Of Taxes, Black Holes, and Brooklyn: A Survey of the Federal Income Tax for Individuals
They say that life's two sole absolutes are death and taxes. This presentation can't help you with the former, but it will address the latter by surveying the basic principles of federal income taxation for typical individual taxpayers. We'll cover the whole process of calculating federal tax liability, from computing taxable income to running that number through the tax tables to properly accounting for payments and credits.
Nick Quesenberry: Welcome to Of Taxes, Black Holes, and Brooklyn: a Survey of the Federal Income Tax for Individuals, produced with love and care here at Quimbee. I'm Nick Quesenberry, and I'll be your host today. I used to represent tax payers before the IRS and state taxing authorities. So hopefully, my experience and research will prove helpful. This presentation includes a number of course materials including today's slides complete with detailed presenter notes. You can follow along with those slides if you like, or just sit back and enjoy our taxing journey through the internal revenue code.
To start, let's note that no one likes a tax cheat. Throughout the decades, people have devised all sorts of crazy schemes and convoluted legal arguments to escape income taxation. In this regard, the federal income tax is a bit like a black hole. In brief, a black hole is a massive cluster of super dense matter in outer space often resulting from a collapsed star. A black hole has a gravitational pull so strong that almost nothing can escape it, not even light, though the occasional subatomic particle might break free if it's in the right place at the right time. Similarly, every now and then some clever tax cheat may successfully hide income from the government and skate by without paying taxes on it, but overall, the reach of the income tax is almost absolute. And the law of federal income taxation is breathtaking in its scope and complexity.
Even if we produced a thousand presentations like this one, we'd barely cover a fraction of it. So for this presentation, we'll hit the highlights of federal income tax law as it applies to most average individuals in the United States. We'll leave the heavy, complicated stuff for another day.
Meet Ted Taxpayer. Ted lives in East Tennessee with his wife, Tina Taxpayer, in a nondescript suburban home that they own together. Ted and Tina have two children named Tommy and Tessa. Ted is a licensed attorney, though he doesn't practice law anymore. Instead, Ted works from home full time as a staff writer for an online legal education company writing case summaries, subject matter outlines, scripts for lesson videos and so on. Ted earns the great bulk of his income from this job. But Ted's not just a lawyer and writer. He's also an avid gamer. Ted earns a little money each month streaming himself playing video games on an internet platform called Stitch. Ted finds it gratifying that people are willing to pay him to play video games for their entertainment. Even so, that money is nowhere near enough to defray the cost of video games and hardware Ted needs for streaming, let along pay the bills.
Streaming is really a hobby for Ted, more so than a viable source of income. Tina worked as a waitress at a cocktail bar for most of her marriage to Ted. But for the past couple of years, she's been attending college full time. She wants to get her master's degree in nursing and eventually work as a pediatric nurse. Tina gets scholarships, which she uses entirely for tuition and fees. While Tine attends classes, Ted keeps one eye on the kids as he's working and streaming. In 2019, Ted paid a hefty amount of interest on his student loans. Additionally, he and Tina sold their prior residence where they'd lived for 10 years and which they owned. They used the proceeds to buy the house where they now live. The proceeds weren't quite enough to pay for the new house in full, so Ted and Tina took out a mortgage loan on which they make monthly payments of principal and interest.
That same year, Tina inherited a small apartment building from her late Aunt. She uses the rental income from that building to pay college tuition and expenses. Tina's Aunt also left her some corporate stock. Tina sold the stock and used the proceeds to buy braces for Tommy, glasses for Tessa, and a small car for herself so she could commute to college. This was back before COVID-19 when commuting to college was still a thing. Ted and Tina's overall family and financial situations are pretty straightforward for the most part. But even this relatively uncomplicated narrative will give Ted and Tina much to think about when it comes time to do their 2019 taxes. So much, in fact, that we'll spend the rest of this presentation unpacking it all.
We'll start with a short introduction to the major players in the federal income tax system, including congress, the IRS, the relevant courts and more. Then, we'll briefly survey the historical and constitutional foundations of the federal income tax system. Having done that, we'll familiarize ourselves with the major sources of federal income tax law, including the internal revenue code, or IRC, the regulations by the Department of the Treasury and various non-binding but often crucial sources of agency authority. Once all that's done, we'll get into the meat of the presentation as we walk Ted and Tina through the basic steps to calculate their federal income tax liability. We'll begin by briefly discussing the foundational concepts of the taxable year and accounting methods. After that, we'll outline the six basic steps to determine and individual's federal income tax liability. Along the way, we'll cover the basics of calculating gross income and properly characterizing that income together with some of the more important exclusions and deductions from gross income for people like Ted and Tine. We'll also highlight the role of filing status and the basic operation of the progressive income tax system. In closing, we'll highlight some options for taxpayers who find themselves in tax trouble.
What we won't do at any point is to try to determine Ted and Tina's actual federal tax liability or equip you to prepare someone's federal tax return. To do that, we'd have to delve into matters far beyond this presentation's scope. In any event, preparing tax returns is generally more in the wheelhouse of an accountant or IRS enrolled agent than an attorney. That's not to say, of course, that attorneys don't or can't prepare tax returns. I've prepared a few myself. What we will do, however, is acquaint you with the fundamental legal concepts in federal income tax and some of the major issues that professionals in this field can expect to encounter. And for the most part, we'll confine ourselves to federal income tax law as it applies to individuals. We won't mess with corporate or partnership tax. That stuff gets pretty gnarly, and we want this presentation to be fun, as fun as any tax presentation can be anyway.
