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Individual Income Taxes Rules [and Codes] Summarized



Most individuals find taxes [particularly income tax] to be tedious. First, everyone faces the chore of gathering various complicated-looking documents to complete the annual ritual of filling out IRS Form 1040 and whatever form your state may require.

Perhaps you need to figure out how to submit a quarterly tax payment when you no longer work for a company and now receive self-employment income from independent contract work. Maybe you sold some investments (such as stocks, mutual funds, or real estate) at a profit (or loss), and you must calculate how much tax you owe (or loss you can write off). You’ll pay more in taxes than you need to if you don’t understand the tax system.


Unfortunately, when you try to read and make sense of the tax laws, you quickly realize that you’re more likely to win the lottery than figure out some parts of the tax code! That’s one of the reasons that tax attorneys and accountants are paid so much — to compensate them for their intense and prolonged agony of deciphering the tax code.

Learning and understanding individual income tax rules, there are at least 5 areas to cover: [1] incomes, [2] exchanges, [3] deductions and itemized deductions, [5] tax credit. That is a huge set learning curve. Just “Individual Income Tax” rules [codes] alone can create a 100 pages book. But I tried to summarize and present them into a single post, as you can find it here.  Although it is still a chubby post, it should be handy enough compare to a tax text book. Enjoy!


Completing Individual Income Tax Form [Form 1040]

An individual completes Form 1040 in filing federal income taxes in the following sequences:

  • Various sources of income are reported first. Usually any amounts that are earned must be reported: salary, dividends, capital gains and losses, rents, interest, sole proprietorship gains and losses, partnership gains and losses, etc.
  • Specifically allowed adjustments to income are subtracted. These include (under certain conditions) individual retirement account (IRA) payments, retirement account payments by self-employed individuals, alimony payments, moving expenses, a portion of payments made for self-employment taxes, a portion of payments made by self-employed individuals for medical insurance, etc.
    Net figure is adjusted gross income (AGI).
  • Next, the larger of taxpayer’s itemized deductions or standard deduction should be subtracted.
  • The standard deduction is based on the taxpayer’s filing status but will increase each year with inflation. Because of the annual change, extensive questions about specific amounts are not likely.  Elderly and blind taxpayers receive an increased standard deduction. Itemized deductions include certain payments for medical services, taxes, interest, charitable contributions, and miscellaneous items as well as casualty and theft losses.  If AGI is high, the amount of a taxpayer’s itemized deductions that can be subtracted is reduced.
  • A subtraction is then made for the taxpayer’s personal exemptions.  This amount will also change with inflation over the years. Taxpayer is entitled to one personal exemption and, on a joint return, a second is received for spouse. An extra exemption is received for each dependent. If AGI is high, a taxpayer’s deduction for personal exemptions is reduced. No personal exemption is allowed if taxpayer is claimed as a dependent on another person’s tax return. In that situation, the standard deduction may also be limited.
  • Remaining figure is taxable income on which tax is computed. The rate depends on filing status. Joint status and qualifying widow/widower have lowest rates. Head of household requires use of next lowest rates with highest rates applied to single taxpayers.
  • After an income tax figure is computed, any tax credits should be subtracted. Common credits include the child care credit, earned income credit, child tax credit, Hope scholarship credit, adoption expense credit, etc.
  • Any extra taxes (such as self-employment tax or alternative minimum tax) are added to give final tax figure for taxpayer.
  • Any income tax withholding, estimated tax payments, and the like are subtracted to get amount due or refund claimed.


Filing status is determined by taxpayer’s status at year’s end (or date of death if taxpayer died during current year). A joint return is normal if taxpayer is married although separate returns are allowed. A single, divorced, or legally separated individual will usually fine as single. Qualifying widow or widower with dependent child is allowed to use same rates and standard deduction as a joint return. Status is permitted for the two years following the year of spouse’s death. Must have dependent child living in home. It can be child, stepchild, adopted child, or foster child. Joint return is normally filed in year of death.

