRS released final regulations on required
minimum distributions (RMDs) and beneficiary options. These final regulations clarify significant
changes that have resulted from the SECURE Acts, which were passed in 2019 and 2022, respectively.
These changes apply to both traditional IRAs and Roth IRAs.
In the past, beneficiaries of inherited IRAs could choose a “lump sum” withdrawal or stretch the
withdrawal of required minimum distributions over their life expectancy. 210 The SECURE Act
abolished “stretch IRAs” for most non-spousal beneficiaries. To take advantage of the “stretch IRA”
option, a beneficiary must be an eligible designated beneficiary, or EDB. An “Eligible Designated
Beneficiary” includes:
• A surviving spouse: Surviving spouses have the most flexibility and can choose to treat the
IRA as their own by changing ownership or rolling over the balance to their own account. They
also have the flexibility to take distributions over their own life expectancy.
• Disabled beneficiary: A disabled or chronically ill individual,

210 Beneficiaries who inherited IRAs before 2020 are grandfathered, and may still utilize the previous “stretch IRA” rules.
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• Minor child beneficiary: A minor child of the IRA owner (but not a grandchild), or
• Not 10 years younger: A beneficiary not more than 10 years younger than the IRA owner. An
example of a beneficiary who is "not more than 10 years younger" than the IRA owner would
be a sibling who is 5 years younger than the IRA owner; if the IRA owner is 65 years old, their
60-year-old sibling would qualify as a beneficiary within the "not more than 10 years younger"
category.
Individuals who are not EDBs must generally withdraw all the funds from the inherited IRA within
10 years after the original owner passes away. However, if the original owner of the IRA had already
reached the required age for taking RMDs, not only must the account be fully distributed within the
10-year period, but the beneficiary must also take annual RMDs during the first nine years based on
their life expectancy.
Example: Mariella, 42, and Kazim, 53, are married. Mariella dies in 2024, and at the time of her death,
she has $83,000 in her traditional IRA account. Kazim is still working, and does not plan to retire for
many years. Therefore, he chooses to roll over the entire $83,000 into his own IRA account. As a
spousal beneficiary of his deceased wife’s IRA, he can do this, thereby avoiding taxation on the income
until he starts taking distributions.
Example: Claudio, age 74, and Nanette, age 61, are married. Both spouses have traditional IRA
accounts, and Claudio has already started taking RMDs from his traditional IRA. On February 1, 2024,
Claudio dies, and Nanette inherits her husband’s IRA account. Rather than take a distribution from her
late husband’s account, Nanette decides to do a spousal rollover of the entire account balance into her
own IRA. The rollover is not a taxable event, and Nanette is not required to take any minimum
distributions from the account until she reaches the required age for her own RMDs.
Rules for Other Eligible Designated Beneficiaries (non-spouses): Other eligible designated
beneficiaries may take their distributions over their own life expectancy. However, minor children
must still take remaining distributions within 10 years of reaching the age of majority.
In other words, the 10-year payout “clock” will begin to run when the minor reaches the age of 18.
This means that a minor child must distribute all the assets in an inherited IRA on or before turning 28
years of age.
Example: Shakira is age 50 and widowed. Five years ago, Shakira’s husband died and she chose to
rollover his entire traditional IRA into her own IRA account. She was permitted to do this because she
was a spousal beneficiary. On May 30, 2024, Shakira dies. She has one son, Robby, who is 16 years old.
Robby inherits his deceased mother’s IRA. Robby is a minor, and qualifies as a “designated beneficiary.”
His 10-year “payout clock” starts when he turns 18 years of age. He does not have to take any
distributions from the inherited IRA now, he can choose to wait and allow the funds in the account to
grow until his 18th birthday. When he does start taking distributions, the distributions will be subject
to income tax, but not an early withdrawal penalty (regardless of his age) because it is an inherited
IRA.

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Example: Wallace is 49 and unmarried. On February 28, 2024, Wallace dies. The beneficiary of
Wallace’s IRA is his permanently disabled sister, Megan, who is 29 at the time of her brother’s death.
Since Megan is a permanently disabled beneficiary, she is allowed to “stretch” the inherited IRA, taking
distributions and stretching the tax liability over her lifetime. This allows for more tax-deferred growth
and potentially a lower annual tax liability.211
Any other beneficiary: For any other beneficiaries, the account balance must generally be fully
distributed by the 10-year period after the death of the IRA owner. This 10-year rule also applies to
beneficiaries that are entities (trusts, estates, charities, and other organizations).
Example: Crystal, age 65, was unmarried and had no children, died on May 30, 2024. At the time of
her death, Crystal had a traditional IRA worth $200,000. The beneficiary of her IRA is her nephew,
Ozzie, age 32. Ozzie is not disabled. Ozzie can choose to distribute the IRA as a lump sum, or he has 10
years to distribute the balance and pay the tax. No matter what type of distribution he chooses, the
amounts he withdraws from the inherited IRA will be subject to income tax. However, the 10% early
withdrawal penalty is waived for a beneficiary of an IRA when the original IRA owner has died,
(regardless of how old the beneficiary is).

Roth IRA Conversions

A rollover from a traditional IRA to a Roth IRA is more commonly called a “Roth conversion,” but it
is still a type of rollover. A Roth conversion will result in taxation of any previously untaxed amounts
in the traditional IRA that were rolled over into a Roth IRA.
Roth conversions are used frequently as a tax strategy. In the past, taxpayers in higher income
brackets were unable to contribute to a Roth IRA. They were also unable to convert from a traditional
IRA to a Roth IRA. The IRS rules changed several years ago, and there is no longer an income threshold
on Roth IRA conversions. High-income taxpayers can convert a traditional IRA to a Roth as long as they
pay the appropriate tax on the conversion. This is frequently called a “backdoor Roth” or “backdoor
conversion.”
There is no 10% early withdrawal penalty on a Roth conversion, but if a taxpayer wishes to convert
a traditional IRA to a Roth IRA, they are required to pay income taxes on the amount of pretax
(deductible) contributions converted, as well as the growth in value resulting from earnings on those
contributions.
Example: Geniece is 40 years old. She converted her entire traditional IRA to a Roth IRA in 2024. The
traditional IRA has a balance of $150,000. The entire balance represents deductible contributions and
earnings that have not previously been taxed. She reports the amount of the balance that was
converted to a Roth IRA as taxable income on her 2024 tax return. The conversion is not subject to a
penalty, regardless of Geniece’s age.
After the funds are converted to a Roth IRA, distributions of conversion amounts are not subject to
tax (because tax was paid upon conversion); however, to avoid the 10% penalty, a taxpayer must keep
the converted amounts within the Roth IRA for at least 5 years.

211Disabled beneficiaries can potentially avoid the negative impact of required minimum distributions (RMDs) on their eligibility
for means-tested benefits. A special needs trust may also be used to protect the beneficiary's eligibility for government benefits.
Special needs trusts are covered in Part 2, Businesses.
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Roth conversions are reported on Form 8606, Nondeductible IRAs. An inherited traditional IRA is
generally not eligible to be converted to a Roth IRA unless it is inherited directly from a spouse. Non-
spousal beneficiaries (for example, a child who inherits a traditional IRA from a deceased parent) are
not allowed to convert an inherited IRA to a Roth IRA.
Example: Carson is age 42 and unmarried. Carson’s 70-year-old mother died on June 1, 2024. Carson
inherited her traditional IRA. He wants to convert the IRA to a Roth, but he is not allowed to do so
because the IRA was not inherited from a spouse. He will be required to distribute the amounts in a
lump sum, or create a beneficiary IRA in order to distribute the funds within 10 years.
Example: Jolene is age 60, and married to Fred, age 71. Fred dies in 2024, leaving his entire traditional
IRA account to Jolene. Jolene does not want to start taking distributions from the inherited IRA,
because she is still several years from retirement. She wants to convert the IRA to a Roth so the
amounts can grow tax-free. Because she is a spousal beneficiary, Jolene can choose to assume
ownership of the inherited IRA, and can then convert the funds to a Roth IRA, if she chooses.

Excise Tax on Overcontributions

If a taxpayer accidentally contributes more to an IRA than is allowed for the year, the excess
contribution is subject to a 6% excise tax. However, the IRS will allow a taxpayer to correct an excess
contribution if certain rules are followed.
If a taxpayer makes an IRA contribution that exceeds the annual maximum (or qualifying
compensation), the excess contribution and all related earnings must be withdrawn from the IRA
before the due date (including extensions) of the tax return for that year. If a taxpayer corrects the
excess contribution by this deadline, the 6% penalty will not apply, but the interest or other earnings
on the excess contributions will be taxable income in the year the excess contribution was made.
If the overcontribution is not withdrawn, the taxpayer must pay a 6% excise tax, and this tax will
apply for every year that the overcontribution remains in the account. However, this excise tax can
never exceed 6% of the value of the taxpayer’s IRA at the end of the tax year.
Example: In 2024, Katie, a 30-year-old taxpayer, mistakenly deposits $9,000 into her Traditional IRA,
exceeding the annual contribution limit of $7,000 for the year. This results in an excess contribution of
$2,000. Katie discovered her mistake after the year ended. To avoid incurring a 6% excise tax, she
needs to withdraw the excess $2,000 along with the earnings generated from it before the tax return
filing deadline for 2024, including any extensions. Katie removes the $2,000 excess contribution and
$32 in earnings it generated on March 1, 2025. By correcting the excess contribution before the
deadline, she avoids the 6% excise tax. The $32 in earnings is taxable on Katie's federal income tax
return for the year 2024, the year the contribution was made.
Note: A taxpayer cannot apply an excess contribution to an earlier year even if the taxpayer
contributed less than the maximum amount allowable for an earlier year. However, the taxpayer is
allowed to apply an excess contribution to a later year if the contributions for that later year are less
than the maximum allowable for that year. This is a permitted type of recharacterization.

IRA Recharacterizations
In the past, a taxpayer was able to “undo” or reverse a rollover or conversion of one type of IRA to
a different type of IRA through a recharacterization. Essentially, by recharacterizing an IRA, it is as if
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the conversion or rollover never occurred. The Tax Cuts and Jobs Act eliminates the option to
recharacterize, or “unwind” an earlier Roth conversion. This means that a Roth IRA conversion cannot
be reversed.
Example: On June 1, 2024, Lawrence converts his entire traditional IRA to a Roth IRA. However, the
investments in his Roth IRA perform poorly, and his account loses value after the conversion. Lawrence
wants to go back and change his mind. However, since he converted his traditional IRA to a Roth, the
conversion is permanent. He cannot undo the conversion.
Some types of recharacterizations are still permitted. For example, a recharacterization is allowed
for fixing certain mistakes. A taxpayer can use the recharacterization rules to fix an invalid contribution
or an invalid rollover, for example. When taxpayers accidentally make an overcontribution to a
traditional IRA or Roth IRA, they can also choose to either recharacterize the contribution or withdraw
it; otherwise, a 6% excise tax will apply.
Example: Armin is age 50 and unmarried. He earns $40,000 from his technician job at a hotel. He does
not have a retirement plan at work, so he has always contributed to a Roth IRA. On May 2, 2024, Armin
makes an $8,000 contribution to his Roth IRA for the year. In December, he sells a large block of
cryptocurrency at a large gain, which raises his 2024 MAGI to $290,000, which is in excess of the
maximum income thresholds to be eligible to contribute to a Roth, making the entire $8,000 an excess
contribution. By the time he discovers his error, it is February 5, 2025 (the following year). Armin
corrects his mistake by moving the entire contribution into a traditional IRA by making a trustee-to-
trustee transfer. This is not a “rollover.” It is a recharacterization. Armin has recharacterized the
prohibited Roth IRA contribution into a traditional IRA, which is permitted. He will be able to deduct
the traditional IRA contribution, as well as avoid the 6% excise tax that would have otherwise applied
to his earlier (improper) Roth contribution.

Prohibited Transactions
A prohibited transaction is the “improper use” of an IRA by the owner, a beneficiary, or a
disqualified person (typically a fiduciary or family member). Prohibited transactions related to an IRA
include:
• Using an IRA as security or collateral for a loan,
• Buying property for personal use with IRA funds (for example, using IRA funds to buy a
vacation home the IRA owner will use),
• Borrowing money from the IRA (i.e., there is no such thing as an “IRA loan,” although some
types of retirement plans do allow borrowing, traditional IRAs do not) 212
• Selling, leasing, or exchanging property to the IRA account,
• Accepting unreasonable compensation for managing IRA assets,
• Granting account fiduciaries to obtain, use, or borrow against account assets for their own gain,
• Transferring plan assets, lending money, or providing goods and services to “disqualified
persons,” usually a close family member, or a business that a close family member owns and
controls.

212Do not confuse the borrowing restrictions for traditional IRAs and other types of retirement accounts. Loans are not permitted
from IRAs or from other IRA-based plans such as SEP-IRAs and SIMPLE IRA plans. Loans are only possible from qualified plans,
such as: 401(k) plans or 403(b) plans, and from governmental plans. Qualified retirement plans are covered in detail in Book 2,
Businesses.
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For the purposes of the prohibited transaction rules, “family members” include the taxpayer’s
spouse, parents, grandparents, children, and grandchildren and spouses of the taxpayer’s children and
grandchildren. Family members do not include: in-laws, cousins, aunts, uncles, siblings, and
stepsiblings.
Although occurrences of prohibited transactions are rare, the consequences can be catastrophic. If
a prohibited transaction occurs at any time during the year, normally, the account ceases to be treated
as an IRA, and its assets are treated as if having been wholly distributed on the first day of the year.
However, in situations where an IRA account, or a portion of an IRA account, is used as security for
a loan, only the amount used as security for the loan is treated as a distribution from the IRA as of the
first day of the year that the loan was made, but the IRA continues to exist.
If the total fair market value as of that date is more than the taxpayer’s basis in the IRA, the excess
amount is reportable as taxable income. It may also be subject to the additional 10% penalty on early
distributions.
Example: Zamir, age 40, has a self-directed IRA account. The fair market value of Zamir’s traditional
IRA was $300,000 as of January 1, 2024. He had previously made $200,000 of nondeductible
contributions to his IRA, so that was his basis in the account. On January 10, 2024, Zamir borrows
$150,000 from his IRA to purchase a vacation home for himself. He believed that he was permitted to
do this, but he misunderstood the IRA rules. This is a prohibited transaction, and Zamir’s entire IRA
account will no longer be treated as an IRA from the date of the withdrawal. Since the FMV of the IRA
on the first day of the year, $300,000, is greater than Zamir’s basis ($200,000) the excess amount of
$100,000 must be reported as taxable income. Zamir would also be subject to the additional 10%
penalty on the entire amount, for withdrawing funds before the age of 59½.
Note: Prohibited transactions are rare occurrences, and they generally only occur when a taxpayer has
a “self-directed” IRA. A self-directed IRA is a type of account that offers a taxpayer the ability to use his
retirement funds to make almost any type of investment without requiring a financial institution or
another custodian.