Now, aside from taxpayers themselves, the major participants in the federal income tax system are Congress, the Treasury Department, or Treasury for short, the Internal Revenue Service, or IRS, and the courts. Congress, of course, enacts all federal tax legislation. Treasury is generally tasked with administering the federal tax laws. To that end, Treasury has propounded voluminous binding regulations that carry the force of law. We'll talk more about Treasury regulations shortly. Now, the IRS is the subordinate agency of Treasury that handles the lion's share of the day-to-day work of implementing the tax laws and interacting with taxpayers. The IRS receives and scrutinizes tax returns, puts out non-binding guidance for taxpayers and practitioners, litigates tax controversies and much, much more. The courts interpret the tax laws and resolve controversies between taxpayers and the government. That's their role. At the trial level, most litigation takes place in the U.S. Tax Courts, the Federal District Courts, and the Court of Federal Claims. Appeals usually go to the various circuit courts of appeal subject to discretionary review by the U.S. Supreme Court.
Now, the big sources of federal income tax law are the Constitution, the Internal Revenue Code and the binding Treasury regulations. Article One, Section Eight, Clause One of the Constitution empowers Congress to "lay and collect taxes". This provision standing alone seems to confer limitless taxing authority, but not so fast, Congress. Remember one crucial reason the founders fought the American Revolution in the first place was to cast off the weight of oppressive taxation. So there was no way they were going to give Congress truly unlimited taxation power. Perhaps the Constitution's biggest restraint on Congress's taxing power appears in Article One, Section Nine, Clause Four of the Constitution, which forbids Congress from imposing any direct tax unless the tax is apportioned among the states according to their respective shares of the national population as determined in the most recent census.
So what's a direct tax? There's a lot of disagreement on it, but for most practical purposes, it'll suffice to think of a direct tax as either a general tax on accumulated wealth on which tax has already been paid, or a tax on real estate. Probably the most common examples of direct taxes are state and local property taxes. The apportionment requirement means that any federal direct tax must be administered so that each state's share of the tax burden correlates to that state's share of the total national population. This, of course, means that specific rates of taxation would necessarily vary from one state to the next. For this and other reasons, the apportionment requirement entails extreme political and administrative difficulty making imposition of a federal direct tax virtually impossible. And of course, a direct tax doesn't necessarily have to be imposed on wealth upon which tax has been paid, but oftentimes that could be the case.
Anyway, to illustrate, let's suppose Congress decides to impose a direct tax on all privately owned real estate in the United States. At the time, California boasts one-sixth of the nation's total population. Under the apportionment requirement, Congress must administer the tax so that one-sixth of the total revenue from the tax comes from California. Now, in 1895, the Supreme Court hailed that the apportionment requirement applies not only to a tax on real estate itself but also to a tax on income from real estate such as rent. The court reasoned that taxing the economic fruits of real estate is the same as taxing the real estate itself. In a visceral and enthusiastic rejection of this holding, Congress and the states enacted the 16th Amendment which explicitly empowers Congress to tax all income from any source without apportionment. The 16th Amendment, then, is the Constitutional foundation for our modern federal income tax system.
Of course, the primary source of federal income tax law is the Internal Revenue Code, apart from the Constitution. And Congress enacted the Internal Revenue Code initially and often amended. The code resides in Title 26 of the United States Code. Now, the Internal Revenue Code is very prolific and detailed, but even so, it has a multitude of gaps and ambiguities. To fill the gaps and clarify the ambiguities, Treasury has propounded a gargantuan body of binding regulations commonly called the Treasure Regulations. The Treasury Regulations live in, you guessed it, Title 26 of the Code of Federal Regulations. How clever. Treasury Regulations are, at least technically, subordinate to the IRC. Even so, Treasury Regulations do have the force of law until they are overturned. Now, overturning a duly enacted Treasury Regulation is difficult even on the best of days.
Accordingly, in practice, courts and practitioners usually put Treasury Regulations on more or less equal footing with the IRC. Now the combined length and complexity of the Internal Revenue Code and the Treasury Regulations is mind boggling. But even these two mammoth compendium cannot fully address the practically infinite variety of situations that arise in federal income taxation. To that end, the IRS frequently puts out various types of non-binding agency guidance including revenue rulings, private letter rulings and the internal revenue manual, or IRM. Though non-binding agency guidance technically lacks the force of law, courts and practitioners often afford it considerable weight assuming that it rests on a reasonable interpretation of the law. However, some particular types of agency guidance receive more deference then others depending on the level of care and deliberation the IRS puts into them among other things.
Revenue rulings usually receive the most deference because the IRS intends for taxpayers and practitioners to rely on them as agency precedent. The IRM, though, is the authoritative compendium for the IRS's internal policies, procedures and guidelines. Though the IRM lacks the force of law, IRS employees are generally expected to abide by it. Thus, the IRM can be a very valuable resource for those dealing directly with the IRS, for instance, during an audit.
To kick things off, let's talk about the taxable year. For any system of taxation to be viable, taxpayers must be required to account for taxable events and pay tax on them at designated times. To that end, the two prevailing systems of tax accounting are transactual, excuse me, transactional and annual accounting. Almost made a [inaudible 00:13:01] there, transactual. In pure transactual... There I go again. In pure transactional accounting, a taxpayer accounts for and pays tax on a given transaction only when it is complete whether the transaction is brief or spans many years. At that point, the taxpayer will balance expenditures against gains to determine whether the transaction as a whole produced a net profit or a net loss. If the transaction yielded a net profit, then the taxpayer will report and pay tax on the profit. If the transaction produced a loss, then there'll be no tax on it, and the taxpayer may be able to deduct the loss against net gains from other completed transactions.
Annual accounting, on the other hand, revolves around the concept of a taxable year. For each taxable year, the taxpayer must add up all taxable gains during the year and subtract from that sum all deductible costs during the year. This computation includes taxable events arising from both complete and incomplete transactions. Events occurring in prior or later years are generally ignored unless the tax laws require otherwise. If the year produces a net taxable gain, then the taxpayer must pay tax for the year. If not, there's no tax liability for the year. Put more succinctly, in annual accounting, each taxable year exists by itself. To illustrate, suppose a taxpayer enters a four year contract with a customer. In year one, the taxpayer loses $50,000 on the contract. In year two, the taxpayer loses another $50,000. In year three, the taxpayer fortunately profits on the contract to the tune of $100,000, but in year four, the taxpayer loses $100,000 on the contract. So the contract as a whole produced a net loss of $100,000.