To qualify as head of household, taxpayer must be unmarried or legally separated.  Must maintain an unmarried child or any dependent relative in home. If dependent relative is a parent, that person does not have to live in taxpayer’s home. Parent can live, for example, in a rest home, hospital, or own home.


For person [individual] to qualify as a dependent of another, five rules must be met:

  • Rule-1. The person’s gross income (not counting nontaxable income) must be below the amount of a personal exemption. This rule does not apply if person is taxpayer’s child who is either (1) under nineteen or (2) under twenty-four and a full-time student for at least five months during the year.
  • Rule-2.  Taxpayer must provide over one-half of person’s support during the year.
  • Rule-3.  If potential dependent is married, that person cannot file a joint return.
  • Rule-4.  Person must be US citizen or person must reside  in US, Canada, or Mexico.
  • Rule-5.  Must be a blood relative (includes aunts, uncles, nephews, and nieces but not cousins) or a member of taxpayer’s household for entire year.


Statute of limitations (time limit for correction of mistakes on a tax return by the government or by the taxpayer) is normally three years from the due date of return. If an extension is received, it is three years from the date of filing.  The period is extended to six years if income was omitted from the return equal or greater than 25% of reported gross income. For tax fraud cases, no statute of limitations exists.

If not enough income tax is paid through withholding, the taxpayer must make estimated tax payments. To encourage adequate payment, a penalty is incurred unless taxpayer pays at least 90% of the taxes for the current year or 100% of the prior year’s taxes. Taxpayers with high AGI who base estimated payments on prior year’s taxes must pay slightly more than 100%.

Anyone who prepares a tax return for compensation is a tax preparer and has certain responsibilities:

  • Can recommend or agree with positions that are realistically possible.  To meet this criterion, position must have at least a 1/3 likelihood of being sustained if challenged.  Preparer can be penalized for using information where there was no realistic possibility of success.  Penalty is increased if preparer was making a willful attempt to understate taxes.
  • Can rely on client information without verification unless it appears incorrect, incomplete, or inconsistent.
  • Can use estimates if real numbers are not available.

After IRS conducts an audit (assuming no agreement is reached), taxpayer receives a thirty day letter outlining deficiencies.  Taxpayer can accept, appeal to appellate level of IRS, or do nothing. If nothing is done (or if appeal does not lead to agreement), another letter is sent giving the taxpayer ninety days to file a petition with the tax court. If petition is not filed, amount must be paid in ten days or IRS can begin legal action to force payment.


Income On the Individual Income Tax

Virtually any income that a taxpayer strives to get is taxable: wages, interest, dividends, alimony, state income tax refunds (if tax payments were taken previously as an itemized deduction), partnership and sole proprietor income, rental income, prizes, capital gains and losses, unemployment benefits, reimbursed moving expenses, reimbursed business expenses (if no accounting is required by employer), etc.

