Federal Income Taxation of Individuals
Unless a question says otherwise, all taxpayers are cash-method, calendar-year individuals, and all dollar figures use the 2026 inflation-adjusted amounts of Rev. Proc. 2025-32, 2025-45 I.R.B. Work each answer fully before revealing the model answer, then grade yourself honestly — the tracker keeps score.
During 2026, Dana (a) finds $4,000 in cash inside a used desk she bought at an estate sale for $150; (b) borrows $20,000 from a bank; (c) has her $3,500 state income tax bill paid directly by her employer as a "thank you"; (d) paints her own house, saving the $6,000 a painter would have charged; and (e) receives a $1,000 refundable security deposit from a tenant.
For each item, is there gross income to Dana, and why?
(a) Yes — $4,000. Found property is an undeniable accession to wealth, clearly realized, over which Dana has complete dominion (Glenshaw Glass); treasure trove is income when reduced to undisputed possession (Cesarini; Reg. § 1.61-14). Her $150 cost is basis in the desk, not the cash.
(b) No. Loan proceeds are offset by the obligation to repay — no accession to wealth.
(c) Yes — $3,500. Discharge of the taxpayer's obligation by a third party is income (Old Colony Trust); from an employer it is compensation, not a § 102 gift (§ 102(c)).
(d) No. Imputed income from self-performed services is systematically excluded — administrability, not statute.
(e) No, if a true security deposit. Funds held subject to an obligation to return are not income (Indianapolis Power); prepaid rent, by contrast, would be income on receipt.
Marta, a retiring church organist of 30 years, receives $15,000 collected from congregants "in appreciation of her faithful service." The same month, a wholesale customer to whom Marta's brother Gus had freely passed business leads gives Gus a new car (FMV $45,000), telling him "you didn't ask for it, but the leads made us money." Gus's employer separately hands him a $500 "holiday gift" check.
Analyze the gross-income consequences of each transfer.
Framework. § 102 excludes gifts; a gift proceeds from "detached and disinterested generosity … out of affection, respect, admiration, charity or like impulses," judged by the transferor's dominant intent as a question of fact (Duberstein).
Marta: likely excludable. Payments from congregants to a retiring minister-type figure, unbargained-for and motivated by affection and gratitude rather than obligation, resemble Stanton; the past-services setting cuts the other way, so argue both sides — but detached generosity plausibly dominates where there is no expectation of future service.
Gus's car: taxable, ~$45,000. On near-identical facts Duberstein held the transfer was a recompense for past economic benefit — an inducement/reward, not generosity — despite the "you didn't ask" framing.
Employer check: taxable. § 102(c) categorically bars employer-to-employee "gifts"; $500 cash can never be a de minimis fringe (cash is always includible; Reg. § 1.132-6(c)).
A jury awards Priya, injured by a delivery truck: $200,000 for her broken back and medical costs; $60,000 for emotional distress flowing from the physical injuries; $150,000 in punitive damages; and $40,000 of lost wages attributable to the injury. Her employer's disability policy (premiums she paid with after-tax dollars) separately pays her $25,000.
How much is excluded from gross income?
Excluded: $325,000; included: $150,000. The § 104(a)(2) test is "on account of personal physical injuries": compensatory streams tracing to the physical injury (including consequential wage loss and derivative emotional distress) are excluded; punitive damages are not compensation "on account of" injury (O'Gilvie). Freestanding emotional-distress recoveries (no physical injury) would be taxable beyond medical costs.
Rocco owes Lender $180,000 (recourse, unsecured). In settlement, Lender accepts $110,000 cash and forgives the rest. Immediately before the discharge Rocco's assets total $300,000 and his liabilities (including this debt) total $345,000. Rocco has a $12,000 NOL carryover.
Compute Rocco's gross income from the discharge and describe the collateral consequences.
$25,000 of gross income. The insolvency exclusion is capped at the amount by which liabilities exceed assets immediately before discharge. The price of exclusion is attribute reduction under § 108(b): the excluded $45,000 first wipes out the $12,000 NOL, then reduces other attributes (credits, capital-loss carryovers, basis) in statutory order — deferral, not forgiveness.
Sole proprietor Lena, who runs a bakery, spends in 2026: (a) $9,000 replacing the shop's broken front window with like-kind glass; (b) $85,000 adding a second oven room that doubles capacity; (c) $30,000 in legal fees defending her divorce, in which her ex-spouse claims half the bakery; (d) $2,400 on distinctive logo-embroidered chef's uniforms she also finds comfortable off-duty; and (e) a $5,000 fine for a health-code violation.
Deductible, capitalized, or disallowed — and under what authority?
(a) Deduct. An incidental repair keeping property in ordinary operating condition (Midland Empire; Reg. § 1.162-4) — restores, does not better or adapt.
(b) Capitalize. A betterment/enlargement with benefits beyond the year (§ 263; INDOPCO); recover through depreciation (§ 168).