In transactional accounting, the taxpayer would not report the contract for tax purposes at all until year four when the contract ended. The contract as a whole again produced $100,000 of net loss over the four year period. Thus, the taxpayer would owe no tax on the overall contract, and she may get to deduct the losses against other gains from other transactions. Matters are different, though, in annual accounting where we have to look at each year by itself. Now, here in years one, two and four, the taxpayer would owe no tax on the contract because she suffered losses in each of those years. But in year three, the taxpayer would have to report and pay tax on the $100,000 gain she made on the contract. The federal income tax system adopts annual accounting with multitudinous adjustments to even out some of the distortions and inequities that would arise from pure strict annual accounting.
Thus, in federal tax, the concept of the taxable year takes center stage. Most individuals use the calendar year, which is the 12 month period ending on December 31st. Many businesses use a fiscal year, which is a 12 month period ending on a date other than December 31st. But in specific circumstances, such as an individual's death or a corporation's formation or disillusion, a taxpayer may use a short taxable year, which is one spanning less than 12 months time. In this presentation, we'll assume that Ted and Tina always use the taxable, excuse me, the calendar year, not the taxable year. The particular taxable year for which a taxpayer reports income and takes deductions depends on the taxpayer's accounting method.
In federal tax law, the two most prevalent accounting methods are, number one, the cash receipts and disbursement method, also termed the cash method, and number two, the accrual method. Because individual taxpayers typically use the cash method and the accrual method is quite complicated, we'll stick to the cash method in this presentation. Generally, a cash method taxpayer reports income for the year she receives it. Cash is received when it's paid or tendered to the taxpayer. Similarly, a cash method taxpayer receives payment by check when she receives a check, regardless of when the check is deposited or cashed. The constructive-receipt doctrine, though, prevents cash method taxpayers from indefinitely postponing to report income by refusing to accept it. So regardless when a cash method taxpayer actually receives income, the regulations deem her to receive it during the year when the income is tendered, credited, set apart, or made available to her so that she could effectively reach out and take it whenever she wanted.
This rule does not apply, though, to the extent of our substantial restrictions or limits on the taxpayer's control of the income's receipt. Now, as for deductions in the cash method, generally, a cash method taxpayer will take a deduction in the taxable year when she actually makes the corresponding expenditure. In the realm of deductions, there's no rule analogous to the constructive-receipt doctrine. Cash payment is made when the cash is transferred, and payment by check is usually made when the check is deliver, assuming the check is later cashed or deposited. Payment by credit card is deemed to made when the charge occurs and not when the debt is repaid to the credit card provider.
Now, for purposes of this presentation, we'll assume that the alternative minimum tax does not apply to Ted and Tina. With that understanding, there are six basic steps to determine an individual's federal tax liability. Number one, determine gross income. Number two, determine adjusted gross income by subtracting from gross income any allowable above-the-line deductions. Number three, subtract either the standard deduction or any available below-the-line deductions from adjusted gross income. Number four, if needed, apply the deduction for qualified business income. Number five, determine tentative tax liability. And number six, determine final tax liability.
Let's tackle each of these steps one at a time. Of course, we'll start with gross income. In general, gross income is all income that is potentially subject to federal income taxation. If a thing is not gross income, then it's not taxable. If it is gross income, then it is taxable. But before we say more about gross income, perhaps it's best to get a handle on the economist's definition of income, if indeed there is on. Economists have long disagreed on a precise definition of income, but many adopt the so-called Haig-Simons Definition. Briefly, this definition posits that income equals the sum of an individual's consumption for personal use plus any increase in net worth over a specific period. For instance, suppose that, during year one, a person earns $50,000 and spends 40,000 of that on personal consumption. The person also owns land whose value increases by $10,000 in year one. That year, on the land, the person grows crops worth $1,000 which the person consumes.
Under Haig-Simons, the person has $61,000 of income for year one, including the $40,000 of personal consumption, including the $10,000 of unspent earnings and the $10,000 in real estate appreciation and the $1,000 of crop consumption. Haig-Simons may be a workable economic definition, but in its full scope, it's impractical for establishing a tax base. Accordingly, Congress and the Constitution have carved out the concept of gross income as a net worth subset of Haig-Simons income. Unfortunately, Internal Revenue Code's definition of gross income is a bit circular. Gross income means "all income from whatever source derived". Fortunately, the code does provide an illustrative list of 14 items constituting gross income including compensation for services, business income, gain from property dealings, interest, dividends, rent and so much more. Because the list is illustrative, many other receipts also constitute gross income.
Further examples of gross income include barter transactions, found money, such as a treasure trove found in the backyard, and even unlawful gain such as from bribery or extortion. However, unlike Haig-Simons, products or services that a taxpayer produces for herself and consumes for herself are not included in gross income, though they are if she sells them and reaps income that way. For instance, a farmer does not reap gross income by consuming any crops she grows for herself, but she will have taxable income once she sells the crops. But none of this gives us a workable general definition of gross income to apply in all cases. Fortunately, the Supreme Court did just that in the seminal case of Commissioner of Internal Revenue versus Glenshaw Glass Company. Say that five times fast.
Glenshaw Glass defines gross income as "undeniable accessions to wealth, clearly realized...over which the taxpayer has complete dominion, excuse me, the taxpayers have complete dominion". From this quote, we see that gross income has three elements, in accession to wealth, realization and dominion. In accession to wealth is basically any increase in net worth. If receiving an item of value makes the taxpayer richer or less poor, then it's accession to wealth. However, if a taxpayer receives value with the corresponding, consensual, repayment obligation, then the value is not in accession to wealth and therefore is not gross income. So for instance, borrowed funds, security deposits and similar receipts are not gross income because there's an offsetting consensual repayment obligation. But even these funds may constitute gross income if the obligation is discharged other than by repayment. Of the three requirements for gross income, realization may be the most obscure.