  • Some income is specifically nontaxable income: welfare benefits, gifts, inheritances, child support, life insurance proceeds, compensation for injuries, etc. Gifts and inheritances may be taxed but that is not an income tax. Social security benefits are tax free if AGI plus tax-exempt income plus 1/2 of social security benefits are less than $32,000 (on a joint return) but 85% is taxable if this total is over $44,000 and 50% is taxable in between.
  • Payments or other compensation from employer are usually considered taxable as a salary. If payment is not cash, taxable income is fair value at date of transfer. If employer pays for group-term life insurance on employee, the cost of the first $50,000 in coverage is a tax-free fringe benefit. The cost paid by the employer for any coverage over that amount is taxable income to the employee.
  • Dividends and interest revenue received by taxpayer are listed on Schedule B of the tax re-turn. Most such inflows are fully taxed. Dividends on life insurance policies are not taxed.  Stock dividends are usually not taxable unless cash could have been received instead. State and city bond interest is nontaxable although interest on US (federal) bonds is taxable.  Interest on Series EE US Savings Bonds may be tax exempt. To qualify, bonds must be bought by and belong to taxpayer (who was over twenty-four when acquired) and be used to pay college costs for taxpayer, spouse, or dependent. Tax-free exclusion is limited or lost if taxpayer’s AGI is high.
  • Revenues and expenses from rental activities are reported on Schedule E. Revenues minus expenses gives income or loss to be reported. All ordinary and necessary expenses such as repairs, depreciation, insurance, etc. are allowed.
  • A passive activity is a business in which the taxpayer/owner does not materially participate. Rental activities and limited partnerships are also included in this category regardless of the owner’s participation.  All gains and losses for passive activities are netted together. If a net gain results, it is taxable income. If a net loss results, it is not deductible. Net passive losses can be carried over indefinitely to reduce future passive gains. If taxpayer is actively involved, losses from rental activities of up to $25,000 can still be deducted. This deduction is phased out if taxpayer’s AGI is high.
  • Under a cash accounting system, revenues and expenses are taxable when cash or any other asset is actually conveyed.  However, the creation of a receivable or payable does not affect income.  According to an accrual accounting system, a revenue is recognized when the right to receive payment has occurred and an expense is recognized when an obligation to pay has been incurred.
  • Life insurance proceeds received at death are not taxable. However, if payments are spread over a period of time, any extra amount received each year is taxable interest. Prizes and awards are taxable even if taxpayer made no attempt to win.
  • Scholarships are nontaxable but only if used to cover tuition and course related costs such as books and supplies. Any other amounts must be reported as taxable income. If student has to work to earn the money (such as teach a class), it is taxable. If student is not a degree candidate, the money is taxable.
  • Alimony is taxable to recipient although child support is not taxable. If alimony and child support are both received during the year, the child support is assumed to be received first. Alimony is only taxable after a legal separation or divorce. Payments must be cash and must terminate at death. Payments must be to or for benefit of spouse. Lump-sum property settlements are not taxable.


If taxpayer owns a sole proprietorship, all revenues and expenses are reported on Schedule C which is basically an income statement for the business.  The taxpayer can deduct all expenses that were ordinary and necessary. Proprietorship income is taxable while losses are deductible. Business-related taxes and interest that do not qualify as itemized deductions can be deducted here if ordinary and necessary. However, charitable contributions are always itemized deductions. A loss may be so large that it cannot be deducted entirely in the current year. The resulting net operating loss can be carried back to reduce taxable income in the two prior years and, if a loss still results, the remainder can be carried forward to reduce taxable income for the subsequent twenty years.


Exchanges On the Individual Income Tax

Gains and losses resulting from capital asset transactions are reported on Schedule D of the Form 1040. Capital assets include investment property such as land, shares of stock, and bonds. Personal properties such as furniture are also capital assets but only gains are reported for these assets, losses are not deductible.