Prohibited IRA Investments

Almost any type of investment is permissible inside an IRA, including stocks, bonds, mutual funds
and even rental real estate. However, some investments are prohibited. For example, the law does not
permit IRA funds to be invested in life insurance contracts or collectibles. If the taxpayer invests in any
of these prohibited investments using IRA funds, it is treated as a prohibited transaction. The following
investments are prohibited:
• Collectibles such as: artwork, jewelry, antiques, porcelain, fine wines, baseball cards, uncut
gemstones, and comic books,
• Most precious metals or coins, although there is a narrow exception for investments in gold
and silver coins minted by the U.S. Treasury Department.213
• S corporation stock,
• Life insurance contracts,

213 Investments in certain gold, silver, palladium, and platinum bullion are permitted.
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• Real estate held for personal use (real property can be held in an IRA as long as the investments
are not in the taxpayer’s personal name, and not used for personal use, such as a vacation home
used by the taxpayer, a spouse, ancestor, lineal descendant and any spouse of a lineal
descendant).214
Example: Wheeler is 52 and has $500,000 in his traditional IRA. In early 2024, he purchased a rental
property within his IRA as an investment property and listed it as a short-term rental online. The rental
is in a popular tourist zone, and a few weeks later, Wheeler’s daughter, Maryanne, uses the property
to spend a week-long vacation. Even if she pays for her stay, this is considered “self-dealing” and is a
prohibited transaction. For Wheeler, the IRA is deemed immediately disqualified as of 2024 (the year
in which the prohibited transaction occurred). The entire amount of the IRA is deemed distributed,
and an early withdrawal penalty of 10% would also apply to the entire amount of the IRA.
Example: Donna has a Checkbook IRA, which is a self-directed IRA that she controls. On January 30,
2024, Donna purchased $374,000 of U.S. gold coins with IRA funds. The coins were shipped directly to
Donna’s home, in a package addressed to her. She stored the coins in her safe, alongside her personal
jewelry. Donna’s tax return is later selected for audit. The Tax Court deemed that Donna received a
taxable distribution when she took physical possession of the coins, and had “co-mingled” the coins
with other assets by putting them in her personal safe. An owner of a self-directed IRA may not take
actual possession of IRA assets. The court treated the amount used to purchase the coins as a
distribution and imposed accuracy-related penalties. (Based on Tax Court case: McNulty v.
Commissioner).

Retirement Plans for Businesses

Retirement plans for businesses include Simplified Employee Pension (SEP-IRA) plans, Savings
Incentive Match Plan for Employees (SIMPLE) plans, and qualified plans. The term “qualified” refers to
certain IRS requirements that the employer must adhere to in order to obtain a retirement plan’s tax-
favored status. SEP and SIMPLE plans must also meet certain requirements but are much less complex
than those that apply to qualified plans.
Study Note: Business retirement plans are covered in greater detail, and from the employer’s
perspective, in Book 2: Businesses, as much of the related information is tested on Part 2 of the EA exam.
In Part 1 of the exam, you will need to understand the employee’s perspective regarding retirement
plans. For Part 2, you must understand retirement plans from the employer’s perspective.
If retirement plans are structured and administered properly, businesses can deduct contributions
they make on behalf of their employees or, if self-employed, themselves. Both the contributions and
the earnings are generally tax-free until distribution. Further, some plans also allow employees to
make contributions, most commonly in pretax dollars (so that a portion of their salaries are not taxed
until the amounts are later distributed to them by the plan).
SEP-IRA Plans: SEPs provide a simplified method for employers to make contributions to a
retirement plan for themselves and their employees. Instead of setting up a profit-sharing plan with a
trust, an employer can adopt a SEP agreement and make contributions directly to individual SEP-IRA

214For the purposes of the prohibited transactions rule, family members would include parents, children, grandchildren, and the
spouses of children or grandchildren. Siblings, cousins, aunts and uncles, or step-children are not disqualified persons.
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accounts (similar to a traditional IRA as described previously) for themselves and each eligible
employee. In a SEP plan, only the employer makes contributions; employees are not allowed to
contribute.215 If an individual is self-employed and earns income from their business, they can establish
and fund a SEP plan.
SIMPLE Plans: An employer can generally set up a SIMPLE plan if the business has 100 or fewer
employees. Under a SIMPLE plan, employees can choose to make salary reduction contributions rather
than receiving these amounts as part of their regular pay. An employer is allowed to contribute
matching contributions or non-elective contributions.
A SIMPLE plan can be structured in one of two ways: as a SIMPLE IRA (again, similar to traditional
IRAs as described previously) or as a SIMPLE 401(k) plan (similar to the qualified 401(k) plans
described below).
Qualified Retirement Plans
There are two basic kinds of qualified retirement plans: defined contribution plans and defined
benefit plans, and different rules apply to each. An employer is allowed to have more than one type of
qualified plan, but contributions cannot exceed annual limits.
All qualified plans are subject to federal regulation under the Employee Retirement Income
Security Act (ERISA). The federal government does not require an employer to establish a retirement
plan, but it provides minimum federal standards for qualified plans.
Defined Contribution Plans
A defined contribution plan provides an individual account for each participant in the plan
depending upon how the plan is structured. It provides benefits to each participant based on the
amounts contributed to the participant’s account, along with subsequent investment income or losses,
and, in some instances, allocations of forfeitures among participant accounts.
The participants, the employer, or both may contribute to the individual participant accounts.
Examples of defined contribution plans include profit-sharing plans, 401(k) plans, 403(b) plans, and
457 plans. Depending upon how a qualified plan is structured, salary reduction/elective deferral
contributions are employee contributions based on a percentage of the employee’s compensation and
are generally made on a pretax basis.
This limitation applies to the aggregate amounts of contributions to any qualified plans, SEPs, and
SIMPLE plans in which the individual participates during the year. However, the contribution cannot
exceed the amount of the employee’s compensation. Depending on the individual plan, the employer
may provide matching contributions for employees who make elective deferrals.
Example: Spencer earns $80,000 per year as a full-time insurance adjuster. He participates in his
company’s profit-sharing 401(k) plan. He contributes 3% of his pretax wages to the plan in 2024, or
$2,400 ($80,000 × .03). Spencer’s employer also contributes a matching 3% to his individual 401(k)
account.
Distributions: Distributions to participants may be made either on a periodic basis, such as
annuity payments or as a lump sum. As is the case with distributions from traditional IRA accounts (as

215There are some older, grandfathered SEP plans that were set up before 1997, called SARSEPs, that permit employees to make
contributions through employee salary reductions. These were discontinued after 1996, but some grandfathered plans still exist.
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well as SEP and SIMPLE plans), distributions generally are not permitted prior to when the participant
retires or otherwise terminates employment, dies, becomes disabled, or reaches age 59½. Earlier
distributions are generally subject to an additional 10% penalty tax.
Note: For purposes of the net investment income tax (NIIT), net investment income does not include
distributions from a qualified retirement plan, such as a 401(k), or from traditional or Roth IRAs.
However, these distributions are taken into account when determining the modified adjusted gross
income threshold.
In 2024, required minimum distributions (RMDs) from defined contribution plans216 must
generally begin by April 1 of the year following the calendar year when the taxpayer retires, or the year
in which the taxpayer reaches age 73, whichever comes later.217
Example: Norman retires at age 67 after working for three decades at an automobile manufacturing
plant. His employer offers a 401(k), a defined contribution plan, in which Norman participates.
Norman chooses to begin taking distributions from his 401(k) plan in the same year he retires. The
distributions would be taxed as retirement income on his individual tax return. The amounts will be
subject to income tax.

Defined Benefit Plans

A defined benefit plan, often called a traditional pension plan, promises a specified benefit amount
or annuity for each participant after retirement. Benefits are typically based on formulas that consider
the participant’s years of service with the employer and their earnings history. The federal government
and most state and local governments provide defined benefit plans for their employees. The benefits
promised by many defined benefit plans are protected by federal insurance. Contributions to a defined
benefit plan are not optional.
Contributions are typically based on actuarial calculations that estimate the amounts necessary to
pay benefits in the future. Defined benefit plans are still commonly offered to federal and government
workers; however, fewer and fewer private companies offer defined benefit plans because they are
costly to administer and inflexible.
Example: Garrison has been a police officer in Boulder, Colorado for many years. Garrison has a
defined-benefit pension through his employer. Colorado has a statewide Defined Benefit Plan that
covers all full-time firefighters and law enforcement officers. Garrison retires at age 62 with a pension
of $82,000. He will receive a monthly retirement benefit that is payable until his death.

Loans and Distributions from Qualified Plans

Unlike traditional IRAs and Roth IRAs, where withdrawals are permitted at any time, distributions
from qualified plans are generally restricted by the employer. This means that an employee cannot
withdraw from the qualified plan whenever they choose, (like one can from a traditional IRA or Roth
IRA). Generally, distributions of elective deferrals cannot be made until one of the following occurs:
• The taxpayer dies, becomes disabled, or has a severance from employment.

216Defined contribution plans include 401(k) plans, profit-sharing, and 403(b) plans.
217The Secure Act 2.0 increased this age limit from 72 to 73. This means that individuals born in 1951 must receive their first
required minimum distribution by April 1, 2025.
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• The plan terminates, and no successor-defined contribution plan is established or maintained
by the employer (this may happen when a business dissolves or files for bankruptcy)
• The taxpayer reaches age 59½, or the taxpayer incurs significant financial hardship.
Some limited borrowing from qualified plans is allowed. Loans are not dependent upon hardship,
but some plans may provide for loans as well as hardship withdrawals (although the plan is not
required to do so).218 If a loan is not repaid according to the specified payment terms, it may be
considered a taxable distribution. This may happen if a participant terminates employment with the
employer that sponsors the plan.219
Example: Ember, age 60, borrowed $40,000 from her 401(k) plan at work in order to pay some
emergency expenses. She paid the balance of the loan down to $22,000 before quitting her job and
defaulting on the remaining part of the loan. Ember will be treated as having taken out $22,000 from
her 401(k) plan in the year of the default. She will not owe an early withdrawal penalty because she is
over 59½, but she must include the $22,000 “deemed distribution” in her taxable income for the year.
Example: Ophelia participates in her 401(k) at her work. Her employer’s 401(k) plan allows for
participant loans. Ophelia has a vested account balance of $100,000 in her 401(k). In 2024, Ophelia has
an unexpected dental emergency and must have four root canals done in the same month. Her health
insurance does not include dental coverage, so she has to pay for the root canals herself. Ophelia
requests a plan loan from her 401(k) of $20,000 to be paid in 20 installments. The loan is not treated
as a distribution, and is not taxable to Ophelia, as long as she satisfies the plan loan rules and makes
her payments on time.

Hardship Distributions
A 401(k) plan may allow participants to receive hardship distributions because of an immediate
and heavy financial need, such as sudden medical or funeral expenses. Hardship distributions are
limited to the amount of the employee’s elective deferrals and generally do not include any income
earned on the deferred amounts.
The drawback to hardship distributions is that the amounts withdrawn can be subject to income
tax as well as an early withdrawal penalty. The amount of the distribution may also include
withholding to pay taxes or penalties anticipated to result from the distribution.
Note: Some types of retirement plans provide for hardship distributions. These include 401(k) plans,
403(b) plans, and 457(b) plans, which are employer retirement plans that may permit hardship
distributions. A “hardship distribution” is not the same as a “disaster distribution.” A qualified
disaster distribution gets special tax treatment and is only available to taxpayers who have incurred
losses or hardship in a presidentially declared disaster area (i.e., a FEMA disaster area). Hardship
distributions are not eligible for repayment, but qualified disaster distributions can be repaid. Any

218 Note that these special rules for plan loans do not apply to IRAs, because loans are never permitted from an IRA. If an owner of
an IRA borrows from the IRA, this is a prohibited transaction, and the value of the entire IRA is included in the owner’s income (less
any potential tax basis in the IRA).
219 Most qualified plans offer employees the ability to borrow from their own retirement account and repay that amount with

interest to their own retirement account. IRS regulations permit qualified plans to offer loans to plan participants, but the plan is
not required to.
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disaster relief withdrawal will not be taxable if it is recontributed to the account within three years of
the date of distribution.
Example: Damara is 37 years old. Her home is in foreclosure, and she is in immediate danger of being
evicted. Her employer’s 401(k) plan does not allow participant loans, but does allow for hardship
distributions. Damara requests a $15,000 hardship distribution from her 401(k), which is granted.
Since she is under age 59½, Damara would likely have to pay the 10% early distribution penalty, as
well as income tax on the amounts withdrawn.

Traditional IRA vs. Roth IRA Comparison

Issue Traditional IRA Roth IRA

Age limit No age limit in 2024 for No age limit for contributions
contributions.
2024 The lesser of $7,000 (or $8,000 if age Same
Contribution 50 or older by the end of the year)
limits and qualifying compensation.
Deductibility of Generally deductible. Contributions to a Roth IRA are
contributions never deductible.
Filing No filing requirement unless Filing requirement related to a
requirements nondeductible contributions are conversion of a traditional IRA
made. Nondeductible contributions to a Roth IRA. None related to
must be reported on Form 8606. contributions made directly to
a Roth IRA.
Mandatory RMDs by April 1 of the year No distributions are required
distributions following the year a taxpayer unless the IRA owner dies.
reaches age 73 (in 2024)
How distributions Distributions from a traditional IRA Qualified distributions from a
are taxed are taxed as ordinary income. Roth IRA are not taxed.
Income limits Anyone with qualifying There are income limits for
compensation can contribute, but contributions, but “backdoor”
deductibility is based on AGI if the conversions of a traditional IRA
taxpayer or spouse has an employer to a Roth IRA are still
plan. permissible.

