Welcome back. In the next series of videos, we'll be examining gross income more deeply. Looking back at our income tax formula, we'll start right at the top, income broadly conceived. Before we get into specific roles and examples of various items includible in gross income, let's first talk concepts. First of all, what is gross income? Internal Revenue Code Section 61 states that income is all income from whatever source derived. Treasury Regulation Section 1.61-(a) clarifies that income can be realized or received from another party in any form. We typically think of income received as cash received only. But in fact, it includes any other benefit received, including property received or services received. We value the property or service at its fair market value. For example, if I do my friend's tax return, and if instead of paying me $100 in cash, he pays me with a new pair of sunglasses worth $100 or a gift certificate to a restaurant worth $100 or paints my dining room for me worth $100 of his time - regardless of how my friend pays me, if the value is $100, then I must include $100 in my gross income, and thus it will be part of my tax base and will be taxed. So when do taxpayers recognize income? That is, when do taxpayers report the income on their tax returns? Well, taxpayers recognize income when three conditions hold. First, taxpayers have to recognize gross income when they receive an economic benefit. Second, they must realize the income. Third, the tax law does not provide for any exclusion or deferral of that income. So let's look at each of these three conditions more closely. The first condition to recognize income is that there's an economic benefit to the taxpayer. In thinking of an economic benefit, we should think of whether the taxpayer receives some kind of asset - that is cash, property, or even services. Or if the taxpayer eliminates a liability. In other words, if my net worth goes up, I must recognize the income. For example, if my friend pays me not with cash, or a new pair of sunglasses, or painting my dining room, but rather pays off $100 on my mortgage or pays off $100 on my credit card bill, that payment made by my friend is still value that I'm receiving. Therefore, the hundred dollars of reduced liability must still be recognized as gross income. I may still report the hundred dollars on my tax return. Note here, however, that incurring a liability is not income even though it is cash in my pocket. That is, if I borrowed $20,000 to purchase a new car, the $20,000 that I receive is not income, and I do not need to pay tax on that. The reason is that it's a liability. I'll have to pay that $20,000 back. There's no economic benefit here. My net worth did not increase. The second condition to recognize income is that there must be a realization of income. That is, a taxpayer has to engage in a transaction. The transaction must result in a measurable change of property rights and the transaction provides the wherewithal to pay the associated tax on the income. So back to my example where I completed my friend's tax return. If my friend is paying me somehow in cash, or property, or services, or pays off some of my debt, we've engaged in a transaction. Not only have we engaged in a transaction, but I now have the property rights over what my friend gave me. I have the right to use his cash or his property or his services. He owes me something for the transaction, and once I receive it, it will be mine. Finally, when I received the payment from my friend, I'll have the ability to pay the tax associated with that income. If he pays me cash, I will, of course, have the ability to pay the cash taxes. If he pays me with property, I can always sell the property to get the cash to pay the tax. Even with services and debt reduction, I can always opt to receive a more liquid payment from my friend, and thus I will have the wherewithal to pay. The third condition to recognize income is that there must not be a rule that lets me differ or exclude income. That is, assume everything is income unless Congress says it's not. Congress can, in fact, say that some types of realized income are not recognized at all. So they're excluded from gross income or taxpayers can delay recognizing the income. Back to our example. If I completed my friend's tax return, and he pays me on account, perhaps a note receivable on my end - that is, I will get the cash over the next five years, for example - then if I elect to treat the transaction as an installment sale, I can recognize the income over the next five years, not all in the current year. Of course, certain rules apply under installment sale, but the point is that the tax law does provide some avenue for deferring the recognition of income. If on the other hand I completed the tax return for my friend and did not expect anything in return because I did it because he is my friend - that is, there's no transaction - then me performing the service for my friend could be considered a gift to my friend and the tax law says that the value of any gift received is not included in gross income. That is, the value is excluded. In other words, my friend will not have to recognize income on his tax return for the value of the service I provided him because I provided it as a gift. He gets the value of my services essentially tax-free. So let's look at a more detailed example here. Must gross income be recognized? So in the first example here, Pete is a teacher, and he gets summers off. During the summer, he builds his own home. The cost of the land, materials, and labor Pete purchase from others was $100,000. The fair market value of the completed house was $250,000. He moves into the house. Is the $150,000 difference between the cost and fair market value recognized as gross income? To answer this question, we have to look at our three criteria for recognition. First, does building the house increase Pete's net worth? Yes, in a way it does. He paid $100,000 to develop an asset worth $250,000. So yes, this work increases Pete's net worth by $150,000. Second, is there a realization of $150,000? Does Pete engage in a transaction that changes his property rights in the house and provides his with a wherewithal to pay? Here, Pete does not actually engage in a transaction. He builds his house and simply moves into it. That's it. He doesn't sell it, so there's no change in property rights. By not selling it, he doesn't have the money to pay the tax on the $150,000 income. Therefore, here he violates the realization principle. There is no realization. Finally for completeness, even if there was realization, the question is whether there are any rules in the Internal Revenue Code that allow for deferral or exclusion of that income. Here, a good tax lawyer or accountant might help. There is, in fact, a