In general, gain is realized when received. So a taxpayer typically realizes gain when the taxpayer receives money or money's worth. But what about appreciation in the value of property? You'll recall that under Haig-Simons, appreciation in property value is income. However, that's not quite true in the federal tax system. Typically, federal tax law deems property appreciation to be realized only upon the property sale, exchange or other disposition. Simply put, for appreciation in property value to be realized, the property must typically change hands. So suppose a taxpayer owns stock that appreciates in value by $10,000 through year one. That's in accession to wealth, but it's not realized so long as the taxpayer holds onto the stock. But suppose the taxpayer sells the stock for $20,000 total in year two. At that point, the taxpayer will report and pay tax on her gain from the sale including any appreciation in value that is reflected in the sale price.
Moving on. The Supreme Court has explained that complete dominion exists if the taxpayer has genuine command over the taxable value so that practically speaking, the taxpayer derives economic value from it that can readily be realized. Often, this is when the taxpayer has possession or control or the ability to exercise possession or control over the property or its value. The control requirement can be satisfied even if it's possible that the taxpayer may someday have to relinquish the gain to someone with the superior rite to it. For instance, an embezzler has gross income even though the embezzler may have to restore the funds to the victim. Gross income also includes gain from dealings in property. A dealing in property is, generally speaking, a sale exchange or other disposition of the property. Gain or loss on any property disposition equals the amount realized in the disposition minus the taxpayers adjusted basis in the property. If the difference is greater than zero, there is a gain. If it's less than zero, there's a loss. Amount realized includes just about any economic value that the taxpayer receives upon disposing of the property including cash, other property, debt relief and so on.
Initial basis is the property's cost to the taxpayer. Cost includes not only purchase price but many other transactional costs to facilitate the acquisition such as transportation costs, professional fees, title registration and so on. Adjusted basis is initial basis as increased or decreased by specified events occurring after the taxpayer acquires the property. For instance, a taxpayer's cost to improve property such as by adding a patio to a home may increase basis. On the other hand, depreciation deduction claimed against a property will decrease basis. Now, special rules apply if a taxpayer receives property by lifetime gift, also termed Inter Vivos Gift. In that case, the taxpayer's basis in the gift usually equals the donor's adjusted basis at the time of the gift, at least so long as the gift's fair market value exceeds the donor's adjusted basis in the gift. If adjusted basis exceeds value, then different rules may apply.
Special rules also apply if a taxpayer receives property by bequest or inheritance. Here, the recipients basis in the property is generally the property's fair market value on the date of the decedent's death. So Congress has chosen not to tax income from specified sources. Although, the inlay would otherwise constitute gross and hence taxable income. These untaxed inlays are called exclusions, as the Internal Revenue Code effectively excludes them from the concept gross income. Now, the code sets forth many exclusions from gross income, examples include lots of standard employer-provided fringe benefits within limits to the great delight of working Americans everywhere. Now, aside from fringe benefits, one of the more important exclusions for individuals is that for the value of any property acquired by gift, by will or by intestacy. However, this exclusion doesn't apply to transfers of income from property, nor does it apply to any right to receive payments at intervals to the extent the payments derive from income from property.
Interestingly, the exclusion for gifts, bequest, and inheritances does not apply to any transfer from an employer to or for the benefit of an employee regardless of the employer's motivations for the transfer. To illustrate, suppose an aunt dies, and her will leaves to her niece interest-bearing bonds worth $50,000. Later that year, the bonds produced $5,000 of interest income for the niece. The bond's $50,000 value is excluded from the niece's gross income, but the niece would have to include the $5,000 interest in her gross income and pay tax on it. Another popular exclusion is one for which Ted and all the rest of us who went to law school are quite grateful. That is, the exclusion for qualified scholarships and fellowship grants. To receive the exclusion, the recipient must be a candidate for a degree at a nonprofit educational organization, a term which should cover most reputable schools.
Now, a scholarship or a fellowship grant is qualified if the recipient establishes that according to the conditions of the grant, the grant was used for qualified tuition and related expenses and nothing else. A scholarship grant is not qualified to the extent that it's spent on anything else. If a scholarship or fellowship grant is not qualified, then it will be treated as a taxable prize or award and therefore included in gross income. Qualified tuition and related expenses in turn are limited to fees, books, supplies and necessary equipment for classes. They do not include lodging. Athletic scholarships present some of the more interesting issues in this arena. As a general rule, the exclusion for qualified scholarships and fellowship grants does not apply to the extent that the benefit represents compensation for services. Now, intuitively, an athletic scholarship smells like compensation because in a sense, the students get a significant break on tuition in exchange for participating in the school's athletic programs.
However, athletic scholarships may be excluded from the student's gross income but only if three requirements are met. First, the school doesn't require the student to participate in a particular sport. Second, the school doesn't require the student to engage in any other activity in lieu of participating in any sport. And third, the school won't cancel the scholarship if it turns out the student cannot or will not participate in the school's athletic program. If an athletic scholarship fails any of these requirements, then it'll be included in the student's gross income. Finally, let's talk about the exclusion of gain on the sale or exchange of a principle residence. Here are the general rules. First, an unmarried individual may exclude from gross income up to $250,000 of gain on the sale of exchange of a principle residence if number one, the taxpayer owned the property and used it as a principle residence for a total of two out of the five years immediately proceeding the sale or exchange. And two, the taxpayer has not utilized this exclusion at any point within the two year period ending on the date of the sale or exchange.