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Unit 17: Foreign Financial Reporting

More Reading:
Instructions for FinCEN Form 114
Instructions for Form 3520
Publication 5569, Report of Foreign Bank & Financial Accounts (FBAR) Reference Guide
Beneficial Ownership Information Reporting Rule Fact Sheet

This chapter will cover foreign financial reporting requirements for U.S. taxpayers. The Bank
Secrecy Act (BSA) is the law that imposes reporting requirements on foreign financial accounts. The
Foreign Account Tax Compliance Act (FATCA) is the law that mandates the reporting of foreign financial
assets. The subject of foreign financial reporting is extremely complex, and the IRS continues to issue
guidance on how taxpayers and tax professionals should approach this difficult topic.
Note: Congress passed the Corporate Transparency Act (“CTA”) on January 1, 2021, but the
requirements to report beneficial ownership information (BOI) did not go into effect until January 1,
2024. On Sunday, March 2, 2025, the Treasury Department announced that it will not enforce the
reporting rule against domestic reporting companies and plans to issue proposed regulations to revise
it so that only foreign reporting companies must file a BOI report with the FinCEN. At the time of this
book’s printing, foreign entities still have a filing requirement. Note that the current EA exam
specifications do not include these new BOI requirements.
A person who holds a foreign (non-U.S.) financial account may have a reporting obligation even
when the account produces no taxable income, and even if the person does not have an individual
income tax filing requirement. The definition of a “United States person” for foreign financial reporting
purposes includes U.S. citizens, U.S. nationals, U.S. residents, and U.S. entities. Generally, nonresident
aliens are not obligated to file FBARs. However, exceptions may occur if the nonresident chooses to be
treated as a resident for tax purposes or elects to file a joint tax return with a U.S. citizen or resident.
There are several different forms220 used for reporting foreign bank accounts, foreign assets, and
foreign gifts. These are:
• FBAR, Form 114, Report of Foreign Bank and Financial Accounts
• Form 8938, Statement of Specified Foreign Financial Assets
• Schedule B, Interest and Ordinary Dividends (Part III)
• Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain
Foreign Gifts
• Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations
Federal law requires that U.S. persons report all worldwide income, including income from foreign
trusts and foreign bank accounts. In many cases, these taxpayers need to complete Schedule B and
attach it to their tax return. Certain taxpayers may also have to fill out and attach Form 8938, Statement
of Foreign Financial Assets. Form 3520 is used to report certain foreign gifts and bequests, as well as

220 This list is not comprehensive. It only includes the most commonly used forms for foreign-financial reporting and those that are

listed on the Prometric test specifications for Part 1 of the EA exam. There are additional forms, such as Form 8865, Return of U.S.
Persons with Respect to Certain Foreign Partnerships, which is used to declare interest in a foreign partnership.
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certain transactions with foreign trusts. Schedule B, Form 3520, and Form 8938 are all filed with the
Internal Revenue Service.
The FBAR filing requirement, however, is a separate filing requirement than filing a regular tax
return. FBARs are not filed with the IRS; these forms are filed directly with the Financial Crimes
Enforcement Network (FinCEN), a division of the U.S. Treasury Department. Generally, records of
accounts required to be reported on the FBAR should be kept a minimum of five years from the due
date of the report, which is the year following the calendar year being reported.
Example: Eliza is a U.S. citizen and is the sole shareholder of Trendy International. Trendy
International, Inc., is a Florida C corporation that conducts business operations in Spain. The
corporation has foreign bank accounts in Spain with account balances in excess of $10,000 during the
year. Eliza has signature authority over all the foreign accounts. Therefore, Eliza and Trendy
International must file FBARs (described in further detail below), because both have a financial
interest in, or authority over, a foreign financial account.

FBAR Enforcement Authority

The term “FBAR” refers to Form 114, Report of Foreign Bank and Financial Accounts. The FBAR is a
reporting requirement and does not directly impact tax liability. In 2003, the Department of the U.S.
Treasury delegated FBAR enforcement authority to the Internal Revenue Service (IRS). This means
that the IRS does not process the FBAR filings, but the IRS is responsible for FBAR enforcement. With
regard to FBAR filings, the IRS is responsible for:
• Investigating possible civil violations,
• Assessing and collecting civil penalties, and
• Issuing administrative rulings.
The FBAR must be filed electronically and is only available online through the BSA E-Filing
System.221 The FBAR form itself is not considered part of the taxpayer’s individual tax return, but
disclosure of ownership of any foreign account or an FBAR filing requirement is required on Form
1040, Schedule B, Part III. A U.S. taxpayer is required to file an FBAR if:
• The person had a financial interest in, or signature authority over, at least one financial account
located outside of the United States, and
• The aggregate value of all foreign financial accounts exceeded $10,000 (U.S. dollars) at any
time during the calendar year reported.222 This $10,000 aggregate threshold is the same for
every filing status.223

221 The “BSA E-Filing System” is an official U.S. Treasury website and is used for online filing of FBAR returns. The website also
supports electronic filing of Bank Secrecy Act (BSA) forms through a secure network.
222 Accounts are converted to U.S. currency based on the exchange rate as of the end of the calendar year, applied to the highest

balance in the account during the year, even if the highest balance in the foreign account (in U.S. dollars) was sometime before the
end of the year.
223 Currently, the Report of Foreign Bank and Financial Accounts (FBAR) regulations do not define a foreign account holding virtual

currency as a type of reportable account, but FinCEN intends to propose regulations regarding reports of foreign financial accounts
(FBAR) to include virtual currency as a type of reportable account (FinCEN Notice 2020-2).
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Example: Emily is a 25-year-old U.S. citizen whose grandparents live in France. Emily visits her
grandparents in France at least once a year, and she plans to study French at an international college
this year. To facilitate her future studies, Emily opened a savings account in France, where her
grandparents live. The highest total value of her savings account in 2024 was $18,500 (in U.S. dollars).
Emily’s family is wealthy and supports her financially. She does not work, and does not have an
individual filing requirement. However, since she has a foreign bank account exceeding $10,000, Emily
must file an FBAR.
Example: Gustavo is a U.S. citizen who has a bank account in Mexico. This is the only foreign account
that he has. In prior years, the highest value of his Mexican bank account totaled approximately $7,500
in equivalent U.S. dollars. Therefore, Gustavo did not have an FBAR requirement. However, in 2024,
Gustavo decides that he wants to build a vacation home in Mexico. He transfers $29,000 to his Mexican
bank account on January 17, 2024, to begin construction on his new residence. Although he later
withdraws all the funds, he is still required to file an FBAR, because the aggregate value of his foreign
accounts reached $10,000 during the year. However, he is not required to file Form 8938 (to be
discussed later) because the value of his foreign assets is below the reporting threshold for Form 8938.
When filing an FBAR, taxpayers must, “reasonably figure and report the greatest value of currency
or assets in their accounts during the calendar year.” For example, a foreign financial account located
in Japan would typically be valued in yen. The owner of the account must first determine the maximum
value of the account in yen. Then, convert the maximum value of the account into U.S. dollars.
The IRS defines “signature authority” as the authority of an individual or individuals to control the
disposition of assets held in a foreign financial account by direct communication with the bank or other
financial institution. In other words, FBAR reporting requirements are not determined by ownership
of the funds. “Foreign financial accounts” include the following types of accounts:
• Foreign bank accounts, including savings accounts, checking accounts, and time deposits,
• Foreign securities accounts such as brokerage accounts and securities derivatives or other
financial instruments accounts, commodity futures or stock options accounts,
• Insurance policies with a cash value (such as a whole life insurance policy),
• Foreign mutual funds or similar pooled funds (i.e., a fund that is available to the general public
with a regular net asset value determination and regular redemptions),
• Any other accounts maintained in a foreign financial institution or with a person performing
the services of a financial institution.
The FBAR is due by April 15th of the year following the year in which the account holder meets the
$10,000 threshold. However, FinCEN grants filers an automatic extension to October 15 to file the
FBAR. There is no requirement or form to request this extension. This threshold is the same for every
filing status.
Whether or not an account produces income does not affect the requirement to file an FBAR. Also,
if the IRS issues a news release for filing extensions due to a disaster, do not assume that the FBAR
filing deadlines are extended, as well. FBAR filing extensions are rare, even for disaster situations.

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Note: U.S. law requires taxpayers to file a Report of Foreign Bank and Financial Accounts (FBAR) if
they meet a threshold of $10,000 in a foreign bank account at any time during the calendar year. This
includes all accounts that the taxpayer may own or have any financial interest in—this includes
signature authority, power of attorney, or custodianship.
Example: Carlos, a U.S. citizen, co-owns a foreign bank account in Costa Rica with his mother, Juliana,
who is a Costa Rican citizen. The highest value in the account was $16,000 USD in 2024. Half of the
income in the account belongs to Juliana, and the account does not produce any interest income. Carlos
is required to file an FBAR. He must report the full value of the account.
There is no minimum age requirement for filing an FBAR. The requirement includes minor
children, as well. If a child holds $10,000 in a foreign financial account, even if the account is not
earning revenues, the child will be required to file their own FBAR. This is true even if the child would
otherwise not have a U.S. filing requirement. If a child cannot file their own FBAR for any reason, such
as age, the child’s parent, guardian, or another legally responsible person must file and sign it for the
child.
Example: Blaise is six years old. He is a U.S. citizen. Blaise’s grandmother, Aurelia, is a citizen of Italy.
Aurelia sets up a savings account for her grandson in an Italian bank, and deposits €50,000 Euros into
the account. Aurelia then named Blaise the co-owner of the account. Using current currency conversion
rates, the account balance is worth approximately $52,300 U.S. dollars. Blaise is required to file an
FBAR to report the existence and value of the account, even if he does not withdraw the funds or
personally receive any of the proceeds from the account.

Example: Russell is a U.S. citizen. Russell’s parents are citizens of Canada and live in Canada. Russell
has signature authority on his elderly parents’ accounts in Canada, but he has never written a check or
made any withdrawals from his parents’ bank account. The Canadian bank account balance reaches
$10,000 USD for the first time in 2024. Russell is required to file an FBAR. Even though Russell does
not have a financial interest in the account, he must file an FBAR because he has signatory authority
and the account exceeds $10,000. Whether or not his signature authority is ever exercised on the
Canadian account is irrelevant to the FBAR filing requirement.
U.S. partnerships, corporations, estates, and trusts that meet the $10,000 threshold are also
required to file an FBAR. The federal tax treatment of an entity does not determine whether the entity
has an FBAR filing requirement.
For example, an entity that is disregarded for purposes of Title 26 of the United States Code must
file an FBAR, if otherwise required to do so. Similarly, a trust for which the trust income, deductions,
or credits are taken into account by another person for purposes of Title 26 of the United States Code
must file an FBAR, if otherwise required to do so.
Spouses and Jointly-Owned Accounts
Spouses do not need to file separate FBARs if they complete and sign Form 114a, Record of
Authorization to Electronically File FBARs, and they each do not have their own separately owned
foreign accounts. Taxpayers don’t submit Form 114a with the FBAR, but they must keep it for their
records. The rules for filing with Form 114a are as follows:

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• All reportable financial accounts of the non-filing spouse must be jointly owned with the filing
spouse.
• The filing spouse must report all jointly-owned accounts on a timely-filed FBAR.
• The e-filing system will not allow both spouses’ signatures on the same electronic form – only
the filing spouse must sign in the system.
If the above conditions are not met, then both spouses must file separate FBARs. Each spouse must
report the entire value of the jointly-owned accounts on their respective FBARs.

Example: Remy and Lisa are both U.S. Citizens. They are married and have three foreign bank accounts
in Spain, where they frequently visit and own a vacation property. All of these accounts are jointly
owned, with a total value of $20,000. They do not have to file separate FBARs. They complete and sign
Form 114a, and Remy files an FBAR reporting all three accounts. Lisa does not need to file a separate
FBAR.
Example: Erma and Quincy are married and file jointly. They are both citizens of Ireland. Erma and
Quincy are also legal U.S. residents (green-card holders). Erma and Quincy live most of the year in the
United States, but they frequently travel back to Ireland and maintain bank accounts there. They have
a joint foreign bank account with the highest account balance during the year of $15,000. Additionally,
Quincy has his own separate foreign account in Ireland, with the highest balance during the year being
$5,000, and Erma has her own account in Ireland, with the highest balance being $6,000. Since the
combined total of each of their foreign accounts (the joint account plus their own separate account)
exceeds $10,000, they must each file their own FBAR.
Example: Reuben and Joana are married and live in Wyoming. They file joint income tax returns. They
are both U.S. citizens, and they live in the United States. Reuben has a foreign bank account in France,
where his parents live. Joana has a bank account in Portugal, where she also has family. Reuben’s
account has $4,000 in equivalent U.S. dollars. Joana has $19,000 in her foreign account. They each own
their foreign bank accounts separately (their foreign bank accounts are not jointly held). Joana must
file an FBAR. Reuben does not have to file an FBAR. This is true whether they choose to file their income
tax returns separately or jointly.
Example: Fabien and Sarah are married and have five foreign bank accounts in Italy, where both own
rental properties. Two accounts are jointly owned with a total value of $26,000, one account is solely
owned by Fabien with a value of $11,000, and Sarah solely owns two accounts, with a total value of
$12,000. Since not all of their accounts are held jointly, both Fabien and Sarah must file separate
FBARs, each reporting the entire value of the jointly-owned accounts, plus their individually-owned
accounts.

FBAR Penalties
The Treasury Department reports that FBAR filings have surged recently, with current filings
exceeding one million per year. The consequences of failure to timely file an FBAR can be extremely
severe. According to the Taxpayer Advocate’s Purple Book, the maximum FBAR penalty is among the
harshest civil penalties the government may impose.

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The most common FBAR reporting mistake is simply failing to file. For “non-willful” FBAR
violations, a civil penalty of up to $10,000 per return (adjusted for inflation) can be imposed.224 For
2024, the maximum “non-willful” failure to file penalty is $16,117.225
Note: For the purposes of the “non-willful” civil penalty, on February 28, 2023, in a 5-4 decision, the
United States Supreme Court ruled that this penalty applies per FBAR report—not for each reportable
foreign account.226 Therefore, even if an individual has multiple reportable foreign bank accounts with
a “non-willful” FBAR violation, only one civil penalty can be imposed on the taxpayer for the year. Prior
to this decision, there was a split in the lower courts about whether the non-willful civil penalty could
be imposed per FBAR report or for each reportable foreign account.
A “willful” failure could result in the greater of $100,000 (this penalty is adjusted for inflation, so
for 2024 it is $161,166) or 50% of the balance in an unreported foreign account per year, for up to six
years.
For example, if an account holder maintains a balance of $25,000 in a foreign account that they
willfully fail to report for many years, the IRS may impose a penalty of over $100,000 (adjusted for
inflation) per year and may go back six years, producing an aggregate statutory maximum penalty of
over $600,000.
In addition to the above-mentioned civil penalties for “willful” failures, criminal penalties can also
be imposed. Criminal penalties may include a fine of up to $250,000 and five years in prison (in most
situations) for willfully failing to file an FBAR report, and up to $10,000 and five years in prison for
knowingly and willfully filing a false FBAR report.
Note: The potential penalties for willful failure to file an FBAR are huge. These penalties can include
criminal prosecution as well as severe monetary civil penalties.
Example: Harold Kahn had two bank accounts in Switzerland. He failed to report the funds in his
foreign bank accounts on the FBAR. The total in both accounts was over $8 million. The U.S.
government determined it was a willful failure to file the FBAR, and assessed a willful nonfiling penalty
of $4 million, which was equal to 50% of Harold’s aggregate account balances. Harold Kahn died soon
after this penalty was assessed, and the Estate of Harold Kahn was forced to litigate, with Harold’s two
sons as co-executors of the estate. The government went after the estate for the penalty, and the
penalty was affirmed (United States v. Kahn, No. 19-3920).
FBAR penalties for inadvertent or “non-willful” failure to file are limited. In most cases, the total
penalty amount for all years under examination will be limited to 50% of the highest aggregate balance
of all unreported foreign financial accounts during the years under examination. The guidance also
establishes procedures and documentation requirements for IRS examiners conducting examinations
related to FBAR penalties.
The IRS will normally not impose a penalty for the failure to file a delinquent FBAR if a taxpayer
properly reports on the federal income tax return, and paid all tax on, the income from the foreign

224 In prior years, the National Taxpayer Advocate recommended in its annual Purple Book that Congress clarify that the IRS must
prove a violation was “willful” without relying on the instructions to Schedule B or the failure to check the box on Schedule B before
imposing a willful FBAR penalty and must do so by clear and convincing evidence; the standard typically required in fraud cases.
225 Per 31 USC 5321(a)(5) adjusted for inflation by 31 CFR § 1010.821(b).
226 Bitner v. U.S. (No. 21-1195).