provision in the tax code - section 121 - that does allow for the first $250,000 of gain related to the sale of one's primary residence to be tax-free. That is, even if there was realization, that is, let's say Pete sold his house for $250,000, Pete's $150,000 gain would be entirely excluded from his gross income. Some rules apply here for section 121 to apply. But generally, this provision would allow for exclusion. But back to the facts. So here, Pete does not recognize income because this activity violates the realization principle - it's not a transaction and there's no change in property rights and there's no wherewithal to pay. Another important principle here in income recognition is the return of capital principle. What this says is that the cost of an asset or the tax basis of the asset is excluded when calculating realized and recognized income. So when the capital we invested is returned to us in a transaction, that is we get our basis back, receiving this capital back does not represent any economic benefit. We are in effect just getting our money back. For example, if I buy a public company stock for $50 and then I sell it for $60, how big is my income here? Well, if I sold it for $60, $50 of that is a return of my invested capital and thus it's tax-free. Only the difference between the $60 and $50 is truly income to me. Those $10 represent economic benefits that increase my net worth. The $50 did not increase my economic benefit, I invested $50 and I just got it back. It's like moving money from my right pocket to my left pocket. Those $50 are tax-free and thus would be excluded when figuring my gross income. In addition to excluding basis when calculating income, we can also reduce our income by any fees associated with getting the transaction complete. So for example, if I paid $1 to my broker to sell the stock, then my realized and recognized income is really only $9. That is $60 received in the transaction minus $50 return of capital that's tax-free, minus the $1 broker fee that I had to pay to sell the stock. This should all make sense - if I sell a stock for $60 but paid $50 for it and a dollar to sell it, I shouldn't be taxed on the whole $60. In fact, the tax on the entire $60 might be bigger than any gain I received on the stock's appreciation. So, you can see that this would basically make it entirely cost ineffective to even invest in stocks if the return of capital principal did not apply. Here are a few other income concepts. The first relates to the recovery of amounts previously deducted or the tax benefit rule. What this says is, if you deducted an expense on your tax return any prior year but this year you receive a refund for that expense, that refund is included in your gross income and must be taxed. That is, this year's inclusion of the income will wash out last year's deduction of the same expense. For example, the federal tax rules say the taxpayers can deduct state income taxes paid on their federal tax return if they itemize. So let's say last year I deducted the state income taxes I paid to the state of Illinois. Let's say the deduction was $5,000, which had a 30 percent tax rate reduced my liability, my federal tax liability by $1,500, that is 30 percent of $5,000. However, if after calculating my state tax return which I calculate after my federal return, I find that I overpaid state taxes by a $1,000 and I'll get $1,000 refund for those overpaid state taxes, it means I am actually deducting too much for my federal tax return for state taxes that I'm paying. I'm deducting $5,000, but overall I should only be deducting $4,000. Again, at the time of my filing of the state tax return, I just didn't know that I would have gotten a refund from the State of Illinois. This happens to taxpayers all the time and this is nothing illegal, it's just the timing issue. Therefore, what happens is that the $1,000 refund I get this year for state taxes paid that I deducted last year, must that be included in my current year's federal tax return. This inclusion in gross income basically reverses out the fact that I took too big of a deduction last year. At a 30 percent tax rate my $1,000 too-big-of-a-deduction, means I will have to re-include the $1,000 in income and thus pay $300 more in federal income taxes. So putting the two years together, I've only reduced my federal tax liability by $1,200, or the $1,500 original tax deduction due to the $5,000 deduction, less the $300 in taxes I had to repay because I over deducted by a $1,000. If however, all along I only deducted $4,000 on last year's federal tax return and did not receive any refund, then my federal tax liability using a 30 percent tax rate would be exactly the same. It would be $1,200. So what this tax benefit rule does, is it addresses timing issues related to deductions I took in previous years, for which I'm reimbursed in the current year. It gives me a net number, it's just spread across two years. Note that if the expense and reimbursement happened in the same year, I would only have to report the net amount anyway. So, in all, the timing of the deductions or refunds has no net impact on my federal tax liability. Of course, there are areas for tax planning too. The ideal is for the deduction to occur in a high-tax year and the reimbursement to happen in a low-tax year. For example, perhaps due to retirement or legislation, I know that this year's tax rate is smaller than last year's tax rate. Then the difference in tax rates between the two years is essentially free money. The deduction I took last year, shielded income that would've been taxed at a higher rate compared to the refund I have to report this year and it being taxed. This is perfectly legal, so some tax planning is valuable here. The mirror concept to this tax benefit rule is the claim of rights. Here a taxpayer who reported income received in a prior year can deduct the amount he or she repaid in a subsequent year. Again this nets out the two year's tax effects to the overall the taxpayer is only paying tax on the income that was kept. Finally, income recovery simply says that when an expense item resulted in a partial tax benefit that has a partial deduction or partial reduction in tax liability, any refund or recovery is first considered to be from the benefit received. This just means that the IRS wants to make sure that any refunds you receive for a deducted amount, is reclaimed as income in the following year. In all, at a conceptual level, we need to assume that all income is recognized for tax purposes in the current year unless there's a specific rule excluding or deferring that income. Income doesn't just include cash received and it could include refunds or reimbursements for past deductions. It's important to understand these concepts as we move forward in studying gross income.