Now let's talk about married taxpayers. Married taxpayers who file a joint return may exclude up to $500,000 on the sale or exchange of their principle residence if number one, either spouse owned the property and both spouses used the property as their principle residence for two out of the five years immediately proceeding the sale or exchange, and number two, neither spouse has used this exclusion at any point within the two year period ending on the date of the sale or exchange. Now let's come back to Ted and Tina. With these rules in place, let's try to figure out which of Ted and Tina's receipts for the last year constitute gross income.
Obviously, Ted's salary from his employer is gross income, so we'll include that. Similarly, all the money that Ted makes streaming video games on Stitch goes right into the pile of gross income. Now, how about Tina's scholarships to college? Fortunately for Tina, the exclusion for qualified scholarships seems to apply to her because she uses her scholarships primarily for tuition and fees. So it looks like Tina won't have to pay taxes on her scholarships. Now, how about any gain from the sale of Ted and Tina's prior residence? First, let's see whether they had any gain and how much. Then we'll see whether or to what extent the exclusion applies. Let's assume that Ted and Tina sold the house. Their adjusted basis in the house was $400,000 and then they sold it for $550,000. Well, that's a gain of $150,000.
Now, under the general gross income rules, Ted and Tina would have to include that gain in their gross income and pay tax on it. But Ted and Tina both owned the prior home and lived in it for 10 years before they sold it. Thus, it looks like Ted and Tina can exclude from gross income that nice $150,000 gain on the sale of the old house. Now how about the stock that Tina took under her aunt's will? Let's assume that when Tina's aunt died, the stock was worth $70,000. Tina later sold it for $90,000 after it suddenly jumped in market price. Now, thanks to the exclusion for property taken by will, Tina can exclude the stock's $70,000 value from her gross income. And that amount in turn will be her initial basis in it because again, she took it by will and that was the stock's value on the date of the aunt's death.
Accordingly, when Tina sold the stock for $90,000, she had a gain of $20,000. That $20,000 gain is gross income, which Tina must report and upon which she must pay tax. Next, let's talk about the apartment complex that Tina took under her aunt's will. Let's assume that when the aunt died, the complex was worth $500,000. Here again, Tina can exclude that value from gross income, and that amount is her initial basis in the complex. But the rent that Tina receives from the apartment complex is another matter. As we've learned, rents are gross income, and the exclusion of the value of property taken by will does not apply to income from property, which of course includes rent. Accordingly, Tina must include in gross income any rents she received from the apartment complex. Now, before we talk about adjusted gross income, we need to introduce ourselves to the concepts of deductions and exemptions. It is vital not to confuse deductions and exemptions on the one hand with exclusions on the other hand.
An exclusion, as we've said, represents an inlay, a receipt of value that is simply not subject to tax. A deduction on the other hand, relates to either an outlay or a loss. An outlay is an expenditure. A loss arises if a taxpayer disposes of property for less than her adjusted basis in it to the extent a deduction is allowable, the amount is subtracted from gross income in computing or adjusted gross income I should say in computing taxable income. Needless to say, the only deductible outlays or losses are those that the code expressly makes deductible. All others are non-deductible. Speaking very broadly, business expenses like employee salaries are typically deductible as are business losses. But personal expenses and personal losses are usually not deductible, although there are some limited exceptions to this rule.
An exemption, rather, on the other hand, is a fixed amount that the code allows a taxpayer to subtract from gross income without tying the amount to a specific outlay or loss. For instance, there was a time when the code allowed taxpayers to exempt a fixed dollar amount for herself and each of her dependents as a personal exemption. However, for taxable years 2018 through 2026, Congress has set the value of all personal exemptions to zero, goose eggs. Now, with this brief introduction, let's move to step two in calculating an individual taxpayer's tax liability. That is, calculating adjusted gross income. At this step, it is crucial to divide the universe of available deductions into two categories; above-the-line deductions and below-the-line deductions. The former are taken into account here at step two in determining adjusted gross income. The latter are taken into account if at all at the next step, step three.
So to determine gross income, excuse me, to determine adjusted gross income, one simply subtracts from gross income the combined value of all allowable above-the-line deductions. Above-the-line deductions are limited to those specific deductions that are set forth in Section 62A of the Code. All other deductions are below-the-line deductions. Above-the-line deductions include, but are not limited to, most deductions relating to the taxpayer's trade or business expenses provided the trade or business does not involved performing services as an employee as opposed to a contractor of another. Another above-the-line deduction is losses on the sale or exchange of property as well as deductible expenses relating to property held for the production of rent or royalties, and interest on student loans up to $2,500 and subject to phaseout if the taxpayer's income is too high.
Now, let's talk a bit more about business deductions. Very important. In general, Section 162A of the Code allows a deduction for "ordinary and necessary expenses paid or incurred during the taxable year and carrying on a trade or business" which includes reasonable salaries and other compensation for employees, some travel expenses and the cost of renting property that is used in the trade or business. This language gives us five discreet elements to unpack. First, the expense must be ordinary. The Supreme Court has suggested that ordinary refers to expenses that could foreseeable arise in the taxpayer's trade or business. Although the expense may be unusual for the particular taxpayer, for instance, though litigation is not common for many taxpayers, litigation in business is generally foreseeable. Thus, the cost of business related litigation are often ordinary expenses. Second, the expense must be necessary. The term necessary is not confined to strictly needful or crucial expenses. Rather, the term includes expenses that are appropriate, helpful and closely connected to the taxpayer's trade or business provided thee expenses are reasonable in amount.