  • Gains and losses are classified as short-term (held twelve months or less) or long-term. All gains and losses are netted to arrive at a single short-term taxable figure and a single long-term taxable figure. If one of these is a net gain and the other is a net loss, a further netting is made to arrive at one taxable figure. A net short-term gain is taxed at ordinary income rates whereas a net long-term gain is usually taxed at a maximum rate of 20%. For low income taxpayers, a net long-term gain is taxed at a maximum rate of 10%.
  • If capital gains and losses are netted and a net loss results, it is deductible up to $3,000 per year.  Any remaining loss is carried over indefinitely and included on future tax returns. Some distributions from mutual funds represent capital gains. Non-business bad debts are treated as short-term capital losses.
  • If a taxpayer trades business or investment property, a taxable gain may result. The trade of certain types of like-kind property (land for land, for example) is normally not taxable. New item is recorded at basis of old property. Like-kind means same class of property.
  • If like-kind property is exchanged and boot (property that is not like-kind, usually cash) is received, a taxable gain may be recognized. Taxpayer must recognize gain as the lesser of the boot received or the gain realized on the exchange. Realized gain is the difference in basis of property given up and the fair market value of the amounts received. If buyer assumes debt of seller, that is boot to the seller. If property is exchanged that is not like-kind, realized gain must be recognized for tax purposes.
  • Receipt of inherited property is tax-free for income tax purposes but basis must be determined if property is ever sold by the recipient. Normally, basis is the fair market value of the property at date of decedent’s death. An alternative date must be used if it is selected by the executor of the estate.  In that case, basis is value six months after death (or at date of conveyance if earlier than six months).
  • Taxpayer can lose property by involuntary conversion. Property can be condemned, destroyed, or stolen. If amount received from insurance or government is below tax basis, loss is immediately recognized. It is a capital loss if investment property was involved; it is an itemized deduction if personal property.
  • If payment is above basis, a gain has been earned but part (or all) of the gain may be excluded from taxable income. If taxpayer acquires similar replacement property, the amount to be taxed is the lesser of (1) the realized gain and (2) any proceeds left over after replacement. If no part of the proceeds is left, gain is not taxable.
  • In sales made to related parties, gains are taxable but losses are not deductible. Related parties are members of taxpayer’s family. Also, corporations and partnerships are related parties to a taxpayer who owns over 50%. If a loss is not deductible, it can be used to decrease any later gain on eventual sale of the property to an unrelated party.  The loss can reduce a subsequent gain but cannot create a loss even when property is sold to an outsider.
  • If a personal residence is sold, a gain of up to $500,000 (joint) or $250,000 (single) can be excluded. Exclusion can only be taken once every two years. To qualify, property must have been taxpayer’s principal residence for at least two out of the previous five years.
  • When a gift is received, it has no effect on taxable income. However, if the gift is ever sold, a gain or loss may result.
  • To compute a taxable gain, sales price is compared with the basis of the property to the previous owner. To compute a taxable loss, sales price is compared with the lower of (1) the previous owner’s basis and (2) the fair market value of the property at the date of gift. If gain computation arrives at a loss and loss computation gives a gain, no tax effect results from the sale. This situation occurs when property’s value  (1) drops between date of original purchase and the date of the gift,  (2) then rises after gift is made, and (3) is still below previous owner’s basis.


Deductions For Adjusted Gross Income (AGI)

A number of specific items can be deducted in arriving at adjusted gross income (AGI). These items are allowed whether the taxpayer report itemized deductions or takes the standard deduction.

  • Alimony is deductible by the payer if it is taxable to the recipient as discussed previously in the rules about income.  In some cases, the early withdrawal of money from a savings or investment account leads to a penalty. All income earned is taxable but the penalty is deductible in arriving at AGI.
  • If a self-employed individual pays self-employment tax, half of the payment is reported as a deduction to arrive at AGI. Deduction is allowed in same year as the income which is taxed. If a self-employed individual pays medical insurance for self, spouse, and/or dependents, 100% is a deduction for AGI.
  • A deduction for AGI is allowed for interest on qualified education loan, a loan that is used to pay for the cost of tuition, fees, room, and board to attend post-secondary institution or certain vocational and other programs (at least on a half-time basis).  Education expenses must have been for taxpayer, spouse, or taxpayer’s dependent. Deduction is only for interest paid during the first sixty months that interest payments are required. Maximum deduction is $2,500 for 2003. Deduction is phased out as taxpayer’s income gets high.
  • Deductible (Traditional) Individual Retirement Account (IRA). Up to $3,000 (or the amount of compensation, if less) that is put into a deductible IRA is a deduction for AGI in that year.  The same amount is available to spouse as long as total compensation is at least $6,000. Alimony is viewed as compensation for this computation. If taxpayer is not an active participant in an employer sponsored retirement plan, the deduction can be taken each year. If taxpayer is an active participant in an employer sponsored retirement plan, the ability to take the deduction is phased out at relatively low AGI levels.  On a joint return, if only one party is an active participant in an employer-sponsored retirement plan, the other party can still take deduction unless AGI is very high.
  • Any money taken out of a deductible IRA is taxable income. Tax is also increased by 10% if any money is taken out before taxpayer is fifty-nine and one-half years old. There is no 10% penalty on any early withdrawal if money is used to pay qualified costs of higher education or to cover the cost of a first-time home purchase.  For a home purchase, only $10,000 can be removed without the penalty. No deduction is allowed for payments to Education IRAs. Nondeductible payments of up to $500 per beneficiary can be made in each tax year until beneficiary becomes eighteen.  There can be any number of beneficiaries and no relationship is required. Each beneficiary is only entitled to $500 per year no matter how many people want to create these IRAs. Distributions from the plan are tax free up to the amount of costs paid for post secondary education including tuition, fees, and some room and board costs. In any year that the taxpayer takes either the Hope tax credit or the lifetime learning credit for a particular student, a withdrawal from an education IRA is not tax free. There is a phase-out for education IRAs but it is relatively high.
  • No deduction is allowed for payments to Roth IRAs. A nondeductible amount of up to $3,000 per year (less any amount put into a deductible IRA) can be put into a Roth IRA. After the Roth IRA is five years old, all distributions are tax free as long as the person is fifty-nine and one-half or uses the money for a first-time home purchase (up to $10,000). There is a phase-out for Roth IRAs but the AGI has to be relatively high before the benefit is disallowed.
  • A self-employed taxpayer can deduct amounts placed in retirement plans; these plans are sometimes called Keogh Plans or H.R.-10 Plans. Taxpayer must generate income from either a partnership or proprietorship. Amount contributed to plan can be deducted up to a maximum that is the equivalent of 20% of self-employment income (less the deduction that is allowed for self-employment tax payments).
  • Moving expenses can be deducted if the move was employment related such as a transfer or moving to a new job. New job must be fifty miles farther from old residence than previous job was. Taxpayer can deduct the cost of physically moving goods and transporting people.