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financial accounts reported on the delinquent FBAR, if they have not previously been contacted
regarding an income tax audit or a request for delinquent returns for the year for which the delinquent
FBAR was submitted.
Foreign Financial Accounts
For FBAR purposes, a “foreign financial account” is a financial account physically located outside of
the United States. An account is considered “foreign” for FBAR purposes if it has a geographical location
outside of the United States.
For example, an account maintained with a branch of a U.S. bank physically located in Germany is
a foreign financial account, whereas an account maintained with a branch of a French bank physically
located in Texas isn’t a foreign financial account.227
A foreign financial account also includes a commodity futures or stock options account, an
insurance policy with a cash value (such as a whole life insurance policy), an annuity policy with a cash
value, and shares in a foreign mutual fund or similar pooled fund (i.e., a fund that is available to the
public with a regular net asset value determination and regular redemptions). The following accounts
are not classified as “foreign financial accounts”:
• Foreign financial accounts owned by a governmental entity,
• Foreign financial accounts owned by an international financial institution,
• Foreign financial accounts maintained on a United States military banking facility (for example,
a banking institution on a U.S. military base).
An owner or beneficiary of an IRA or another qualified retirement plan is also not required to
report a foreign financial account that is held in the retirement plan.
Example: Grady is a casual investor who directly holds shares of a U.S. mutual fund. The mutual fund
invests in foreign stocks as well as domestic stocks. Since the foreign stocks are held in a U.S.-based
mutual fund, Grady does not need to report his ownership in the mutual fund or the holdings of the
mutual fund. The mutual fund itself would be responsible for any required foreign financial reporting.
Note: A safe deposit box at a foreign financial institution is not considered a “financial account” for tax
reporting purposes. However, under the FBAR rules, if gold, bullion, or foreign currency is held inside
a foreign financial institution, it is subject to FBAR reporting. Specified foreign financial assets do not
include gold, bullion, or currency held directly by the taxpayer.
Example: Virgil is a U.S. citizen who lives in Bolivia. Virgil collects gold and silver coins as a hobby. He
keeps the coins in a wall safe inside his home. He does not trust banks, so he does not have a foreign
bank account. He keeps all his cash inside the wall safe, too. Virgil does not have an FBAR filing
requirement.

Form 3520: Reporting Foreign Gifts and Bequests

U.S. individuals who received large gifts or bequests from certain foreign persons may be required
to file Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain

These two examples are taken from the IRS Report of Foreign Bank & Financial Accounts (FBAR) Reference Guide (Publication
227

5569), available at: https://www.irs.gov/pub/irs-pdf/p5569.pdf

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Foreign Gifts. Form 3520 is due at the same time as the U.S. person’s income tax return (including
extensions) but is filed separately from the income tax return.
A foreign person is defined as a nonresident alien individual or a foreign corporation, partnership,
or estate. In 2024, a U.S. person must file Form 3520, Annual Return to Report Transactions with Foreign
Trusts and Receipt of Certain Foreign Gifts, if they receive gifts or bequests valued at more than
$100,000 from a nonresident alien individual or foreign estate. A taxpayer must aggregate gifts
received from related parties.
Form 3520 is considered an “information return,” not a tax return, and no taxes are assessed on
this form, because foreign gifts or bequests are not subject to U.S. income tax.
Example: Alyssa is a U.S. citizen who has many relatives living in Canada. In 2024, Alyssa received
$60,000 from her Canadian grandfather and $52,000 from her Canadian brother. Alyssa must report
the gifts because the total is more than $100,000 in a single year from related parties. These gifts are
not taxable to Alyssa, but she is required to report them in Part IV of Form 3520.
Failure to file a required Form 3520 can result in steep penalties. The penalty is equal to 5% of the
amount of the foreign gift or bequest for each month for which the failure to report continues (not to
exceed a total of 25%). However, no penalty applies if the failure to report was due to reasonable cause
and not willful neglect. The taxpayer is required to report a gift or bequest on Form 3520 when they
actually or constructively receive it.
Note: A “foreign gift” to a U.S. person does not include amounts paid for qualified tuition or medical
payments made on behalf of the U.S. person. These types of gifts do not have a reporting requirement,
regardless of the amounts, if the payments are made directly to the institutions.
Example: Jason is a U.S. citizen attending the University of Chicago in the United States. His aunt,
Sedona, is a citizen of Australia. Sedona is very wealthy, and she offers to pay all of her nephew’s tuition.
She makes a $108,000 payment directly to Jason’s college, covering the entire cost of his tuition and
on-campus housing. There are no filing requirements for this foreign gift, and neither Jason nor his
aunt have to file gift tax returns or a Form 3520.

Example: Percy is a legal U.S. resident (green card holder) who lives and works in California. Percy’s
grandmother, Claudette, is a French citizen. On January 30, 2024, Claudette dies and leaves Percy a
large inheritance of $290,000. After his grandmother’s estate is settled by the executor in France, Percy
receives the inheritance via wire transfer on June 10, 2024. Since Percy actually received the funds in
2024, his Form 3520 is due on April 15, 2025 (the filing due date for 2024 individual tax returns). The
funds are not taxable to Percy, but the inheritance must be reported, since it is a bequest from a foreign
estate over the reporting threshold.

Form 8938: Statement of Specified Foreign Financial Assets

Generally, taxpayers who hold “specified foreign financial assets” must also file Form 8938,
Statement of Specified Foreign Financial Assets, with their tax returns if the amount of their assets
exceeds certain thresholds. This is a separate filing requirement in addition to the FBAR filing
requirements. Form 8938 requires taxpayers to provide detailed financial information about their
foreign accounts. Specified foreign assets include (this is not an exhaustive list):

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• Foreign stock or foreign securities that are not held in a U.S. brokerage account,
• Foreign mutual funds,
• Foreign-issued life insurance or annuity contract with a cash-value,
• Financial accounts maintained by a foreign financial institution,
• Foreign pensions or deferred compensation plans,228
• Interests in a foreign estate,
• A partnership interest in a foreign partnership;
• Any interest in a foreign-issued insurance contract or annuity with a cash-surrender value.
Example: Jocelyn, a U.S. citizen, has an uncle who is a Greek citizen. In 2024, her uncle died, and Jocelyn
inherited $240,000 in foreign bearer bonds from her uncle. The bonds are held outside of a regular
bank account. Jocelyn must report the value of the bonds on Form 8938, even if she did not cash the
bonds out. Jocelyn must also report the inheritance on Form 3520.
Example: Edward, a U.S. citizen, purchased securities of a Swiss corporation through a securities
brokerage firm located in New York. Edward is not required to report his Swiss securities on an FBAR
or on a Form 8938, because he purchased the securities through a brokerage institution located in the
United States.
Failure to report foreign financial assets on Form 8938 on a timely filed return (including
extensions) may result in a penalty of $10,000. If a taxpayer does not file Form 8938 and later receives
a written notice from the IRS about the lack of filing, the taxpayer has 90 days after the mailing of the
IRS letter to file Form 8938 to avoid additional penalties.
If the taxpayer does not file within that 90-day period, an additional $10,000 penalty may apply to
each 30-day period (or a portion thereof) that Form 8938 is not filed after the 90-day deadline (up to
a maximum of $50,000 of additional late filing penalties—resulting in a total late filing penalty
assessment of $60,000). Further, underpayments of tax attributable to non-disclosed foreign financial
assets will be subject to an additional “substantial understatement” penalty of 40%.
If a taxpayer accidentally omits Form 8938 when they file their income tax return, the taxpayer
should file Form 1040-X, Amended U.S. Individual Income Tax Return, with their Form 8938 attached
and attach a statement of reasonable cause to try to avoid any penalties.
Note: Taxpayers that are not required to file an income tax return for the year, also do not need to file
Form 8938, even if the value of their specified foreign assets is greater than one of the reporting
thresholds.
Example: Melinda is a U.S. citizen and full-time graduate student. Melinda does not work and has no
taxable income for the year. She has a bank account in Brazil that holds over $420,000, because she
inherited a large sum of money from her older brother, who died in January 2024. Her brother was a
Brazilian citizen. Melinda must file an FBAR to report the value of the Brazilian bank account, as well
as Form 3520 to report the inheritance. However, she does not have to file a Form 8938 because she
does not earn any income and does not have an income tax return filing requirement.

228 Payments or the rights to receive the foreign equivalent of social security, social insurance benefits or another similar program
of a foreign government are not specified foreign financial assets and do not have to be reported.
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A Form 8938 filing requirement is triggered if the aggregate value of specified foreign financial
assets is more than the following reporting thresholds:
• Taxpayers living inside the U.S.:
o Unmarried and MFS taxpayers: The total value of specified foreign financial assets is
more than $50,000 on the last day of the tax year or more than $75,000 at any time during
the tax year.
o Married taxpayers filing MFJ: The total value of specified foreign financial assets is more
than $100,000 on the last day of the tax year or more than $150,000 at any time during the
tax year.
• Taxpayers living abroad:
o Unmarried and MFS taxpayers: living abroad must file Form 8938 if the total value of
their specified foreign assets is more than $200,000 on the last day of the tax year or more
than $300,000 at any time during the year.
o Married taxpayers filing MFJ: for joint filers, the value of their specified foreign assets is
more than $400,000 on the last day of the tax year or more than $600,000 at any time
during the year.
The filing of Form 8938 does not relieve a taxpayer of the separate requirement to file the FBAR if
they are required to do so, and vice-versa. Depending on the situation, the taxpayer may be required
to file both forms, and certain foreign accounts may be required to be reported on both forms.
Example: Asher is a U.S. citizen who resides in Costa Rica. He is not employed or earning any taxable
income. Ten years ago, he received a substantial inheritance from his grandparents, which has been
his only source of financial support. He currently holds $500,000 USD in a checking account at a bank
in Costa Rica, but it does not accrue any interest. Since he does not have any taxable income, he does
not have to file a U.S. income tax return (Form 1040 is not required). Asher only needs to file the FBAR
to report the funds in his Costa Rican bank account. He does not need to file a Form 1040 or a Form
8938.
Form 8938 filing requirement also applies to specified domestic entities, including a domestic trust
if one or more of the trust’s current beneficiaries is a U.S. citizen or U.S. resident alien and the asset
value thresholds are surpassed.
A taxpayer does not need to report a financial account maintained by a U.S. financial institution or
U.S. brokerage firm, even if the financial institution or fund invests in foreign stock. This also includes
U.S. affiliates of foreign financial institutions. Examples of financial accounts maintained by U.S.
financial institutions that do not need to be reported include:
• U.S. Mutual fund accounts
• IRAs (traditional or Roth)
• 401 (k) retirement plans
• Qualified U.S. retirement plans
• Brokerage and investing accounts maintained by U.S. financial institutions
The following assets are not “specified foreign assets” and do not have to be reported on Form 8938:

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• Payments or the rights to receive the foreign equivalent of social security, social insurance
benefits or another similar program of a foreign government,
• Directly-held tangible assets, such as art, gold, antiques, jewelry, cars and other collectibles,
• Foreign real estate, such as a personal residence in a foreign country, does not have to be
reported as a “foreign financial asset,” unless the property is held by a foreign entity.229
• Foreign currency, if it is directly held by the taxpayer and not held in a financial institution.
Example: Flavienne is a dual citizen of Germany and the U.S. She has funds deposited in three different
German banks. As of December 31, 2024, bank account #1 had $5,000; bank account #2 had $3,000;
and bank account #3 had $2,500. Flavienne is required to electronically file an FBAR by April 15, 2025
(October 15, 2025 with the automatic extension), because the aggregate value of her accounts is more
than $10,000. However, she is not required to file Form 8938, because the value of her offshore assets
is below the reporting threshold.
Example: Darius is a U.S. expat living overseas. He lives and works remotely as a software developer
in Argentina. At the end of the year, Darius has $385,000 in an Argentinian bank account, because he
is saving up money to purchase a condo in Buenos Aires, Darius must file an FBAR and a Form 8938.
Example: Phineas is a U.S. citizen living and working in Sweden. He owns a house in Sweden and some
very valuable artwork. The value of the house is $370,000 USD and the value of the artwork is
$125,000. He owns the house and the artwork outright. He is not required to report the value of these
assets on Form 8938. He also has a foreign bank account in Sweden, with the equivalent of $9,100 USD.
His foreign bank account balance has never exceeded $10,000 USD during the year, so he does not have
to file an FBAR, either.
Example: Khloe is a U.S. citizen who lives and works in Brazil for an online tutoring company that is
based in the United States. Khloe lives with her grandmother, who is a Brazilian citizen. Khloe does not
have a bank account in Brazil. Instead, she has a bank account in the U.S. and she uses her ATM card
and credit cards to withdraw money and make purchases. She keeps a fairly large amount of Brazilian
currency inside her home, in a safe, along with her personal jewelry. Since she does not have a foreign
bank account or any other specified foreign assets, she does not have to file Form 8938 or the FBAR.

Schedule B, Reporting Foreign Accounts and Trusts

Schedule B of the Form 1040 is used to report interest and dividend income received during the
tax year. However, the last part of Schedule B (Part III) is used by taxpayers who have financial
accounts in foreign countries. This section of the form is where the taxpayer must disclose any foreign
bank or investment accounts and whether or not the taxpayer received any distributions from a
foreign trust.
The reporting requirements for these taxpayers have increased significantly in recent years as part
of FATCA, which refers to the Foreign Account Tax Compliance Act. The law addresses tax
noncompliance by U.S. taxpayers with foreign accounts by focusing on reporting by these taxpayers
and by foreign financial institutions.