Indeed, courts tend to construe the term necessary pretty generously in favor of taxpayers. For instance, take the real life case of a famous country music singer, Harold Jenkins, better known as Conway Twitty, who was one of the most successful country recording artists of his time, maybe of all time. In the 1970s, Twitty started a chain of restaurants called Twitty Burger! Yummy! To fund the enterprise, Twitty solicited investments from friends and associates in the country music business. When Twitty Burger failed, Twitty personally made good his investors' losses without any legal or arguable moral obligation to do so. Twitty then deducted the reimbursements from his gross income as a recording artist. Twitty's rationale was that a country music performer's reputation was crucial to success. Twitty refunded the investments to avoid controversy that would've hurt his reputation and in turn harmed his business as a performer. On this reasoning, the United States Tax Court allowed the deduction as a necessary business expense over the IRS's ardent protestations.
Third, a deductible trade or business expense must be paid or incurred during the taxable year. This means simply that the particular taxable year for deducting a business expense will depend on the taxpayer's accounting method. Fourth, the expense must be paid or incurred in carrying on an active, preexisting trade or business. As a result, startup expenditures to establish or acquire a new trade or business are not deductible under Section 162A. Of course, a taxpayer can be in the trade or business of being an employee. To that end, many taxpayers incur significant expenses in seeking work as employees. The general rule is that expenses incurred in seeking a new job in the same trade or business as the taxpayer's current or most recent job may be deductible under Section 162A. Now, this rule applies regardless whether the taxpayer ever finds a job provided the expenses are directly connected to the relevant trade or business.
However, expenses to find a new job in a different trade or business are not deductible under Section 162A, nor are expenses to find a taxpayer's first job. However, some of these expenses may be deductible or amortizable under other provisions of the code. Section 162A may apply to an unemployed taxpayer provided there's no substantial lack of continuity between the end of the previous job and the time the taxpayer starts seeking new employment. Any gap longer than a year is likely a substantial lack of continuity.
Fifth and finally, the taxpayer must incur the expense in connection with a trade or business. Though, any trade or business must be undertaken with a profit motive, not all activities undertaken for profit are trades or businesses. Rather, an activity is a trade or business if the taxpayer regularly and consistently devotes such time, effort and energy to it that it's essentially a livelihood or occupation. For instance, an attorney who earns a living practicing law is in the trade or business of legal practice. On the other hand, a mere hobby, amusement or diversion is no trade or business, even if the taxpayer makes money at it. Similarly, most passive investment activities are not related to a trade or business even though profit is the underlying motive for pretty must all investment. For instance, if a taxpayer spends considerable time, effort and money looking after her own investment portfolio, this activity typically is not a trade or business, unless perhaps the taxpayer is a so-called active trader who devotes her full time and effort to investment activities with the intent to earn a living as opposed to just earning a profit.
Now, let's talk briefly about the deduction for student loan interest, a deduction that's highly relevant to most of us who went through law school and racked up all sorts of student debt. Section 221 of the code allows a deduction for interest paid on a qualified education loan incurred solely to pay qualified educational expenses. Each of these terms has a fairly cumbersome statutory definition. The absolute maximum amount of deductible student loan interest in a given taxable year is $2,500. But even that paltry allowance begins to phase out once the taxpayer's adjusted gross income with modifications surpasses a certain threshold. The precise formula for calculating the phaseout is, to say the least, cumbersome. Now, if a taxpayer is married, then she must file a joint return with her spouse or else she will not get the deduction for student loan interest.
At this point, we should see whether Ted and Tina have any above-line deductions to subtract from their gross income in calculating adjusted gross income. To that end, we know that Ted pays interest on his student loans. So subject to the limitations we discussed, Ted may be able to claim that interest as an above-the-line deduction. We also know that Ted works from home and that trade or business expenses are typically above-the-line deductions and that a taxpayer may be in the trade or business of an employee. However, as we've said, expenses incurred in connection with a particular trade or business of being an employee are not generally above-the-line deductions. Instead, they're below-the-line deductions. So Ted cannot take his cost of working at home into account in calculating adjusted gross income. Those costs might include electricity, office space, wear and tear on computers and other equipment and so on.
Now what about the expenses that Ted incurs to stream video games on Stitch? Ted earns the vast bulk of his income from writing for his employer while he earns, by comparison, mere breadcrumbs from streaming and our facts indicate that streaming is really just a hobby for Ted. So, streaming is not a trade or business for Ted, meaning the expenses he incurs to stream are not above-the-line trade or business deductions. Now, let's talk about Tina. Tina receives rent from the tenants at her apartment complex. Presumably, she incurs all sorts of expenses in servicing the apartment for her tenants, the apartments, rather, for her tenants. These might include property taxes, maintenance costs, utilities and so on. We've learned that expenses incurred in connection to property held to produce rents and royalties are above-the-line deductions. So Tina can subtract these deductions from adjusted gross income.
Okay, let's come to step three to calculating an individual's federal income tax liability and that is, for the individual to take either the standard deduction or any available below-the-line deductions, but not both. If the individual takes the standard deduction, then she'll simply subtract a fixed amount from the adjusted gross income, making the standard deduction feel more like an exemption than a true deduction. The amount subtracted consists of the basic standard deduction plus, if appropriate, an additional fixed deduction for elderly and blind taxpayers. The amount of the basic standard deduction varies depending on the taxpayers filing status. If the taxpayer elects to take below-the-line deductions instead of the standard deduction, this is known as itemizing deductions.
In this event, the taxpayer will subtract from adjusted gross income the combined value of all allowable below-the-line deductions. The standard deduction plus any personal exemptions and plus the deduction for qualified business income. It bears repeating, a taxpayer can take either the standard deduction, or she can elect to itemize deductions, but she cannot do both. Perhaps the most important below-the-line deduction for many individuals is the one for qualified residence interest. In a taxable year, a taxpayer can have two qualified residences, her principle residence and another of her choosing provided she actually uses the other property as a residence. Qualified residence interest is interest that's attributable to either acquisition indebtedness or home equity indebtedness on a qualified residence. Different rules apply to each type of indebtedness. Acquisition debt includes debt secured by a qualified residence, if the debt was incurred to acquire, construct or substantially improve the residence. If a taxpayer refinances acquisition indebtedness and the refinancing increases the principle amount of that debt over what obtained at the time of the refinancing, then the increase will not be deemed to be acquisition indebtedness. Whoo, that's a mouthful.
