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1040 problem, Taxation

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Amy R. and David T. Smith are married and live at 123 Main Street, Stafford, VA 22554. Dave is self-employed as a web developer and Amy is a commercial refrigeration sales representative.

1. David builds and maintains web applications for a number of clients. He does a majority of his work from his home office, but he frequently drives to the client site to meet with his clients. Occasionally, he meets with his clients in his home office. David’s home office occupies 400 square feet of their 4,000 square foot home. The home was built at a cost of $350,000 on a lot previously acquired for $75,000. The Smiths moved into the home on May 10, 2008. As to business use, depreciation has been based on MACRS. Besides home mortgage interest and property taxes, residence expenses for 2011 are summarized below.
Utilities $4,200
Cleaning service 2,400
Home security system 1,200
Homeowner’s insurance 2,100
Repair to drywall in office 750
In addition, David has office supplies expense of $800 and a dedicated phone line at a cost of $600. For use in his business, David purchased a laptop for $2,500 on August 4th and a printer for $400 on March 7th. Except for his vehicle, David opts to maximize his depreciation deductions whenever possible.
2. On May 9th, David paid $34,500 (including sales tax) to purchase a used Audi A8 that he uses 90% of the time for business. No trade-in was involved. David uses the actual operating cost method to compute his tax deduction. His expenses relating to the A8 are as follows:
Gasoline $2,800
Auto insurance 1,250
Interest on car loan 750
Oil changes 425
Traffic violations 350
License and registration 150
Parking 90
Tolls 75
David drove the Audi 13,500 miles for business and 1,500 personal use miles.
3. Most of David’s clients are local. However, a few of his clients require out of town travel. He incurred $2,500 of airfare, $1,570 in lodging and $1,313 in meals relating to the business trips. In addition, David paid for $630 for business dinners with several prospective clients.
4. David also incurred the following business expenses during 2011.
Contribution to Keogh plan $8,000
Premiums on medical insurance for family (spouse and children) 4,500
Premiums on disability insurance policy (AFLAC) 2,400
Birthday gift for unpaid intern ($35 box of chocolates and $3 gift wrap) 38
5. Amy earns $35,000 working part time. Consequently, she is not eligible to participate in her employer’s retirement plan or health insurance program. Amy’s expenses are summarized as follows:
a. Contribution to traditional IRA $4,000
b. Membership dues 120
c. Subscription to trade magazine 90
d. Amy drives her Chevy Tahoe 1,135 miles for job-related use. She purchased the car in 2010 for $25,000. Amy uses the automatic mileage method for computing any available deduction for business use of the car.
6. The Smiths have supported Ron Smith, David’s widowed father, for several years, appropriately claiming him as a dependent for tax purposes. On December, 27 2010, Gene suffered a massive stroke. The doctors did everything they could for Ron, but he died in the ICU on January 8, 2011. The Smiths paid the following expenses on behalf of Ron: $11,800 medical ($6,000 incurred in 2010 and $5,800 in 2011) and $5,300 funeral. These expenses were paid in January and February 2011. Ron’s will named David as executor and sole heir of the estate.
7. The Smiths decided to convert Ron’s home into a furnished rental house. After several minor repairs (touching up the paint, replacing screens, pressure-washing), the property was advertised for rent in the classified section of the local newspaper on March 1, 2011. The repairs cost $720 and the newspaper ad was $360. Based on reconstructed records and appraisal estimates, information about the property is as follows:
Original Cost FMV 1/8/11
House $40,000 $220,000
Land 10,000 50,000
Furniture and Appliances 21,000 14,000