229If real estate is held through a foreign entity, such as a foreign corporation, partnership, trust or estate, then the interest in the
entity is a specified foreign financial asset that must be reported on Form 8938, if the total value of all the taxpayer’s specified
foreign financial assets is greater than the reporting threshold that applies.
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In general, federal law requires U.S. citizens and resident aliens to report any worldwide income,
including income from foreign trusts and foreign bank and securities accounts. In most cases, affected
taxpayers need to complete and attach Schedule B to their tax returns. Part III of Schedule B asks about
the existence of foreign accounts, such as bank and securities accounts, and generally requires U.S.
citizens to report the country in which each account is located. On Part III, Schedule B, a taxpayer must
check “yes” or “no” to the question of whether the taxpayer had at any time during the year a financial
interest in or signature authority over a financial account.
A taxpayer who had a financial interest in a foreign account during the year must check the “yes”
box even if they are not required to file FinCEN Form 114, Report of Foreign Bank and Financial
Accounts (FBAR). There is no dollar threshold to report foreign accounts on Schedule B, so even if the
taxpayer does not have an FBAR reporting requirement, the “yes” box must be checked if the taxpayer
has any financial interest in, or signature authority over, a foreign account.

Note: If a taxpayer does not have a filing requirement, they are not required to file a tax return merely
to report their foreign financial accounts on Schedule B. However, if a taxpayer is required to file a tax
return, they must file Schedule B to report foreign financial accounts even if they would not be
otherwise required to file Schedule B.
Example: Maurice is a U.S. citizen who is age 77, retired, and only has $13,100 in Social Security income
for the year. He owns a foreign bank account in New Zealand with a high account balance of $4,100 for
the year. He does not own any other foreign financial accounts. Since Maurice does not have a filing
requirement due to his lack of taxable income, he is not required to file a tax return. Consequently,
Maurice does not need to file Schedule B to report his foreign brokerage account. The value of his
account does not exceed $10,000, so Maurice also does not have to file an FBAR.
For reporting purposes on Schedule B, a “foreign financial account” includes securities, brokerage,
savings, checking, deposit, time deposit, or other accounts that are maintained within a financial
institution.
A financial account also includes a commodity futures or options account, an insurance policy with
a cash value (such as a whole life insurance policy), an annuity policy with a cash value, and shares in
a foreign mutual fund. A financial account is considered to be located in a foreign country if the account

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is physically located outside of the United States. This includes accounts maintained with a branch of a
U.S. bank if it is physically located outside the United States. However, a branch of a foreign bank is not
a foreign account if it is physically located in the United States.
Example: Olivia is a U.S. citizen who lives in Miami, Florida. She recently opened an account with
Santander Bank, which has a branch in Miami. Oliva has no other bank accounts elsewhere. Later
during the year, Olivia goes overseas to visit her grandmother in Spain, and she uses her ATM card to
withdraw cash at a Santander branch in Spain. Santander is an international bank with branches
overseas in many countries, including Spain. Even though Santander is an international bank with
branches in foreign countries, Olivia does not have to file an FBAR, because she opened her account at
a U.S. branch in Miami. Therefore, her account is treated as a U.S. bank account.

Form 5471: Information Return of U.S. Persons With Respect to Certain

Foreign Corporations
When a U.S. taxpayer is an officer, director, or shareholder in a foreign corporation, they may have
an IRS reporting requirement. Form 5471 is typically used to report ownership of a foreign
corporation that exceeds a 10% threshold. The categories of U.S. persons potentially liable for filing
Form 5471 include:
• U.S. citizen and resident alien individuals
• U.S. domestic corporations
• U.S. domestic partnerships
• U.S. domestic trusts
The requirement to file Form 5471 is not based on whether the business generated any income.
Form 5471 is an informational return, not a tax return. The penalties for nonfiling are severe. Each
failure to file a required Form 5471 can result in a $10,000 penalty.
Furthermore, if Form 5471 is not filed within 90 days after the IRS has mailed a notice of the failure
to file, an additional $10,000 penalty is charged for each 30-day period, or fraction thereof, during
which the failure continues after the 90-day period has expired. This additional penalty is limited to a
maximum of $50,000 for each failure to file.
Example: Breanna is a 15% shareholder in three separate foreign corporations. She inherited the
stock when her German grandfather died two years ago. Breanna fails to seek proper legal advice and
as a result, she does not file her returns on time, including the required Forms 5471 for her ownership
in the foreign corporations. She later receives a notice from the IRS. Since she did not have any
reasonable cause for her failure to file, she is assessed a penalty of $30,000 ($10,000 for each entity
that she failed to report on Form 5471).
The Form 5471 is generally filed with a taxpayer’s individual return. Even if a person is not
required to file a tax return (for example, their income is below the filing threshold), the Form 5471
may still be required. Exceptions to the filing requirement exist in cases of constructive ownership, or
an election to be treated as a domestic corporation.

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Differences Between the FBAR vs. Form 8938

Data FBAR Form 8938

Legal Authority Authorized by the Bank Secrecy Act of Authorized by the Foreign Account Tax
1970 (BSA). Compliance Act of 2010 (FATCA).
Who must file? U.S. persons, which includes U.S. citizens, Specified individuals, which includes U.S.
U.S. resident aliens, trusts, estates, and citizens, resident aliens, and nonresident aliens
other domestic entities. who elect to be treated as resident aliens for
purposes of filing a joint tax return; also applies
to certain domestic entities.

Reporting $10,000 held in any foreign bank at any $50,000 ($100,000 MFJ) on the last day of the tax
thresholds time during the calendar year. Based on year or $75,000 ($150,000 MFJ) at any time
(U.S. tax home) the aggregate value of all reportable during the tax year.
accounts.
Reporting $10,000 held in any foreign bank at any $200,000 ($400,000 MFJ) on the last day of the
thresholds time during the calendar year. Based on tax year or $300,000 ($600,000 MFJ) at any time
(foreign tax the aggregate value of all reportable during the tax year.230
home) accounts.
When does the Financial interest in an applicable foreign Any income, gains, losses, deductions, credits,
taxpayer have “an account, or signature authority on an gross proceeds, or distributions from holding or
interest” in an applicable foreign account. disposing of the account or asset that are (or
account or asset? would be required to be) reported, included, or
otherwise reflected on the taxpayer’s return.
What is reported? The maximum value of financial accounts. The maximum value of specified foreign
financial assets.
How are values Converted to U.S. dollars using the end of The fair market value of the asset in U.S. dollars.
determined and the calendar year exchange rate and
reported? reported in U.S. dollars.
Due date Due by April 15 (an extension is allowed The same due date as the taxpayer’s individual
to October 15).231 return, including extensions.
Filing procedures File electronically through FinCEN’s BSA This form must be filed with the taxpayer’s
E-Filing System. The FBAR is not filed with income tax return (Form 1040).
a federal tax return.

230 These thresholds apply even if only one spouse resides abroad. Married individuals who file a joint income tax return for the
tax year will file a single Form 8938 that reports all of the specified foreign financial assets in which either spouse has an interest.
231 These are the normal due dates. The due dates follow the same rules as for income tax purposes, so for 2024, the return due

date is April 15, 2024, with the automatic extension until October 15, 2024.
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Unit 18: Estate and Gift Taxes for Individuals

More Reading:
Publication 559, Survivors, Executors, and Administrators
Instructions for Form 1041, Form 706 and Form 709

Estates in General
An estate is a separate legal entity created when a taxpayer dies. The estate tax is a tax on the
transfer of assets or property from an individual’s estate to a decedent’s beneficiaries after death. The
Tax Cuts and Jobs Act (TCJA) made substantial changes to the estate tax exemption that will continue
through tax year 2025. In 2024, the estate tax exemption is $13,610,00 per decedent. 232 This
exemption is indexed for inflation at the current levels through 2025. The top estate and gift tax rate
remains at 40%.
What this means is that most estates of up to $13.61 million in 2024 are free of estate tax, and from
that point on, anything additional above that is taxable, at progressive rates that start at 18% and rise
to 40% at taxable estates that are $1 million above the estate tax exemption. 233
The same exemption level applies to the generation-skipping transfer tax (covered later). The
deceased spousal portability election remains available in 2024 (covered later). Separately, the 2024
annual gift tax exclusion is $18,000 (this threshold increases to $19,000 in 2025).
Note: Sometimes, the estate tax is called a “death tax” or an “inheritance tax.” The estate tax is not an
income tax. It is a tax that is imposed on the transfer of property after a person’s death. Estate and gift
taxes are often considered together because they share the same lifetime exemption amount. However,
the estate tax applies to transfers of the decedent’s property after death, while the gift tax applies to
transfers made while a person is alive.
Note: For Part 1 of the EA exam, you will be required to understand how estate and gift taxes affect
individual taxpayers, especially the surviving spouses and other beneficiaries of those estates. For Part
2 of the exam, you will be tested on the income tax treatment of estates and trusts as legal entities. It
is possible that questions will overlap, and therefore we cover the concept of estate taxation from
various perspectives.

Personal Representative or Executor

When a person dies, a personal representative (an executor or administrator appointed by a court),
will typically manage the estate and settle the decedent’s final financial affairs. If there is no executor
or administrator, another person with possession of the decedent’s property may act as the personal
representative. If a probate court proceeding is necessary, the judge will appoint an executor if one is
not named in the decedent’s will. A trustee can also administer the affairs of a deceased individual if
the deceased individual had a valid trust at the time of their passing.

232This exemption may be less in situations where the exemption has been reduced due to prior taxable gifts.
233Be aware that some states have inheritance taxes of their own. Currently, about half of the U.S. states impose some type of
inheritance or estate tax. Most states that impose estate taxes match the federal exemption threshold, but some states are much
lower. Property left to a surviving spouse is exempt from the tax in all but six states.
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Note: Under U.S. law, a “personal representative” is a living person appointed by the courts to
administer an estate after a taxpayer has died. Executors are appointed when the decedent has a will,
and administrators are appointed when the decedent dies without a will. The IRS also uses the term
“personal representative” to refer to anyone filing a return on behalf of a decedent, regardless if that
person has been appointed by the courts or named in a decedent’s will.
Example: Dominik is 64 and unmarried. He has one 23-year-old daughter, named Jacqueline. Dominik
dies on November 3, 2024. Thankfully, Dominik had a will when he died. In the will, Jacqueline is
named as the sole beneficiary and the executor of her late father’s estate. Jacqueline seeks the help of
a licensed tax professional as well as an attorney to help her navigate the probate process. The attorney
and the accountant will help Jacqueline file all the necessary paperwork with the court as well as the
IRS. Jacqueline will sign her late father’s final personal income tax return as the executor.
The personal representative is also responsible for determining any estate tax liability before the
estate’s assets are distributed to beneficiaries. The tax liability for an estate attaches to the assets of
the estate itself. If the assets are distributed to the beneficiaries before the taxes are paid, the
beneficiaries or the executor may be held liable for the tax debt, up to the value of the assets
distributed. After a taxpayer dies, the following tax returns may need to be filed by the personal
representative of the estate:
• Form 1040: Final income tax return for the decedent (for income received before death).
• Form 1041: U.S. Income Tax Return for Estates and Trusts: Fiduciary income tax returns for the
estate for the period of its administration.
• Form 706: United States Estate (and Generation-Skipping Transfer) Tax Return: If the gross
estate exceeds the applicable threshold. This return is used to report tax on the taxable estate
(the gross estate minus certain deductions).
The personal representative (including a trustee) or executor must sign each required return. A
personal representative should sign the decedent’s final income tax return as “Personal
Representative.”
IRS Form 56, also known as the Notice Concerning Fiduciary Relationship, is an essential form to
file to inform the IRS of the creation (or termination) of a fiduciary relationship for another party. An
executor should submit the form to establish their authority to act on behalf of the estate. This form
should be filed as soon as the estate’s EIN is received, as it ensures that the executor will receive any
important notices from the IRS.
Example: On April 3, 2024, Loretta Johnson, a widow with no children, passes away. She had not filed
her tax return for the year 2024 before her death. In her final will, she named her nephew, Axel, as her
executor. Axel takes on the responsibility of handling Loretta’s final affairs, including his late aunt’s
taxes. To do so, he must first request an Employer Identification Number (EIN) for Loretta’s estate.
Once he receives the EIN, he completes Form 56, Notice Concerning Fiduciary Relationship, to establish
his authority as the executor of Loretta’s estate. On Form 56, Axel provides Loretta’s information in
Part I, including her name and Social Security number. He also includes his own information and the
newly obtained EIN of the estate. After signing the form, Axel is now able to act as the authorized
representative of Loretta’s estate, including managing any tax matters that may arise. If any notices
are generated by the IRS, they will automatically be sent to Axel, as he is the executor.
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If the taxpayer’s final income tax return is a joint return, then the surviving spouse would sign as a
“surviving spouse” without the need to file Form 56 for the final 1040 (joint) return that includes the
deceased spouse.
The executor or “personal representative” must include fees paid to them from an estate in their
gross income. Fees paid to a trustee of a trust that is administering the affairs of a deceased individual
will also be gross income to the trustee. If the executor is not “in the business” of being an executor
(for instance, the executor is a friend or family member of the deceased), these fees are reported on
the executor’s individual Form 1040, as “other income” on Schedule 1.
If the executor is in the “trade or business” of being an executor, (such as a self-employed estate
attorney), the executor would report the fees received from the estate as self-employment income on
Schedule C.
Example: Patricia is a licensed CPA, but she only does audit work and does not prepare tax returns.
Her uncle, Duran, dies in 2024. In his final will, Duran names his niece, Patricia, as the executor of his
estate. Patricia has never served as an executor before, but she agrees to be the executor of her uncle’s
estate as a favor to his family. The fees she receives from the estate, if any, would be reported as “other
income” on the Schedule 1 of her personal income tax return (Form 1040), because she is not a
professional executor.
Note: A personal representative or executor of an estate cannot be held liable if an insolvent estate
does not have enough assets to cover any of the income taxes due or debts. However, the executor must
be sure that any income taxes are paid before any assets are distributed to the beneficiaries of the
estate; otherwise, the executor might be held personally liable for the tax debt.

Example: Jacinta, who was 53 years old, passed away unexpectedly in 2024, leaving behind a valuable
estate. At the time of her death, she was unmarried. Her oldest child, Silas, who is now 27 years old,
was named as the executor of her estate. Silas has two younger siblings, Rebecca and Sasha, who are
both under the age of 18 and still minors. All of the siblings are equal beneficiaries of the estate, but
since Silas is the only legal adult, he is named the sole administrator of his mother’s estate by the
probate court. Silas distributed a large amount of stock and cash to himself and both his sisters before
he had his mother’s assets properly appraised. After the appraisal is done, Silas realizes that his
mother’s estate has a filing requirement and an estate tax liability. Since Silas distributed assets to the
beneficiaries before determining the correct amount of tax due, he may be held personally liable for
paying the estate tax himself.

