4.0 Federal Taxation of Individuals REG Practice Quiz

• A. $50,000, the cancellation is excluded only to the extent of the taxpayer's insolvency immediately before the discharge ($200,000 liabilities − $150,000 assets = $50,000 insolvent); the remaining $30,000 is included in gross income
• B. $80,000, the entire debt cancellation is excluded because cancellation of business debt is always excludable
• C. $0, cancellation of business debt is always fully included in gross income under §61
• D. $80,000, the entire debt cancellation is excluded because the taxpayer is insolvent

§108 insolvency exception: COD income is excluded from gross income to the extent the taxpayer is INSOLVENT immediately BEFORE the cancellation. Insolvency = Total liabilities ($200,000) − Total assets ($150,000) = $50,000. The taxpayer is insolvent by $50,000. Excluded COD: $50,000 (the extent of insolvency, cannot exclude more than the insolvency amount). Included COD: $80,000 cancelled − $50,000 excluded = $30,000 INCLUDED in gross income. Basis reduction: when COD is excluded under §108, the taxpayer must reduce tax attributes (NOLs, credits, asset bases) by the excluded amount. The $50,000 exclusion would require reducing basis of assets or other tax attributes. The taxpayer remains solvent AFTER the discharge: $200,000 liabilities − $80,000 cancelled = $120,000 liabilities; assets still $150,000; net worth = $30,000 (now solvent, the insolvency exclusion restores the taxpayer to solvency, not more).

• A. $500,000, married filing jointly taxpayers who both meet the ownership and use tests can exclude up to $500,000 of gain on the sale of their principal residence
• B. $250,000, the §121 exclusion is limited to $250,000 regardless of filing status
• C. $800,000, all proceeds from the sale of a principal residence are excluded from gross income
• D. $0, the §121 exclusion is only available for first-time homebuyers

§121 principal residence gain exclusion: Requirements: (1) OWNERSHIP: taxpayer must have owned the home for at least 2 of the 5 years ending on the sale date; (2) USE: taxpayer must have used the home as their principal residence for at least 2 of the 5 years ending on the sale date; (3) FREQUENCY: the exclusion may only be used once every 2 years. Maximum exclusion: Single filers: $250,000; Married filing jointly: $500,000 (if both meet the use test; if only one meets the use test, limit is $250,000). Calculation: Realized gain = $800,000 − $300,000 = $500,000. Maximum exclusion = $500,000 (MFJ). Excluded gain = min($500,000 gain, $500,000 exclusion) = $500,000. Recognized gain = $500,000 − $500,000 = $0. The entire gain is excluded. If the gain had been $600,000, only $500,000 would be excluded and $100,000 would be recognized (LTCG).

• A. All $3,000 is included in gross income and taxed as ordinary income at the taxpayer's marginal rate
• B. Gross income: $1,200 ordinary dividends (ordinary rates) + $800 qualified dividends (0/15/20% preferential rates) + $400 corporate bond interest (ordinary rates) = $2,400; the $600 municipal bond interest is excluded from federal gross income
• C. Only the $800 of qualified dividends is includible, other investment income is excluded from gross income under the investment tax exclusion
• D. Gross income: $2,400 (all dividends and corporate interest); municipal bond interest ($600) is included but at a 0% tax rate, it is not truly excluded

Income classification: (1) Ordinary dividends ($1,200): included in gross income; taxed at ordinary income rates; (2) Qualified dividends ($800): included in gross income; taxed at preferential LTCG rates (0%, 15%, or 20% depending on taxable income level) because the holding period requirement is met; (3) Municipal bond interest ($600): EXCLUDED from federal gross income under §103(a), interest on state and local government obligations is exempt from federal income tax; note: municipal bond interest IS included in Alternative Minimum Tax Income (AMTI) for private activity bonds; (4) Corporate bond interest ($400): included in gross income; taxed at ordinary income rates. Total included in federal gross income = $1,200 + $800 + $400 = $2,400.

• A. All four benefits are excluded from gross income, employer-provided benefits are always excluded as compensation
• B. Included in gross income: (B) imputed income on group term life over $50,000 ($30,000 excess coverage valued using IRS Table I); (C) $600 gift card (not de minimis). Excluded: (A) employer health insurance premiums ($6,000); (D) on-premises gym (§132 de minimis/working condition fringe)
• C. All four benefits are included in gross income, employers cannot provide tax-free benefits
• D. Included in gross income: (A) health insurance $6,000; (C) gift card $600. Excluded: (B) all group term life; (D) on-premises gym

Fringe benefit analysis: (A) Health insurance premiums ($6,000): EXCLUDED under §106, employer-provided health insurance premiums are fully excluded from employee gross income (one of the largest exclusions in the Code); (B) Group term life insurance ($80,000): Under §79, the cost of the first $50,000 of group term life insurance coverage is excluded. Employer-provided coverage EXCEEDING $50,000: the COST (per IRS Table I) of the excess $30,000 of coverage is INCLUDED in the employee's gross income. The IRS Table I cost varies by age; the inclusion amount is typically small but is reported on W-2 as income. At minimum, the Table I cost of the $30,000 excess coverage is included; (C) $600 gift card: INCLUDED, gift cards and cash equivalents are NOT de minimis fringe benefits under §132(e). De minimis applies to items of such small value that accounting for them is unreasonable (e.g., occasional office snacks, holiday turkey). Gift cards are cash equivalents that are always included in gross income regardless of amount; (D) On-premises gym: EXCLUDED as a §132(j) qualified on-premises athletic facility, use of employer-operated athletic facilities on business premises is excluded from gross income.