8. Ron’s former residence was rented almost immediately, with occupancy commencing April 1, 2011, under the following terms: one-year lease; $2,400 per month; first and last month’s rent in advance; $2,000 damage deposit; and lawn care, but not utilities, included. The tenant complied with all terms except that the December rent payment was not made until January 1, 2012. Expenses in connection with the property were as follows: Property taxes, $2,600; repairs $320; lawn maintenance $540; insurance, $1,800 and street paving assessment $2,100. The property is located at 549 Columbus Street, Stafford, VA 22554.
9. One month before she died on April 14, 2002, Barbara Gent (Amy’s aunt) gave Amy a coin collection. Based on careful records that Barbara kept, the collection had a cost basis of $9,000 and a fair market value of $18,000 at the time Barbara passed away. On February 19, 2011, The Smith residence was burglarized and the coin collection was stolen. The Smiths filed a claim for $24,000 (the current value of the collection) with the carrier of their homeowner’s insurance policy. All they were able to collect, however, was $5,000, which was the maximum amount allowed for valuables without a special rider.
10. In addition to those previously noted, the Smiths’ receipts during 2011 are summarized below.
a. Payments to David for services rendered $120,000
b. Income tax refunds for tax year 201022
i. Federal 1,000
ii. State 120
c. Interest Income
i. Virginia general purpose bonds 1,400
ii. IBM corporate bonds 1,200
iii. Certificate of deposit 800
d. Qualified dividends 750
e. Cash gifts from David’s sister 24,000
f. David’s net state lottery gains (winnings $1,000; losses $900) 100
11. On June 2 and 3, 2011, the Smiths held a garage sale to dispose of unwanted furniture, appliances, etc. The proceeds were $9,500. The estimated basis of the items sold is $25,500. All were personal use property.
12. Expenditures during 2011, not mentioned elsewhere, are as follows:
a. Medical
i. Copayment for medical expenses $1,300
ii. Dental (orthodontist) 1,200
b. State sales tax 1,120
c. Property taxes on personal residence 3,800
d. Interest on home mortgage reported on Form 1098 4,200
The Smiths’ medical insurance does not cover dental services. The Smiths pledge contributions of $1,200 per year to their church. In 2011, they paid the pledges for 2010-2012. During 2011, The Smiths drove the Tahoe 320 miles for medical purposes and 170 miles for charitable purposes.
13. The Smiths have two children who live with them: Sandy and Judy. Both are full-time students. Sandy is an accomplished singer and made $4,200 during the year performing at special events. Sandy deposits her earnings in a savings account intended to help cover future college expenses.
14. The Form W-2 Amy receives from her employer reflects wages of $35,000. Appropriate amounts for Social Security and Medicare taxes were deducted. Income tax withholdings were $1,320 for Federal and $1,056 for state. The Smiths made quarterly tax payments of $3,500 for Federal and $1,000 for state on each of the following dates: April 15, 2011; June 15, 2011; September 15, 2011; and January 15, 2012. Relevant Social Security numbers are provided below:
Name SSN DOB
David Smith 111-11-1111 06/06/1969
Amy Smith 123-45-6789 08/14/1970
Ron Smith 987-65-4321 03/12/1934
Sandy Smith 222-33-4444 09/13/1993
Judy Smith 555-66-7777 07/20/1991

15. While on a business trip to Texas, David attended a mortgage foreclosure auction. At the auction (held on February 4, 1999), he acquired an abandoned sugarcane farm near Pearland. David financed most of the $30,000 purchase. In view of the expansion trend in nearby Houston, he regarded the purchase as a good investment. Early in 2011, David was contacted by a Houston real estate developer who offered $250,000 for the property. Horrified at the prospect of a large taxable gain, David ultimately arranged for an exchange transaction by written notice on May 10. In exchange for several vacant lots on Padre Island, Texas, worth $240,000 and cash of $10,000, David transferred the property to the developer. The exchange took place at an attorney’s office in Houston on June 20, 2011.
16. On May 9, 1997, David’s father gave him 400 shares of Tango Corporation common stock as a birthday present. The stock had cost his father $16,000 ($40/share) and was worth $20,000 on the date of the gift. In 2007, when the stock was worth $140/share, Tango declared a 2-for-1 stock split. On July 27, 2011, David sold 400 shares for $20,000 ($50/share).
17. On March 2, 2009, Amy was contacted by Laura Jones, a former college roommate. Over lunch, Laura asked Amy for a loan of $6,000 to help finance a new venture. Because the venture sounded interesting, Amy made the loan. Laura signed a note due in two years at 10% interest. In late 2011, Amy learned that Laura had disappeared after being charged with grand theft by New Mexico authorities. Even worse, Laura was wanted in Arkansas for parole violation from a prior felony conviction. Laura has never paid any interest on the note.
18. The Smiths have a long-term capital loss carryover of $10,000 from 2010.
19. On May 9, 2007, David’s uncle, Joe, gave him the family antique gun collection. Based on family records and educated estimates, the collection had an adjusted basis to Joe of $4,200 and was worth $13,000 on the date of the gift. Because Amy abhors guns, David has been under heavy pressure to get rid of the collection. After Joe died in early 2011, David donated the collection to the Colt Museum (a qualified charity). The transfer was made on December 5, 2011; at that time, several qualified appraisers valued the collection at $16,000. The museum plans to add the collection to the other firearms it exhibits to visitors.
20. While walking the dog in late December 2010, Amy was hit by an out-of-control delivery truck. The mishap sent Amy to the hospital for several days of observation and medical evaluation. Aside from severe bruises, she suffered no permanent injury. Once apprehended, the driver of the truck was ticketed for DUI. The owner of the truck, a local distributor for a national brewery, was concerned about the adverse publicity that would result if Amy filed a lawsuit. Consequently, it paid all of her medical expenses and offered her a settlement if she would sign a release. Under the settlement, Amy would receive $134,000 - $8,000 for loss of income and $126,000 for personal injury. On January 31, 2011, Amy signed the release and was immediately paid $134,000.

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