Final Income Tax Return (Form 1040)

A decedent’s final income tax return is filed on the same form that would have been used if the
taxpayer were still alive. The filing deadline is April 15 (April 15, 2025, for the tax year 2024) of the
year following the taxpayer’s death, the same deadline that applies for individual income tax returns.
The personal representative must file the final individual income tax return of the decedent for the
year of death and any returns not filed for preceding years (if required to be filed). If an individual dies
after the close of a tax year but before the return for that year is filed, the return for that year will not
be the final return. The return for that year will be a regular return, and the personal representative
must file it.

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Example: Huxley was unmarried when he died on March 20, 2024. His adult child, Janna, is the
executor and sole heir of her father’s estate. Huxley earned $49,000 in wages before his death, so a
final tax return is required for 2024. Janna asks her accountant to help prepare her father’s final Form
1040, which will include all the taxable income that Huxley received before his death. The accountant
also helps Janna with the valuation of her father’s estate. After determining the fair market value of all
her father’s assets, her accountant concludes that Huxley’s gross estate is valued at approximately $16
million on the date of his death. As this exceeds the filing threshold for estate tax purposes for 2024,
an estate tax return (Form 706) is also required to be filed, and Janna is responsible for filing both
returns and signing them as the official representative of the estate.
Example: Esmeralda dies on February 28, 2025. At the time of her death, she was unmarried and had
not yet filed her prior-year tax return. She earned $129,000 of wages during 2024. She also earned
$27,200 of wages between January 1, 2025, and her death on February 28, 2025. Therefore,
Esmeralda’s 2024 and 2025 tax returns must both be filed by her executor. The 2025 return will be
her final individual tax return, because that is the year that she died.
On a decedent’s final tax return, the rules for deductions are the same as those that apply for any
individual taxpayer. The decedent’s year of death is not treated as a short tax year. In other words, the
full amount of the applicable standard deduction or any applicable credits may be claimed on the final
tax return, regardless of how long the taxpayer was alive during the year.
For example, a decedent who died in the middle of the year would still be eligible for EITC (the
Earned Income Tax Credit), if they otherwise qualified, even though their final return covers less than
twelve months.
Example: Ruthie, age 59, was unmarried when she passed away on July 30, 2024. Her only brother,
Vernon, is named the executor of her estate. Ruthie earned a small amount of wages, $8,300, in the
months before she died. Her income is below the filing requirement, so a return does not have to be
filed. However, taxes were withheld from Ruthie’s wages, so Vernon files an individual tax return in
order to receive his late sister’s refund. Ruthie is allowed the full standard deduction, as well as the
EITC, even though she was only alive for part of the year.

Income in Respect of a Decedent (IRD)

Income in respect of a decedent (IRD) is any taxable income that was earned but not received by
the decedent by the time of death. IRD is not taxed on the final return of the deceased taxpayer. IRD is
reported on the tax return of the person (or entity) that receives the income.
This could be an heir, or the surviving spouse. If IRD is paid directly to a beneficiary, it is reported
on the beneficiary’s income tax return (Form 1040). If the estate itself receives IRD, or if there is no
designated beneficiary for the income, then the IRD is reported on the estate’s Form 1041.
IRD retains the same tax nature that would have been applied if the deceased taxpayer were still
alive. For example, if the income would have been short-term capital gain, it is taxed the same way to
the beneficiary. There is no “step-up” in basis for IRD items.

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Example: Wallace, age 65, sells a rental property that he had owned for many years to a private-party
buyer on January 2, 2024, for $120,000. The sales contract was signed between both parties, and the
buyer promised to deliver a cashier’s check to Wallace the following week. A few days later, on January
5, 2024, Wallace dies, before receiving the check from the buyer. Wallace’s adjusted basis in the rental
property was $100,000 at the time of the sale, and he had owned the property for six years. The buyer
of the property remits the $120,000 cashier’s check to Wallace’s daughter, Sheri, who is her father’s
only beneficiary and heir. The gain from the sale ($20,000) is IRD to Sheri, and she must report the
gain on her own return. There is no step-up in basis, because Wallace already sold the home, so there
is no “asset” for Sheri to step up, but Sheri is the one who received the gain from the sale. The sale
generates a long-term capital gain, which Wallace would have recognized on his own return, had he
lived long enough to collect the check. The income is reported and treated the same on Sheri’s return,
since she is the one who received the sale proceeds.

IRD can come from various sources, including:

• Unpaid salary, wages, or bonuses
• Amounts distributed from retirement plans distributed by the payor before the taxpayer’s
death, but not yet received by the decedent at the time of death.
• Deferred compensation benefits
• Accrued but unpaid interest, dividends, and rent
• Dividends declared before the decedent’s death, but payable after death
• Outstanding income owed to a self-employed decedent (accounts receivable) is considered IRD
but is not subject to self-employment tax.
• Gains on the sale of property sold before death but not collected until after death.
For self-employment tax purposes only, a decedent’s self-employment income will include the
decedent’s distributive share of a partnership’s income or loss through the end of the month in which
death occurred.
Wages paid to a deceased employee's estate or executor/administrator in the year of death are not
subject to income tax withholding, but employment taxes, such as FICA, must be withheld. Wages paid
after the year of death are generally not subject to withholding for federal taxes.
Wages paid after the employee's death are considered "Income in Respect of a Decedent" (IRD).
This means they are taxable to the recipient, whether it is the heir or beneficiary of the decedent. No
Form W-2 should be issued in the deceased employee's name for wages paid after the year of death.
Example: Zahid was owed $15,000 of wages when he died on December 27, 2024. The final check for
these wages was not remitted by his employer until several weeks later (in late January 2025, the
following year) and was received and cashed by his daughter and sole beneficiary, Jolene. The wages
are considered IRD to Jolene, and Jolene must recognize the $15,000 as ordinary income, the same tax
treatment that would have applied for Zahid. However, since the wages were paid in the year following
Zahid’s death, no federal income tax or FICA taxes are withheld from the $15,000. The employer will
issue a Form 1099-MISC to the beneficiary, reporting the $15,000 in Box 3 (Other Income).

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Example: Jasper is a self-employed architect who reports his income on Schedule C. Jasper usually
bills his clients monthly. Jasper is married to Zelda, who is a homemaker and does not work in his
business. Jasper dies on December 27, 2024, with several unpaid client invoices outstanding at the
time of his death. Jasper’s surviving spouse, Zelda, receives all the payments from Jasper’s outstanding
invoices the following year, in January 2025. Since the outstanding accounts receivable was earned by
Jasper while he was alive, but not received by Zelda until after his death, then it is considered IRD to
Zelda, and it would be taxed as ordinary income to her in 2025, but not subject to self-employment tax,
because Zelda is not self-employed.
Example: Reginald, age 67, decides to cash out his traditional IRA in order to take a nice vacation. He
contacts his IRA trustee and requests a $12,000 distribution in the form of a check on February 1, 2024.
The trustee tells Reginald that the check will take 7 days to deliver to his home. Two days later,
Reginald dies. The $12,000 check for the IRA distribution is received by Reginald’s daughter, Selma,
who is the executor and sole heir of his estate. The distribution is treated as IRD to Selma.

In rare instances, IRD must be included in the decedent’s estate and may be subject to estate tax.
This may happen with a very wealthy person. If the decedent’s estate was large enough to be subject
to estate tax, this can result in a form of double taxation: once at the estate level and again when the
beneficiary receives the income.
If a beneficiary receives IRD and the income is also subject to estate tax, the beneficiary can deduct
the tax on Schedule A of their individual income tax return as a miscellaneous itemized deduction. This
is called the “IRD deduction” or “Estate Tax Deduction.” A beneficiary must claim the IRD deduction234
in the same tax year in which they actually receive the income.
If the value of the decedent’s estate isn’t subject to estate tax (because it falls within the estate tax
exemption), the IRD deduction is not permitted.
The Estate Tax Return (Form 706)
An estate tax return is filed using Form 706, United States Estate (and Generation-Skipping
Transfer) Tax Return. This return is due nine months after the death of the decedent. A six-month
extension is allowed. After the taxable estate is computed, it is added to the value of lifetime taxable
gifts.
The applicable estate tax rate is applied to derive a tentative tax, from which any gift taxes paid or
payable are subtracted to determine the gross estate tax. The maximum estate tax rate is 40% in 2024.
Less than 1% of taxpayers are affected by the estate tax.
However, all or a portion of the gross estate tax may be eliminated after applying the Basic
Exclusion Amount. The estate tax exclusion is $13.61 million in 2024.235 The assessment period for
estate tax is three years after the due date for a timely filed estate tax return. The assessment period is
four years for transfers from an estate.

234 The “IRD deduction” is short for Income in Respect of a Decedent tax deduction. The IRD deduction is a miscellaneous itemized
tax deduction, not subject to the 2% of AGI floor. The IRD deduction was not suspended by the TCJA.
235 This threshold is much lower for nonresident aliens at $60,000 in 2024. However, nonresident aliens are only potentially subject

to estate tax upon their death for assets located within the United States. Form 706-NA is used for nonresident aliens.
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Example: Wilhelmina was age 60 and unmarried when she died and left an estate valued at $9 million.
She had no children, and her only heir is her 48-year-old brother, Mathis. Wilhelmina had not
previously used any of her basic exclusion amount to avoid paying gift taxes, so the entire exclusion
amount of $13.61 million (in 2024) is available to her estate. As this amount exceeds the entire estate’s
value, no estate tax is owed, and an estate tax return (Form 706) does not need to be filed. All of
Wilhelmina’s assets shall pass tax-free to Mathis (no estate tax will be owed).
A special rule applies to widows and widowers. A surviving spouse can add any unused exclusion
of a predeceased spouse who died most recently to their own estate tax return. This is also known as
“portability” or the Deceased Spousal Unused Exclusion (DSUE), which we will cover later.
Form 1041, Annual Income Tax Return for Estates and Trusts
An estate is a legal entity that exists from the time of an individual’s death until all assets have been
distributed to beneficiaries. As investment assets will usually continue to earn income after a taxpayer
has died, this income, such as rents, dividends, and interest, must be reported. Most estates are
administered and distributed within 12 to 18 months, but sometimes, if the decedent was a famous or
wealthy person, the estate may not terminate for years, and sometimes, even decades. Probate
litigation can drag on for a long time. If there is a dispute about the will, or between the heirs, the estate
cannot terminate until the legal dispute is resolved.
Example: Geneva Jones is a popular writer with many bestselling novels. She is unmarried and has no
children, but she has five adult siblings. Geneva dies without a will on January 19, 2024, at age 52. The
estimated value of her estate exceeds $25 million, and her novels continue to sell briskly after her
death. Geneva’s siblings are her only living relatives and are therefore equal heirs of her estate. The
siblings immediately start to squabble over their late sister’s assets. All five siblings petition to be
named the executor. The probate court is forced to appoint a professional executor, and the litigation
will likely drag on for years. The estate is still generating revenue during this time, so the Form 1041
will need to be filed every year by the professional executor, in order to report the ongoing income of
the estate until the legal dispute between the siblings is resolved.
Note: “Probate” is the court-supervised process of settling a decedent’s estate. It takes longer to
probate an estate that owes estate taxes because a taxable estate cannot be closed until either the
estate obtains an IRS transcript showing the acceptance of the estate tax return, or it receives a final
closing letter from the Internal Revenue Service. 236

Form 1041 is an annual fiduciary return used to report the following items for a domestic
decedent’s estate, trust, or bankruptcy estate:
• Current income237 and deductions, including gains and losses from the disposition of the
entity’s property, and excluding certain items such as tax-exempt interest (collectively,
distributable net income or DNI),
• A deduction for income either held for future distribution or distributed currently to the
beneficiaries (income distribution deduction), and
• Any income tax liability.

236 The IRS no longer automatically issues Estate Tax Closing Letters. However, an estate or trust may request one by paying a fee.
The IRS recommends waiting at least 9 months after the filing of an estate tax return to request an Estate Tax Closing Letter.
237 “Current income” may include IRD (if it was received by the estate, rather than a beneficiary).

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Expenses of administering the estate can be deducted either from the estate’s income on Form
1041 in determining its income tax, or from the gross estate on Form 706 in determining the estate tax
liability but cannot be claimed for both purposes.
Schedule K-1 is used to report any income that is distributed or distributable to each beneficiary
and is filed with Form 1041, with a copy also given to the beneficiary. If the beneficiary of the estate is
a person (and not an entity, like a charity) then the beneficiary would report the distributive income
on Form 1040, Schedule E.
Example: Andrae owned three valuable rental properties before his death on July 1, 2024. The gross
value of his assets on the date of Andrae’s death was $2 million, so an estate tax return (Form 706)
does not have to be filed. The income from the rental properties that was received while Andrae was
alive would be reported on his final Form 1040, Schedule E. The rental income that was received by
his estate after his death would be reportable on Form 1041, Annual Tax Return for Estates and Trusts.
Example: Annabelle is 67 years old and unmarried. She dies on January 31, 2024, and her only heir is
her adult son, Nolan, who will inherit his mother’s entire estate. This includes her primary home valued
at $400,000 and a rental property worth $240,000 which brings in $3,000 of net income each month.
Since the total value of Annabelle’s assets falls below the estate exemption amount, no estate tax return
(Form 706) is required. However, a Form 1041 must be filed to report the rental income earned by the
estate after Annabelle’s passing. Only the rental income earned in January will be reported on
Annabelle’s last income tax return (Form 1040), while the remaining rental income generated after
her death will be reported on Form 1041. Her executor will be responsible for filing her final income
tax return (Form 1040) as well as the tax return for her estate (Form 1041).
Estates and trusts are allowed some of the same tax credits that are allowed to individuals. The
credits are generally allocated between the estate and the beneficiaries. However, estates are not
allowed the Child Tax Credit, or the Earned Income Tax Credit. However, the Earned Income Tax Credit,
Child Tax Credit, and any other applicable credits can be claimed on the decedent’s final return.
Note: Just like individual taxpayers, estates and trusts are subject to the Net Investment Income Tax
(an additional tax of 3.8% on net investment income). The basic provisions for this tax are similar to
those for individuals, and it must be reported on Form 8960, Net Investment Tax: Individuals, Estates,
and Trusts.
The due date for Form 1041 is the fifteenth day of the fourth month following the end of the entity’s
tax year but is subject to an automatic extension of five-and-one-half months if Form 7004 is filed by
the original due date. The tax year may be either a calendar or a fiscal year for an estate, subject to the
election made at the time the first return is filed. An election will also be made on the first return as to
the accounting method (cash or accrual) of reporting the estate’s income.
Form 1041 is required to be filed for any domestic estate that has (1) gross income for the tax year
of $600 or more, or (2) a beneficiary who is a nonresident alien (with any amount of income). If the
estate has no income-producing assets, and generates no income, no income tax return is necessary.