As you might imagine, this deduction has its limits. The general rule is that up to one million dollars of debt may be treated as acquisition debt in any given taxable period. Anything more is not acquisition debt even if it otherwise meets the requirements. However, for taxable years 2018 through 2025, Congress has reduced the maximum amount of acquisition debt to $750,000. In addition, for those same taxable years, Congress has completely disallowed any deduction for interest on home equity debt. Historically, another important below-the-line deduction for many individuals has been that for state and local taxes, for instance, state income taxes and local property taxes. For taxable years 2018 through 2026, the combined deduction for state and local real estate income and personal property taxes that don't relate to a trade or business as well as managing investments or producing income is limited to $10,000.
Moving on. If a taxpayer engages in a profit seeking activity that does not quite rise to the level of a trade or business, then the resulting expenses are generally deductible on the same terms as expenses incurred in the course of carrying on the trade or business with one crucial difference. Deductions in connection with profit seeking activities that don't rise to the level of a trade or a business are usually below-the-line deductions, below-the-line.
Now let's talk about hobbies. In general, a hobby is an activity that is not undertaken primarily for profit even if the taxpayer makes money off it. Hobbies usually involve activities undertaken for a sport, recreation or personal pleasure. Speaking very generally, expenses for hobbies are deductible as below-the-line deductions, but only up to the amount of income attributable to the hobby. Also, the deduction is subject to some other limitations that are, to say the least, quite complicated.
Now let's talk about that home office deduction. In general, taxpayers who work from home in connection with a trade or business or perhaps another profit seeking activity can deduct at least a portion of the resulting expenses, but the home office deduction is subject to some significant limitations and very complex rules. Speaking broadly, the deduction applies only to that portion of the home used exclusively and regularly for business, and for employees working from home for their employers, it's a below-the-line deduction. In addition, for employees, the deduction applies only if the employee works from home for the employers convenience. Thus, the home office deduction won't do most employees any good.
Now, it's time for Ted and Tina to decide whether to take the standard deduction or to take the itemized deductions. Usually, that depends on which course produces the greatest tax savings. If the sum total of below-the-line deductions exceeds the standard deductions, then taxpayers will typically itemize. If not, then taxpayers will typically take the standard deduction. However, if below-the-line deductions exceed the standard deduction but not by much, taxpayers may choose the standard deduction simply to spare themselves the hassle of gathering up receipts and other documentation to substantiate the below-the-line deductions. In addition, for taxable years 2018 through 2026, Congress has gone out of its way to encourage taxpayers to take the standard deduction instead of itemizing. For one, Congress has imposed significant limitations on some of the more popular below-the-line deductions, some of which we've already discussed.
Also, Congress has carved out a special class of below-the-line deductions called miscellaneous itemized deductions. These deductions are generally subject to severe limitations that may not apply to other deductions. And for taxable years 2018 through 2026, miscellaneous itemized deductions have been totally suspended. Finally, on the positive side, Congress has considerably fattened the standard deduction for those years. Here, the below-the-line deductions potentially available to Ted and Tina include interest on their home mortgage and any state and local property taxes they might pay along with, perhaps, a small deduction for what Ted spends on his hobby of streaming and a similarly small deduction for home office expenses. If these deductions substantially exceed the standard deduction, then Ted and Tina will likely itemize.
Otherwise, they'll almost surely claim the standard deduction. Moving on. After subtracting either the standard deduction or total below-the-line deductions, the next step is to apply the deduction for qualified business income if appropriate. Speaking broadly, the deduction for qualified business income is a fixed amount that certain individuals can subtract from adjusted gross income in addition to the standard deduction or the total below-the-line deductions, whichever they take. The specific amount of the deduction will vary from one taxpayer to the next, and the mechanics of calculating it are highly complex featuring all sorts of limitations, phaseouts and exclusions. I mean, after all, if it's not complicated, it's not federal tax.
In any case, the deduction usually applies only to individual taxpayers who hold some equity ownership interest in certain business entities that are not taxed as separate entities from their owners, which are also known as pass-through entities. Examples of pass-through entities include common law partnerships, many LLCs and sole proprietorships as well as so-called S-Corporations. Finally, the deduction for qualified business income will terminate in 2026 unless Congress extends it. Here, nothing in our facts indicate that Ted or Tina owns any interest in a pass-through entity. So the deduction for a qualified business income probably does not apply here.
Now, once either the standard deduction or the itemized deductions have been subtracted from adjusted gross income and any allowable qualified business income deduction has been accounted for, the resulting amount is the taxpayer's taxable income. Once taxable income is determined, the next step is to calculate the taxpayer's tentative tax liability. But before we do this, it's important to determine the proper characterization for each type of income and loss if the taxpayer had losses. The two major characterizations are ordinary income and capital gains. Capital gains in turn are subdivided into short term capital gains and longterm capital gains. Generally, ordinary income is income other than capital gains. Capital gains and losses are those that arise from the sale or exchange of a capital asset.
A capital asset in turn is any property the taxpayer holds with certain exclusions, for instance, stock and trade, inventory and most assets used, consumed or sold in the ordinary course of the taxpayer's trade or business are not capital assets. Long term capital gains or losses arise from the sale or exchange of a capital asset that the taxpayer has held for more than one year. Conversely, short term capital gains result from the sale or exchange of a capital asset that the taxpayer has held for one year or less. Broadly speaking, short term capital gain is taxed just the same as ordinary income. Long term capital gain is taxed very differently. Long term capital gain is usually taxed at lower rates than ordinary income up to 20% depending on various factors. But long term capital gain on specified assets called collectibles is taxed at 28%.
