Taxable Income
by
Charles Lamson
Paying your income taxes is a complex process involving several steps and many calculations. Exhibit 1 (below) depicts the procedure to compute your taxable income and subsequent tax liability. It looks simple enough---just subtract certain adjustments from your gross income to get your adjusted gross income, then subtract either the standard deduction or your itemized deductions and your total personal exemptions to get taxable income, and finally subtract your taxes and any tax credits from that amount and add any other taxes to it. This is not as easy as it sounds, however! Various sections of the Internal Revenue Code place numerous conditions and exceptions on the tax treatment and deductibility of certain income and expense items and define certain types of income as tax-exempt. As we will see, a number of problems can arise in defining what you may subtract.
Gross Income
Basically, gross income includes any and all income subject to federal taxes. Some of the more common forms of gross income include:
In addition to these sources of income, some types of income are considered tax exempt and as such are excluded---totally or partially---from gross income. Tax-exempt income does not even have to be listed on the tax return. Common types of tax-exempt income include child support payments, certain types of employee fringe benefits, compensation for accident, health, and life insurance policies, federal income tax refunds, gifts, inheritances, scholarships, and fellowships (limited as to amount and time), and veterans' benefits.
Three Kinds of Income
Individual income falls into one of three basic categories of income:
These categories limit the amount of deductions and write-offs that taxpayers can take. Specifically, the amount of allowable, deductible expenses associated with portfolio and passive income is limited to the amount of income derived from these two sources. For example, if you had a total of $380 in portfolio income for the year, you could write off no more than $380 in portfolio-related interest expense. Note, however, that if you have more portfolio expenses than income, you can "accumulate" the difference and write it off in later years (when you have sufficient portfolio income) or when you finally sell the investment.
For deduction purposes, you cannot mix or combine portfolio and passive income with each other or with active income. Investment-related expenses can be used only with portfolio income, and with a few exceptions, passive investment expenses can be used only to offset the income from passive investments. All the other allowances and deductions are written off against the total amount of active income the taxpayer generates.
Capital Gains
Technically, a capital gain occurs whenever an asset (such as a stock, a bond, or real estate) is sold for more than its original cost. Thus, if you purchased stock for $50 per share and sold it for $60, you would have a capital gain of $10 per share.
Capital gains are taxed at different rates, depending on the holding period. As a rule, taxpayers include most capital gains as part of portfolio income. They will add any capital gains to the amount of dividends, interest, and rents they generate to arrive at total investment income.
Although there are no limits on the amount of capital gains taxpayers can generate, the IRS imposes some restrictions on the amount of capital losses taxpayers can take in a given year. Specifically, a taxpayer can write off capital losses, dollar for dollar, against any capital gains. For example, a taxpayer with $10,000 in capital gains can write off up to $10,000 in capital losses. After that, he or she can write off a maximum of $3,000 in additional capital losses against other (active, earned) income. Thus, if the taxpayer in our example had $18,000 in capital losses in 2017, only $13,000 could be written off on 2017 taxes: $10,000 against the capital gains generated in 2017 and another $3,000 against active income. The remainder---$5,000 in this case---will have to be written off in later years, in the same order as indicated above: first against any capital gains and then up to $3,000 against active income. (Note: To qualify as a deductible item, the capital loss must result from the sale of some income-producing asset, such as stocks and bonds. The capital loss on non-income producing assets, such as a car or TV set, does not qualify for tax relief.)
Selling Your Home: A Special Case
Homeowners, for a variety of reasons, receive special treatment in the tax codes, including the taxation of capital gains on the sale of a home. The Taxpayer Relief Act of 1997 made most home sales tax free. Under that law, single taxpayers can exclude from income the first $250,000 of gain on the sale of a principal residence for at least 2 of the 5 years prior to the sale. For example, the Greenmans (married taxpayers) just sold their principal residence for $475,000. They had purchased their home 4 years earlier for $325,000. They may exclude their $150,000 gain ($475,000 - $325,000) from their income because they occupied the residence for more than 2 years, and the gain is less than $500,000.
This exclusion is available on only one sale every 2 years. A loss on the sale of a principal residence is not deductible. Generally speaking, this law is quite favorable to homeowners.
*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS.
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