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Example: Petra is 76 years old. She dies on July 1, 2024. At the time of her death, she owned a home
valued at $675,000 and a vacation home valued at $900,000. She had $80,000 in a non-interest bearing
checking account. Petra also owned 5 acres of undeveloped land in Texas valued at more than $1
million. She had purchased the land as an investment several years ago but was not currently using it
for anything. While her estate is valuable, it has no income-producing assets. Therefore, there is no
need to file Form 706 or Form 1041 for Petra’s estate since the assets fall below the exemption amount
and do not generate any revenue.

The Value of the Gross Estate

The gross estate reported on Form 706 includes the fair market value of all property and assets
owned by the decedent at the time of death. This encompasses a wide range of items, not just those
with an easily determinable value or cost basis. The gross estate usually includes the fair market value
of all tangible and intangible property owned partially or outright by the decedent at the time of death,
including:
• All real property owned by the decedent, including homes, land, and commercial properties.
• Tangible personal property such as jewelry, vehicles, art, and collectibles.
• Financial accounts, such as bank accounts, brokerage accounts, and other financial accounts.
• Stocks and Bonds
• Life Insurance Proceeds: Proceeds from life insurance policies owned by the decedent, even if
payable to a beneficiary.
• Retirement Accounts: IRAs, 401(k)s, and other retirement accounts.
• Business Interests: Ownership interests in businesses, including partnerships, corporations,
and sole proprietorships.
• Assets held in certain types of trusts, depending on the terms and conditions of the trust.
• The value of certain property that was transferred within three years before the decedent’s
death.
The gross estate does not include property owned solely by the decedent’s spouse or other
individuals. Lifetime gifts that are complete (so that no control over the gifts was retained) are not
included in the decedent’s gross estate.
Example: Cristiano is wealthy and regularly gives money to many of his close relatives. The IRS allows
every taxpayer to gift up to $18,000 in 2024 to an individual recipient, annually, without having to file
a gift tax return. On January 10, 2024, Cristiano writes 10 individual checks for $18,000, giving a check
to each of his siblings, as well as his parents and grandparents. None of the gifts are taxable to the
recipients, and no gift tax reporting is required for Cristiano. Two months later, Cristiano dies. Since
the cash gifts were “completed gifts” the $180,000 (10 checks × $18,000 each) he gifted to his family
members is not includible in his gross estate.

Deductions from the Gross Estate on Form 706

After calculating the gross estate, certain deductions (and in specific situations, reductions) can be
made to determine the taxable estate. These deductions may include:
• Funeral expenses paid from the estate,

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• Administrative expenses for the estate, such as court fees and legal costs (if not already
deducted on Form 1041),
• Debts owed at the time of the individual’s death,
• Marital deduction (the value of property passing to a surviving spouse),
• Charitable bequests (the value of property passing to eligible charities),
• State death tax deduction (inheritance or estate taxes paid to any state).
The following items are not deductible from the gross estate:
• Federal estate taxes paid,
• Alimony paid after the taxpayer’s death; these payments are treated as distributions to a
beneficiary.
Property taxes are deductible on Form 706 only if they accrue under state law prior to the
decedent’s death.
Example: Alfred Williams, age 82, passed away in 2024, leaving behind an estate worth $14,900,000.
Alfred’s only heir is his adult daughter, Melanie, who is named as the executor of his estate. His estate
has a filing requirement, so Melanie must file Form 706 for her late father’s estate. Alfred had a will
when he died, leaving most of his estate to his daughter, but also a large donation to his favorite church.
The following deductions are permitted from Alfred’s gross estate: funeral expenses ($15,000), legal
expenses and court costs ($10,000), debts owed at the time of death ($550,000), the charitable bequest
to the church ($100,000), and state inheritance taxes ($20,000).

Special Rule for Medical Expenses

If a person passes away with unpaid debts, including medical expenses that are unpaid at the time
of death, those debts can be deducted from the total value of their estate on the estate tax return. Any
outstanding medical expenses at the time of death are considered liabilities of the estate.
However, if these medical expenses are paid by the estate within one year after the individual’s
death, the personal representative has the option to treat them as if they were paid by the deceased
when incurred, instead of when they were actually paid, and deduct them on Form 1040 instead of
potentially on Form 706, if it results in a better tax outcome to the estate. This election can also be
made by filing an amended return.
Example: Jimena, age 76, died on February 1, 2025, after a long battle with cancer. She had filed her
2024 return just two days prior to her death (on January 29, 2025). She had incurred $42,000 of
medical expenses, half during 2024 (the prior tax year) and half during 2025. When she died in
February, all her medical bills remained unpaid. The estate’s executor is her adult son, Ralph. After
consulting with an estate attorney, Ralph pays the entire $42,000 medical bill on April 30, 2025, with
funds from his late mother’s estate. Ralph, the executor, elects to file an amended return (Form 1040-
X) for Jimena for 2024, claiming $21,000 as a medical expense deduction on Schedule A (the year the
medical expenses were incurred). The remaining $21,000 will be deducted on Jimena’s final income
tax return (her 2025 Form 1040, which will be due the following year).

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The Marital Deduction

Transfers from one spouse to the other are typically tax-free. The marital deduction allows spouses
to transfer an unlimited amount of property to one another during their lifetimes or at death without
being subject to estate or gift taxes.
Note: The marital deduction is NOT the same thing as the Deceased Spousal Unused Exclusion, or
DSUE, which is covered in the next section. The DSUE is an election that is generally only available to
U.S. citizen spouses.
To receive an unlimited marital deduction, the spouse receiving the assets must be a U.S. citizen
and must have outright ownership of the assets after the passing of the decedent. The unlimited marital
deduction is generally not allowed if the transferee spouse is not a U.S. citizen (even if the spouse is a
legal resident of the United States).
Example: Lorenzo and Margie are married, and both are U.S. citizens. Lorenzo dies and leaves his wife,
Margie, all his assets, which total $15 million on the date of his death. The transfer is tax-free to Margie
because of the unlimited marital deduction. Margie’s estate may or may not owe tax when she dies, but
the transfer of assets to a surviving spouse is generally a nontaxable event, provided that the surviving
spouse is a U.S. citizen.
Example: Michael, a U.S. citizen, and Sofia, a citizen of Spain, are married. Sofia is a legal resident of
the United States but has not yet obtained U.S. citizenship. Michael passes away in 2024, leaving his
entire estate, valued at $16,500,000, to Sofia. Since Sofia is not a U.S. citizen, Michael’s estate does not
qualify for the unlimited marital deduction. As a result, the transfer of Michael's estate to Sofia will
likely be subject to estate tax. In this scenario, because Sofia is not a U.S. citizen, the unlimited marital
deduction is not available, and the estate must explore other options to manage the estate tax
implications.238

Deceased Spousal Unused Exclusion (DSUE)

The DSUE is an election to transfer the unused portion of the decedent’s predeceased spouse’s basic
exclusion (the amount that was not used to offset gift or estate tax liabilities). A “portability” election
must be made to claim the DSUE on behalf of the surviving spouse’s estate. Once “ported” to the
surviving spouse, the surviving spouse can use the DSUE amount to help shield future asset transfers
from estate tax.
This election is made by filing an estate tax return. Portability is not automatic: Form 706 must be
filed in order to make the DSUE election, even if no estate tax is owed. The Form 706 is due nine months
after the death of the first spouse. A six-month extension is allowed.239 The surviving spouse must be
a U.S. citizen. The DSUE is not available to nonresident alien spouses.

238 To mitigate the tax burden, the estate of a taxpayer can consider creating a Qualified Domestic Trust (QDOT). This option allows

the estate to postpone paying estate taxes until distributions are made from the trust or until a nonresident spouse becomes a U.S.
citizen. This type of trust arrangement would be outside the scope of the EA exam, but this type of arrangement is beneficial in
situations where the surviving spouse is not a U.S. citizen.
239 Revenue Procedure 2022-32 allows for a late estate tax return if it is filed solely for the purpose of making a “portability”

election. This Revenue Procedure extends the time to make the DSUE election to five years after the first spouse’s date of death.
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Example: Myron died on January 13, 2024, and left a gross estate valued at $19 million. All of his assets
were transferred to his wife, Juliet, under the terms of his will. Juliet is a U.S. citizen. As a result, none
of his estate was taxed because of the unlimited marital deduction. None of the $13.61 million basic
exclusion amount available to Myron’s estate was used (and none had been used to offset gift tax
liabilities during his lifetime). Juliet then died later in the same year, on December 20, 2024. Assuming
Form 706 was timely filed for Myron’s estate, electing the DSUE, and Juliet had not used any of her
basic exclusion amount, Myron’s unused basic exclusion is added to Juliet’s basic exclusion, for a total
exclusion amount of $27.22 million between their two estates. If Juliet’s estate is valued at less than
$27.22 million at her death, the full amount can be excluded, and no estate tax will be owed when
Juliet’s assets eventually pass to her heirs.

Inheritances
For federal income tax purposes, inheritances are generally not taxable to the beneficiary, although
the beneficiary may be responsible if there is a related estate tax liability that has not been satisfied.
Example: Caruso’s aunt, Georgina, died and left him $175,000 cash in her will. Georgina’s estate was
only worth $1.5 million, so the estate did not have an estate tax filing requirement, and no estate tax
return (Form 706) was filed. Caruso is a U.S. citizen. He does not owe any federal tax on this
inheritance, and nothing has to be reported on Caruso’s return.
Example: Raquel dies and leaves her entire estate to her son, Gareth. At the time of her death, she had
a significant cash balance in her bank account as well as several valuable rental properties in New York.
Raquel’s estate is worth over $16 million, so the estate has a filing requirement, but Gareth ignores his
accountant’s advice and simply withdraws all the money from his late mother’s bank account. He also
sells all the rental properties and uses the money to take several lavish trips. Although inheritances
are generally not taxable to the beneficiary, the fact that Gareth took possession of his mother’s assets
without filing her required estate tax return or satisfying the estate tax liability would make him
directly responsible for the tax. The IRS can come after Gareth to satisfy the estate’s tax liability.
Inherited retirement accounts are treated a bit differently. Distributions of retirement plan
benefits or distributions from taxable IRA accounts to the decedent’s beneficiaries are generally
subject to income tax when received, although inherited IRAs are not subject to an early-withdrawal
penalty, regardless of the beneficiary’s age. Qualified distributions from a Roth IRA or of previously
nondeductible contributions to a traditional IRA are generally not taxable. The decedent’s surviving
spouse may elect to defer taxation by rolling over the assets of a taxable IRA to another IRA or to a
qualified plan (i.e., the surviving spouse is allowed to treat an IRA inherited from a deceased spouse
“as their own”).
Example: Evan, 55, passed away on September 1, 2024, leaving his $170,000 traditional IRA to his
sister Chanel, age 43. As a non-spousal beneficiary, Chanel cannot roll over the inherited IRA into her
own IRA account. Instead, she is required to either distribute the funds as a lump sum or make a new
inherited IRA account in her name and transfer the funds to this account (this is also called a
Beneficiary IRA). When Chanel starts withdrawing the money from the inherited IRA, she will not be
charged a 10% early withdrawal penalty, even though she is under age 59½. She will only have to pay
income tax on the withdrawals.

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Basis of Estate Property

Although cash inheritances are not subject to federal income tax, money received from the sale of
inherited property may be taxable. The basis of property inherited from a decedent is generally one of
the following:
• The FMV of the property on the date of death,
• The FMV on an alternate valuation date, if elected by the personal representative,
• The value under a special-use valuation method for real property used in farming or another
closely held business, if elected by the personal representative,
• The decedent’s adjusted basis in land to the extent of the value excluded from the taxable estate
as a qualified conservation easement.
Example: Paul, age 66, dies on February 1, 2024. Paul’s adult son, Easton, is the executor of his late
father’s estate. Paul owned a large collection of collectible figurines and rare comic books. Paul’s will
directs that the estate be split equally between Easton and his four siblings. The fair market value of
Paul’s collectibles on the date of his death is $500,000. The collectibles are the only valuable asset that
the estate owns. Since the estate’s total value is less than the exclusion amount, Easton does not file an
estate tax return (Form 706) or elect the alternate valuation date. On November 15, 2024, the siblings
all agree to sell their late father’s collection using an auction house. The entire collection sells at auction
for $552,000. Collectively, Paul’s children (his heirs) must report a capital gain of $52,000 ($552,000
sale price minus the $500,000 basis, based on the collection’s FMV at the date of death).
Alternate Valuation Date: If elected, the alternate valuation date is six months after the date of
death. The estate value and related estate tax must be less than they would have been on the date of
the taxpayer’s death. However, for any assets distributed to a beneficiary after death, but prior to six
months after death, the basis for these assets is the fair market value as of the date of distribution.
Jointly Owned Property: Property that is jointly owned by a decedent and another person will be
included in full in the decedent’s gross estate unless it can be shown that the other person originally
owned or otherwise contributed to the purchase price. The surviving owner’s new basis of property
that was jointly owned must be calculated.
To do so, the surviving owner’s original basis in the property is added to the value of the part of
the property included in the decedent’s estate. Any deductions for depreciation allowed to the
surviving owner for his portion of the property are subtracted from the sum.
If a property is jointly held between spouses as tenants-by-the-entirety,240 or as joint tenants with
the right of survivorship, one-half of the property’s value is included in the gross estate, and there is a
step-up in basis for that one-half.
The other half is stated at the surviving spouse’s cost basis, net of any deductions for depreciation
allowed to the surviving spouse on that half. If the decedent holds property in a community property

240 “Tenancy by the entirety” is a form of property ownership for married couples. In general, “tenancy by the entirety” means that
if one spouse dies, the other spouse will automatically own the real property without the need to probate it.
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state,241 half of the value of the community property will be included in the gross estate of the decedent,
but the entire value of the community property will receive a step-up in basis.
Example: Bong-Cha and Hyun-Shik are married and live together in Texas, which is a community
property state. They hold their personal residence as community property, and both of them live in
the home together. They purchased the home for $450,000 eight years ago. Bong-Cha dies on
December 15, 2024, and the house is valued at $630,000 on the date of her death. Hyun-Shik’s basis in
the house is now $630,000. The entire house gets a step-up in basis to the FMV on the date of one
spouse’s death because it was held as community property. If Hyun-Shik decides to sell the home at a
later date, he would use $630,000 as his basis for determining whether or not he has any gain on the
sale.