Collectibles include works of art as well as rugs, antiques, metals, gems, stamps, coins, bouillon, and everybody's favorite, alcoholic beverages. If a taxpayer engages in multiple capital asset sales or exchanges during the taxable year, the code uses and intricate netting process to determine the overall capital gain or loss along with the applicable rates of taxation. The specific mechanics are set forth in Section 1H, which is one of the more intimidating provisions occurring anywhere in the code. Here, it looks like Ted and Tina sold two capital assets, their home and Tina's stock. They'll probably be able to exclude the gain from the sale of their old home as we discussed above. And Tina sold the stock in 2019, the very same year she inherited it. So Tina's gain on the sale of the stock is short term capital gain. The rent from Tina's apartments is ordinary income. True. The rent derives from the building, and the building is a capital asset, but nothing indicates that Tina ever sold or exchanged the building. And it's a general rule that rent is ordinary income. So it looks like all of Ted and Tina's capital income is going to be taxed as ordinary income.
Now, let's talk about the progressive income tax. Many in the United States advocate for an alternative such as the flat tax. Now, there's disagreement over precisely what a flat tax is. When most people hear the term flat tax, they envision a system in which there are no income brackets and everybody pays the same uniform rate on taxable income. When others hear the term flat tax, they envision a consumption tax, a tax not on what people earn or receive, but on what they spend. This concept of a consumption tax is analogous to a sales tax. What a uniform tax rate and a consumption tax have in common is that both disregard the notion of income brackets. The federal tax system is no flat tax. Rather, it's a progressive tax system in which different portions or brackets of taxable income are taxed at different rates usually with the view towards imposing a heavier tax burden on those with more taxable income.
Now, on the slide in front of you, we'll use a simple and not at all accurate example just to illustrate how tax, or excuse me, a progressive tax works, how it divides up the income. Now, to calculate tentative tax liability, Ted and Tina will have to run their income through the applicable tax rates. One complicating factor here is that the applicable tax rates will differ depending on filing status. For instance, single, married filing jointly, married filing separately, head of household and so on. Generally speaking, if two individuals are married on then last day of their taxable year, which is typically December 31st, and if they're not divorced or separated, they can file a joint return. Their filing status will be married filing jointly.
This filing status generally affords more generous tax rates than either single or married filing separately. For that reason, Ted and Tina's filing status will almost certainly be married filing jointly. Now if married taxpayers file jointly and each taxpayer is jointly and separately liable for all tax due on the return regardless of which spouse generated the income. So if there's a deficiency, the IRS can go after either spouse or both spouses for the full amount. Though, a so-called innocent spouse could escape joint and sever liability in appropriate circumstances. Once the income tax table are applied, the resulting amount is tentative tax liability. It's tentative because there's one more step to arrive at final tax liability, and that is to subtract from tentative tax liability any payments and tax credits.
Now there's a crucial distinction between deductions and credits. Deductions reduce taxable income. Credits reduce tax liability. It's a crucial difference. If a positive balance remains after subtracting payments and credits, then that positive balance is the taxpayer's final liability. If the balance is zero, the taxpayer owes nothing. If the balance is negative, the taxpayer gets a refund. Here is where the distinction between refundable and nonrefundable credits comes into place. A refundable credit is subtracted from tentative taxable income in full. If it results in a negative tax liability, it's treated like an overpayment, which produces a refund. Perhaps the most familiar example of a refundable credit is the so-called earned income tax credit.
A nonrefundable credit, though, cannot produce negative tax liability. Rather, it's subtracted from tentative taxable, excuse me, tentative tax liability up to the point where final liability equals zero. Any remaining portion is unused. For example, let's suppose Ted and Tina's tentative tax liability is 60,000 for which they made $45,000 in payments leaving 15,000 in liability. And suppose they're entitled to 20,000 in refundable credits. This will be subtracted from the remaining 15,000 in liability producing final liability of negative $5,000 which translates to a refund. But if the credits are nonrefundable, they'll reduce Ted and Tina's liability to zero, but the remaining $5,000 in credits will go unused.
Congratulations! We've walked Ted and Tina through the process of computing their tax liability for 2019. Assuming everything looks good, they'll sign their joint return, file it, and if appropriate, wait to receive their refund or pay any outstanding liability. But let's suppose Ted and Tina had a substantial underpayment for 2019. What can they do? Well, what they should not do is ignore it. If taxpayers disregard their obligations and don't reach out to the IRS, bad things start to happen. I saw it firsthand when I was representing taxpayers. Interest and penalties pile up fast, and the IRS may start slapping liens on the taxpayer's property.
So the best and right thing to do is to reach out to the IRS, which is often more than willing to be flexible. For instance, the IRS is usually pretty good about entering installment agreements letting taxpayers pay their liability over time. In more extreme cases, the IRS may settle the liability for less than the stated amount or hold off on collection activity when it's clear that blood can't be extracted from a stone. And if a dispute arises between the taxpayer and the IRS, the taxpayer should hire a competent professional to represent her. These professionals often interact with the IRS, and many have formed good relationships with key IRS decision makers. Their knowledge of the tax law and IRS procedures often prove invaluable to speed up the process and achieve the best resolution possible for both the government and the taxpayer.
Our brief presentation, taxing though it was, didn't even scratch the surface of federal tax laws. In a piece called Only the Dead Know Brooklyn, in the June 15, 1935 issue of the New Yorker, Thomas Boyle wrote that there's no guy living who knows Brooklyn through and through because it would take a guy a lifetime just to find his way around the expletive town. The same could be said of federal tax law. Federal taxation is one of the largest and most elaborate institutions every devised. No one dead or alive knows it fully.
Thank you for joining us for this introduction to basic federal income tax for individuals. To learn more, please check out the accompanying course materials including today's slides and presenter notes. Thanks for choosing Quimbee, and we hope to see you again soon. Cheers, Adios, Salud.