Itemized Deductions On Individual Income Tax

Itemized deductions are reported on Schedule A of the 1040 form.  Taxpayers use the itemized deduction total to reduce taxable income if it is larger than the standard deduction. The total amount of itemized deductions must be reduced, though, if the taxpayer’s AGI is high.

Medical expenses are included if paid for taxpayers, their dependents, and anyone who would have been a dependent except for the income test. All expenses made to maintain or improve health can be taken: doctors’ fees, dental costs, x-rays, medical insurance, crutches, eyeglasses, etc. Prescription drugs and insulin are also included. Capital expenditures made to home for medical reasons can be included for any amount in excess of the increase in the property’s fair market value. Some items are not allowed: cosmetic surgery, over-the-counter medicines, and any costs covered by insurance. The actual deduction is the cost that is in excess of 7.5% of AGI.

The payment of certain taxes can be deducted:

  • State and local income taxes paid during the year are deductible but not the amount paid for federal income taxes. If deduction is taken in year of payment but a refund is later received, refund is tax-able income in later year.
  • Real estate taxes are deductible even if paid to foreign country. Taxpayer must own property to get deduction. If property is owned for just part of a year, only that portion is included. Personal property taxes are deductible if based on value of property.
  • Interest expense is an itemized deduction in certain cases. Interest paid on debts for both principal and second residence is deductible. Interest on acquisition indebtedness of up to $1 million is deductible. Money has to be used to buy, build, or improve house. Interest on home equity indebtedness of up to $100,000 is deductible. Money can be used for any purpose. No interest deduction is allowed on debt in excess of the value of the residence.
  • For interest to be deductible, debt must be that of the taxpayer.  Payment of points is deductible if amount was actually paid, was used to get money to buy, build, or improve home, was normal for that area, and was a normal amount. No deduction is allowed for personal interest such as that paid on credit cards, car loans, etc. Interest expense to buy investments can be deducted but expense in excess of net-investment income is not deductible and must be carried forward. Net investment income includes interest, dividends, rents, and net gains on the sale of investments.
  • Contributions to qualifying domestic charitable organizations is deductible. Payment must be made and not just a pledge. Credit card charges are deductible.  Dues and purchases are deductible if they exceed value of benefits received. Services provided to a charity are not deductible although out-of-pocket costs relating to those services are deductible.
  • Property given to charity is deductible. For inventory or short-term capital assets, deduction is lesser of fair market value or basis (probably cost). For long-term capital assets, deduction is fair market value. The taxpayer does not have to report a gain if the property has appreciated in value.
  • There are several limitations to the amount of charitable contributions that can be deducted in one year. Any amount that cannot be deducted is carried forward for up to five years.  Computation is usually as follows. First, the amount to be included for the donation of long-term capital asset property is determined but only up to 30% of AGI in any year.  Second, allowed deduction for long-term capital asset property is added to all other charitable contributions. This amount gives total deduction but it cannot exceed 50% of AGI.
  • Casualty and theft losses of property are deductible. A casualty is a loss created by a sudden, unexpected, or unusual event.  Examples would include a fire, storm, or accident. Loss is measured as lesser of (1) reduction in value of property and (2) the basis of the property. Loss is reduced by any insurance payment. Loss from each separate incident is further reduced by $100; all losses are then combined and decreased by 10% of AGI to get the amount of the itemized deduction.
  • Several items are reported as miscellaneous itemized deductions.  Other expenses are deductible but only for the total amount over 2% of AGI. These items relate to taxpayer’s job or to income production or protection: unreimbursed job related expenses, union dues, safe deposit box rent, tax preparation fees, professional publications, dues in professional societies, small tools and supplies and the like.  The cost of education is included but only if it is incurred to maintain or improve job skills and the education will not qualify person for new job or position.