• A. SE tax deduction: $0 (not an AGI deduction); SE health insurance: $9,600
• B. SE tax deduction: $7,822 (½ of SE tax paid); SE health insurance: $9,600, both are above-the-line AGI deductions
• C. SE tax deduction: $15,644 (full SE tax); SE health insurance: $9,600
• D. SE tax deduction: $7,822; SE health insurance: $0, health insurance premiums are only deductible as itemized medical expenses

Self-employment AGI deductions: (1) SE tax deduction (§164(f)): Self-employed individuals pay both the employee's and employer's share of FICA (SE tax). To create parity with employees (whose employer's share is not included in their wages), §164(f) allows a deduction for ONE-HALF of SE tax paid: Deduction = $15,644 × 50% = $7,822. This is an above-the-line AGI deduction taken on Schedule 1; (2) SE health insurance deduction (§162(l)): Self-employed individuals may deduct 100% of health insurance premiums paid for themselves and their families as an AGI adjustment (above-the-line), up to the net profit from SE activities. Deduction = $9,600. Limitation: the §162(l) deduction cannot exceed the taxpayer's net profit from SE, here, $120,000 net SE income provides ample room; also, the deduction is not available for any month when the taxpayer was eligible to participate in a subsidized health plan through an employer (or spouse's employer). Total AGI adjustments from SE: $7,822 + $9,600 = $17,422 reduction in AGI.

• A. No tax consequences, cryptocurrency is not recognized as property by the IRS and creates no taxable events
• B. Sale of 1 Bitcoin: $4,000 ordinary income; Receipt for services: $7,000 ordinary income
• C. Sale of 1 Bitcoin: $4,000 short-term capital gain; Receipt for services: $7,000 ordinary income at FMV; basis in the 0.5 Bitcoin received = $7,000
• D. Sale of 1 Bitcoin: $4,000 long-term capital gain; Receipt for services: not taxable until the Bitcoin is eventually sold

Virtual currency tax consequences: (1) Sale of 1 Bitcoin: Basis = $10,000 (purchase price per Bitcoin); Amount realized = $14,000; Gain = $14,000 − $10,000 = $4,000. Character: purchased January, sold October = approximately 9 months → SHORT-TERM capital gain (held one year or less). Taxed at ordinary income rates; (2) Receipt of 0.5 Bitcoin for services: When property (including virtual currency) is received as compensation for services, the taxpayer must include the FMV of the property in ordinary income at the time of receipt. FMV of 0.5 Bitcoin = $7,000 → $7,000 ORDINARY INCOME included in gross income. The taxpayer's basis in the 0.5 Bitcoin received = $7,000 (the FMV included in income, this is the 'tax cost' basis). When this Bitcoin is later sold, gain/loss is computed from this $7,000 basis.

• A. $130,000 excluded, all foreign-earned income is excluded because the taxpayer is a foreign resident; no US tax return required
• B. $0 excluded, the exclusion only applies when no foreign taxes are paid; Germany has a tax treaty with the US, eliminating the exclusion
• C. $126,500 excluded (the 2024 limit); $3,500 of foreign earned income remains taxable in the US; a US tax return is required and must be filed, the exclusion is elected on Form 2555
• D. $130,000 excluded, treaty exempts all income earned in Germany; no US filing required if the taxpayer pays German taxes

§911 Foreign Earned Income Exclusion: (1) Eligibility: US citizens or resident aliens working in a foreign country who meet EITHER: (a) Bona fide residence test: a bona fide resident of a foreign country for an uninterrupted tax year; or (b) Physical presence test: present in a foreign country for 330+ full days in any 12-month period; (2) Exclusion amount: up to $126,500 (2024) of foreign EARNED income (wages, salaries, self-employment income, NOT investment income). Amount excluded: $126,500 (the maximum; the remaining $130,000 − $126,500 = $3,500 is still subject to US tax); (3) US filing requirement: US citizens must file US tax returns reporting worldwide income REGARDLESS of whether they live abroad. The exclusion is ELECTED on Form 2555 attached to Form 1040. Failing to file because all income is excluded is a common mistake, the filing requirement persists; (4) Housing exclusion/deduction: an additional exclusion for foreign housing costs may also be available; (5) Anti-stacking: the excluded income is taxed at the MARGINAL RATE that would apply if the excluded income were included (the income 'stacks' under the excluded income for rate purposes).

• A. $0, all lawsuit proceeds represent compensation for injury and are excluded from gross income under §104
• B. $580,000, all lawsuit proceeds are income under §61 regardless of their source or nature
• C. $330,000, lost wages and future medical expenses are included; only pain and suffering is excluded
• D. $200,000, only the punitive damages are includible in gross income; the compensatory damages for physical injury (pain, lost wages, medical) are excluded under §104(a)(2)

§104(a)(2) exclusion for personal physical injury damages: EXCLUDED from gross income: (1) Physical injury pain and suffering ($250,000): damages received on account of a physical injury or physical sickness are excluded; (2) Lost wages due to physical injury ($80,000): even though this replaces income, if the lost wages are caused by the physical injury, they are excluded as damages 'on account of' physical injury; this is a critical distinction, lost wages due to physical injury = excluded; lost wages from an employment discrimination case = included; (3) Future medical expenses ($50,000): damages for future medical costs caused by the physical injury are excluded. INCLUDED in gross income: (4) Punitive damages ($200,000): under §104(c), punitive damages are NOT excluded even in a physical injury case, they are included in gross income as ordinary income. Rationale: punitive damages are designed to punish, not to compensate, they exceed the economic injury suffered and therefore do not qualify as 'on account of' physical injury.