The Estate Tax

The estate tax may apply to a decedent’s taxable estate, which is the gross estate minus any
allowable deductions. The maximum estate tax rate in 2024 is 40%. In 2024, an estate valued at less
than $13.61 million would generally not have an estate tax return filing requirement. Estates that are
valued at more than this threshold are required to file Form 706, United States Estate and Generation-
Skipping Transfer Tax Return.
Example: Fabio is a U.S. citizen who dies on May 3, 2024. The fair market value of all his assets on the
date of his death totals $8 million. Although his estate is valuable, the combined assets are worth less
than the exemption amount ($13.61 million in 2024). His estate is not subject to estate tax, and Form
706 does not need to be filed. Fabio earned $210,000 in wages before his death, so his executor will
still be required to file a final Form 1040 for the income that Fabio earned while he was alive (from
January 1 to May 3). Form 1041 may also need to be filed if Fabio’s estate earns gross income of $600
or more in 2024.
However, this threshold is much lower for nonresident aliens at $60,000. An executor for a
nonresident alien must file a nonresident estate tax return, Form 706-NA, United States Estate (and
Generation-Skipping) Tax Return, Estate of a nonresident, if the fair market value at death of the
decedent’s U.S.-situated assets exceeds $60,000.
Example: Yong-Sun is a citizen and resident of South Korea. Yong-Sun is a popular Korean recording
artist, and his travels bring him to the U.S. quite frequently. Yong-Sun owns a vacation home in
Hollywood, CA, which he uses at least once a year to entertain his celebrity guests. When he is not in
the U.S., he uses a management company to rent out the home to short-term tenants. Yong-Sun dies on
November 9, 2024. The Hollywood vacation home is the only U.S. asset that Yong-Sun owned. The
house’s FMV on the date of his death was approximately $450,000. Since Yong-Sun is a nonresident for
U.S. tax purposes, his estate has a filing requirement. His executor must file Form 706-NA, report the
value of the asset, and pay any estate taxes owed.

Community property law exists in nine U.S. states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas,
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Washington, and Wisconsin.

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Generation-Skipping Transfer Tax (GST)

In the past, wealthy families used various strategies to transfer wealth and assets to their
grandchildren and other descendants. In response to this, Congress created the generation-skipping
transfer tax, also known as the GST, to close this tax loophole.
The generation-skipping transfer tax (GST) may apply to gifts made during a taxpayer’s lifetime, or
bequests occurring after a taxpayer’s death, made to “skip persons.” A skip person is usually a
grandchild, but it also applies to those who are more than 37½ years younger than the person making
the gift or bequest. The most common scenario is when a taxpayer makes a gift to a grandchild.
The GST is assessed when the property transfer is made, including instances in which property is
transferred from a trust. The GST is based on the amounts transferred to skip persons, after subtracting
the allocated portions of the donor’s available GST exemption. The GST exemption is the same as the
estate tax basic exclusion amount, and the GST tax rate is set at the estate tax rates, with a maximum
of 40%. The GST is imposed separately, in addition to the estate and gift tax.
Example: Sylvester was diagnosed with terminal cancer, and is told that he only has a short time to
live. He is unmarried and has only one adult daughter, named Glenda. Sylvester wants his daughter to
be able to avoid the probate administration process when he dies. He meets with an attorney and sets
up a grantor trust that names his adult daughter, Glenda, as the sole beneficiary of the trust, with his
grandchildren (Glenda’s two children) as contingent beneficiaries, who will only receive assets from
the trust upon Sylvester’s death if Glenda is no longer alive at the time of his passing. Sylvester then
transfers all his assets into the trust. Unexpectedly, shortly after the trust is created, Glenda dies. On
January 10, 2024, Sylvester also dies, and the trust beneficiaries are his grandchildren. The revocable
trust is now irrevocable. That means that any disposition of the assets that Sylvester placed inside the
trust before his death cannot be revoked, nor can beneficiary designations be changed. The trust assets
pass to his two grandchildren. Sylvester’s grandchildren are “skip persons” for GST purposes, and the
trust’s property may now be subject to GST.
Any payments for tuition or medical expenses on behalf of a skip person that are made directly to
an educational or medical institution are exempt from gift tax and GST. There is no reporting
requirement for this type of gift, regardless of the dollar amount.
Example: Robert, a generous grandfather, has decided to assist in his granddaughter Emma's
education and cover all her medical costs. He directly pays $32,000 towards her tuition to her college
and also pays $21,000 for her ankle surgery directly to the hospital. Since Robert made these payments
directly to the respective institutions, which are exempt from gift and GST taxes, this allows him to
support Emma without any tax implications or filing requirements.
The Gift Tax
The gift tax may apply to the transfer of property by one individual to another, whether the donor
intends the transfer to be a gift or not. The gift tax can apply to both cash and noncash gifts. Gift tax is
imposed on the donor, not the receiver, of the gift.

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The recipient of a gift typically owes no taxes and doesn’t have to report the gift unless it comes
from a foreign donor. However, under special arrangements, the donee may agree to pay the tax
instead of the donor.
As discussed previously, an individual taxpayer’s liability for estate tax and gift tax is subject to a
combined basic exclusion amount ($13.61 million in 2024), and the use of any portion of this exclusion
amount to reduce payment of gift taxes during the taxpayer’s lifetime will reduce the amount available
upon death to reduce applicable estate taxes. The following gifts are not taxable and do not have to be
reported:
• Gifts to an individual that do not exceed the annual exclusion amount. In 2024, the gift exclusion
amount is $18,000 per donee.
• Tuition or medical expenses paid directly to an educational or medical institution for another
person (the recipient does not have to be related to the taxpayer).
• Unlimited gifts to a spouse, as long as the spouse is a U.S. citizen.
• Gifts to a political organization for its own use.
• Gifts to a qualifying charity.
• A parent’s support for a minor child. This may include support required as part of a legal
obligation, such as by a divorce decree.
Example: Paxton is 26, and Lynette is his mother. Both are U.S. citizens. Lynette gives her son, Paxton,
a gift of $18,000 of cash in 2024. She also pays his college tuition, totaling $22,000. She writes the check
directly to the college. Paxton broke his leg in a motorcycle accident, and has high medical bills for the
year. Lynette also pays Paxton’s medical bills by issuing a $22,000 check directly to his doctor’s office.
None of these gifts are taxable, and no gift tax reporting is required.
Example: Lincoln is single. In 2024, Lincoln gives his nephew, Jimmy, $39,000 to help start his first
business. Lincoln tells his nephew that he does not have to pay it back. The money is intended as a gift,
not a loan, so Lincoln is required to file a gift tax return (Form 709) since the amount exceeds the
annual exclusion amount.
Example: Salman is a wealthy businessman, and he wants to support his two grandchildren, but he
tries to make sure that his gifts are not subject to gift tax, GST, or estate tax. He also wants to legally
avoid filing gift tax returns whenever possible. In 2024, he gifts each of his grandchildren $18,000 in
cash, in the form of individual checks. He has one granddaughter in medical school, so he also pays his
granddaughter’s tuition in full, making the payment directly to the college for $54,195. His grandson
also had a skiing accident during the year and broke his arm. The medical deductible after the
insurance for the emergency care was $19,500, which Salman also paid directly to the medical provider
on behalf of his grandson. There is no tax consequence for any of these gifts, and no reporting is
required.
Gift taxes are reported on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.
The Form 709 currently cannot be e-filed, and must be filed on paper.242 Form 709 must be filed if:

242Form 709-NA is a new gift tax form specifically for nonresident aliens. The form is currently under development and had not
been published at the time of this book’s printing.
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• A taxpayer gives more than the annual exclusion amount to at least one individual (except to a
U.S. citizen spouse),
• A taxpayer “splits gifts” with a spouse,
• A taxpayer gives a future interest to anyone other than a U.S. citizen spouse.
If a gift tax return is required to be filed, Form 709 is generally due by April 15 of the following
year. However, if a donor dies during the year, the filing deadline may be the due date (with extensions)
for the estate tax return, if earlier than April 15 of the following year. Taxpayers who extend the filing
of Form 1040 for six months using Form 4868 are deemed to have extended their gift tax returns, if no
gift tax is due with the extension.
If the taxpayer does not extend their individual return, the gift tax return can be extended
separately by using Form 8892, Application for Automatic Extension of Time to File Form 709 and/or
Payment of Gift/Generation-Skipping Transfer Tax, which also provides an additional six months to file
Form 709, if filed by the original due date.
Note: A gift is considered a present interest if the donee has all immediate rights to the use,
possession, and enjoyment of the property or income from the property, with no strings attached. A
gift is considered a future interest if the donee’s rights to the use, possession, and enjoyment of the
property or income from the property will not begin until some future date. A gift of a future interest
cannot be excluded under the annual exclusion. With a “future interest” the beneficiary typically does
not become the legal owner of the property until the donor’s death.

Example: Shepard creates an irrevocable trust for the beneficial enjoyment of Bethany, who is his
long-time girlfriend. Shepard transfers an office building to the trust. The office building is currently
rented to business tenants and is subject to a mortgage. The terms of the trust provides that the rental
income from the property will first be used to pay off the mortgage. After the mortgage is paid in full,
the net rental income is then to be paid to Bethany. Since Bethany’s right to receive the rental income
will not begin until after the mortgage is paid in full, the transfer in trust represents a gift of a future
interest.
Applying the Applicable Credit to Gift Tax: After a taxpayer determines which of their gifts are
taxable, the taxpayer must calculate the amount of gift tax on the total taxable gifts and apply the
applicable credit for the year (the applicable credit is covered later in this chapter).
Gift Splitting by Married Couples
Both the basic exclusion amount and the annual exclusion amount apply separately to each spouse,
and each spouse must separately file a gift tax return if they made reportable gifts during the year.
However, if either spouse makes a gift to another person, the gift can be considered as being one-half
from one spouse and one-half from the other spouse. This concept is known as gift splitting.
Note: Starting in 2024, a consenting spouse is no longer required to sign the gift tax return itself but
must sign a Notice of Consent to be attached to the donor's Form 709 return.
Gift splitting allows a married couple to give up to $36,000 (in 2024) to a single individual without
making a taxable or reportable gift. Both spouses must consent in order to split the gift.

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Example: Ignacio and his wife, Elinda, agree to split cash gifts. Ignacio gives his best friend a check for
$22,000, and Elinda gives her niece a check for $20,500. Although each gift exceeds the annual
exclusion amount in 2024, they can use “gift splitting” to avoid making a taxable gift to each donee. In
each case, because one-half of each of the split gifts ($11,000 and $10,250) is not more than the annual
exclusion amount, it is not taxable. However, a gift tax return, Form 709, is required to be filed, in order
to make these split gift elections.
Example: Gertrude gives her favorite cousin, Freddie, $25,000. Gertrude elects to split the gift with
her husband, Maury, and Maury is treated as if he gave Freddie half the amount, or $12,500. Assuming
they make no other gifts to Freddie during the year, the entire $25,000 gift is tax-free. However, a gift
tax return, Form 709 is required in order to report the “split gift.”
Note: A married couple can avoid filing a gift tax return if they each make a gift separately, such as by
writing separate checks or giving separate property. In the example above, if each spouse had written
separate checks for less than $18,000 each in 2024, then a gift tax return would not be required.
If a married couple splits a gift, each spouse must generally file their own individual gift tax return.
However, certain exceptions may apply that allow for only one spouse to file a return if the other
spouse provides their consent. Starting in 2024, the consenting spouse must sign a Notice of Consent
to be attached to the donor's return. Note that if gifts are made by a spouse from community property
funds, the gift is deemed to have been made 50% by each spouse.
Basis of Property Received as a Gift
For purposes of determining gain or loss on a subsequent disposition of property received as a gift,
a taxpayer must consider:
• The gift’s adjusted basis to the donor just before it was given to the taxpayer,
• The gift’s FMV at the time it was given to the taxpayer, and
• Any gift tax actually paid on the appreciation of the property’s value while held by the donor
(as opposed to gift tax offset by the donor’s applicable credit amount).
If the fair market value of the gift is the same as or higher than the donor’s adjusted basis for the
gift before it was transferred, then the donee’s basis will be the same as the donor’s (transferred basis),
adjusted for any gift tax paid on the donor’s appreciation.
Example: Donovan gives his son, Maurice, 20 shares of stock on January 20, 2024. Donovan’s basis in
the stock is $820, and the stock has a fair market value of $8,600 on the date of the gift. Maurice’s basis
in the stock is also $820. This is called a “transferred basis.”
However, in the event that the fair market value (FMV) of the gift is lower than the donor’s adjusted
basis at the time of transfer:
• When the recipient sells the gifted property, any gain will be calculated based on the donor’s
adjusted basis.
• If the recipient sells the property for a loss, their basis will be equal to the FMV at the time of
the gift.

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• If the recipient sells the property for a price higher than its FMV at the time of the gift, but lower
than the donor’s adjusted basis at that time, their basis will be equal to the selling price. This
results in neither a gain nor loss on the sale.
Example: Manuela receives an acre of land as a gift from her brother, Julian. Her brother’s adjusted
basis in the land is $50,000, and its FMV on the date of the gift is $40,000 (the land value has dropped
since Julian bought it). A year later, Manuela sells the gifted land for $35,000 to an unrelated buyer.
Since she sold the property at a loss, her basis in the land for figuring her own loss on the sale is
$40,000, because it is lower than her brother’s adjusted basis and the FMV on the date he gifted the
property to her.
Generally, the value of a gift is its fair market value on the date of the gift. However, the value of the
gift may be less than its fair market value to the extent that the donee gives the donor something in
return.
Example: Albus sells his son, Tanner, a house well below market value. Tanner only pays $10,000 for
the house. In 2024, the fair market value of the house is $90,000. The home was transferred for much
less than its full value. Therefore, Albus gave his son a gift of $80,000 ($90,000 - $10,000 = $80,000).
Albus is required to file a gift tax return because the gift exceeds the $18,000 threshold for 2024.

The Unified Credit (the Applicable Credit)

A taxpayer’s gross estate tax is reduced by the applicable credit, also referred to as the unified credit.
The unified credit is the combination of the lifetime gift tax exclusion and estate tax exclusion. For the
2024 tax year, the estate tax exclusion is $13.61 million. The applicable credit amount for 2024 is
$5,389,800.
Note: For taxable gifts, each taxpayer has an aggregate lifetime exemption before any out-of-pocket
gift tax is due. For example, a taxpayer can give away up to $13.61 million during their lifetime above
the annual gift exclusion ($18,000 in 2024) and still avoid paying any gift tax.
Just as with the basic exclusion amount, any portion of the applicable credit amount used to avoid
payment of gift taxes reduces the amount of credit available in later years that can be used to offset gift
or estate taxes. For example, if a taxpayer exceeds the annual gift tax exclusion amount in any year, the
taxpayer can choose to either pay the gift tax on the excess or take advantage of the unified credit to
avoid paying the tax in the current year.
Example: Regina is a wealthy investor. She is unmarried and does not have any children. Two years
ago, Regina gifted her brother $1 million in cash. She properly filed a gift tax return for the gift, and
used $1 million of her basic exclusion to offset payments of gift tax. Regina dies in 2024 and leaves an
estate valued at $20 million, all of which passes to her brother as her sole heir. Since she gifted $1
million during her lifetime, that reduced the amount her estate may exclude to $12.61 million (rather
than $13.61 million), which is then subtracted from her $20 million taxable estate, to determine the
amount of her estate that will be subject to the estate tax.

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