Individual Income Tax Credits

A tax credit is a direct decrease in an individual’s income tax rather than a reduction in the amount of taxable income.  There are numerous tax credits available.  A credit is allowed for payments for child or dependent care expenses. Credit is taken for payments made to someone to care for a dependent so that taxpayer can be gainfully employed.  Payments have to be for the care of the individual. To qualify, dependents must be under thirteen or unable to care for themselves.

  • Credit is determined by taking a percentage of the amount paid. In determining credit, taxpayer uses payment for the year but not over $3,000 for one dependent or $6,000 for more than one dependent. Percentage is based on taxpayer’s AGI. There are many possible percentages. If AGI is under $15,000, use 35% (the highest rate); if AGI is over $45,000, use 20% (the lowest rate).
  • An earned income credit is allowed for taxpayers with a relatively low amount of earned in-come (usually a salary) who maintain a household for a qualifying child. This credit is one that can create a refund from the government if the credit is larger than the amount of the taxpayer’s income tax. A reduced earned income credit is available even if taxpayer does not have a qualifying child living in the household.
  • US taxpayers include foreign income on their US tax return but can take a credit for taxes paid to foreign countries.   A credit of up to $10,160 (for 2003) is given for qualifying adoption expenses. The credit is reduced and eventually eliminated for taxpayers with a high AGI.
  • The child tax credit is available for if taxpayer has qualifying children under seventeen. Taxpayers get a credit for each dependent who is their child, stepchild, foster-child, or grandchild. Credit phases out at high adjusted gross income levels.  As the number of children increases, the higher the AGI can be before the taxpayer starts to lose the credit. Low income individuals may be entitled to an additional refundable credit.
  • Cost of post-secondary education can lead to the Hope scholarship credit. Taxpayer gets a credit for the costs of first two years of post-secondary education if paid on behalf of taxpayer, spouse, or dependent.  Costs include tuition and related expenses but not room, board, or books. In each tax year, the credit is 100% of the first $1,000 and 50% of the next $1,000.


Costs of education can also entitle taxpayer to lifetime learning credit. Credit is 20% of qualified tuition and fees up to a maximum credit of $2,000 per return.  It must be paid on behalf of taxpayer, spouse, or dependent.  It can be claimed for an unlimited number of years. Qualified cost is the amount paid for any undergraduate or graduate program as long as person is at least half-time student.  Also qualifies (whether half-time or not) if education is to acquire or improve job skills.  A student’s costs can lead to the Hope tax credit or the lifetime learning credit each year but not both.  If costs are for two or more students, one credit can be taken for some and the other credit for the rest.  Ability to take either the Hope tax credit or the lifetime learning credit is lost (phased out) as income gets high.

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