(c) Nondeductible personal expense. Origin-of-the-claim test: the claim arises from the marital relationship, not the business, even though the business is at stake (Gilmore; § 262).
(d) Deduct — but only because the uniforms fail the objective suitability test? Careful: clothing is deductible only if required for work, not suitable for general wear (objectively), and not so worn (Pevsner). Logo-embroidered chef's uniforms are objectively unsuitable street wear → deductible; that Lena finds them comfortable is irrelevant under the objective test.
(e) Disallowed. Fines paid to a government for violation of law are nondeductible (§ 162(f)) — the public-policy limit Congress codified; contrast Tellier (defense costs of a business crime deductible).
Grandpa bought Blackacre for $100,000. When it was worth $70,000 he gave it to Ana. Separately, Grandpa's will leaves Whiteacre (his basis $40,000; date-of-death value $500,000) to Ben.
(i) Compute Ana's gain or loss if she later sells Blackacre for $110,000; for $60,000; for $85,000. (ii) Compute Ben's gain if he sells Whiteacre for $510,000 a month after death. (iii) One sentence: what planning rule do these two answers teach?
(iii) Hold loss property or sell it yourself; give appreciated property by bequest, not lifetime gift. § 1015 kills built-in losses transferred by gift ($30,000 of Grandpa's loss simply vanished), while § 1014 forgives built-in gain at death ($460,000 of appreciation permanently escapes income tax) — the lock-in effect.
Vera buys an apartment building for $1,000,000: $150,000 cash plus an $850,000 nonrecourse mortgage. Over the years she properly deducts $400,000 of depreciation and pays the loan down to $800,000. With the building now worth only $650,000, she deeds it to the lender in full satisfaction of the debt.
Compute Vera's gain or loss and state its rationale. Would the analysis change if the debt were recourse and the lender forgave the shortfall?
$200,000 gain. Symmetry is the rationale: the borrowed $850,000 went into basis untaxed on the Crane assumption it would be repaid; on disposition the relief of that obligation must be an amount realized, without regard to FMV (Tufts).
Recourse variation: bifurcate. Deemed sale at FMV: $650,000 − $600,000 = $50,000 § 1001 gain; the forgiven shortfall $800,000 − $650,000 = $150,000 is COD income (§ 61(a)(11)) — potentially excludable under § 108 (insolvency), which the § 1001 gain is not.
Sam, unmarried, has 2026 wages of $70,000 and no above-the-line deductions; he does not itemize. In June he sells his principal residence (owned and lived in for six years) for $560,000; he bought it for $285,000 and added a $25,000 deck.
Compute Sam's 2026 federal income tax. Use the actual 2026 amounts: standard deduction $16,100 (single); single brackets 10% to $12,400, 12% to $50,400 ($1,240 base), 22% to $105,700 ($5,800 base); LTCG 0% breakpoint $49,450, 15% breakpoint $545,500.
Tax: $6,570. The trap is doing capital-gain stacking at all: the entire $250,000 residence gain is absorbed by § 121, so nothing reaches § 1(h). Had the gain been $300,000, the excess $50,000 would be LTCG stacked on top of $53,900 of ordinary income — filling $49,450 − $53,900 < 0 … i.e., ordinary income already exceeds the $49,450 zero-rate ceiling, so all $50,000 would be taxed at 15% ($7,500 more).
Marginal rate 22%; effective ≈ $6,570 ⁄ $70,000 ≈ 9.4% of AGI.
In 2026 Theo (salary $150,000) sells: 100 publicly traded shares held 3 years at a $14,000 loss; a machine used 4 years in his side business (cost $50,000, depreciation taken $30,000) for $35,000; and one of the 22 lots he subdivided, improved, advertised, and sells to buyers each year, at a $9,000 gain.
Determine the character of each item and Theo's net capital-gain/loss position, including any carryover.
The exam points: recapture converts what looks like § 1231 gain back to ordinary before any netting; dealer property never enters the capital regime; and the $3,000 wall makes character determinations enormously valuable.
Ida, cash method, is a consultant. (a) On December 28, 2026, a client hands her a $30,000 check; she deliberately waits until January 2 to deposit it. (b) Her December invoice offers clients the option to pay in December or January; one client asks where to send $20,000 in December and Ida says "please hold it until January." (c) In 2026 she also receives a $50,000 bonus under a disputed formula; in 2028 a court makes her repay $50,000, when her marginal rate is much lower than in 2026.
When is each amount income, and what relief applies to (c)?
(a) 2026. A check received is income when received (cash equivalence); voluntary non-deposit does not defer.
(b) 2027 — probably. Constructive receipt taxes amounts credited or set apart that the taxpayer may draw without substantial limitation. A bona fide arm's-length deferral arranged before the amount is due/payable generally works; if the money was unconditionally available in December and she merely turned it away, the doctrine reaches it in 2026. Facts matter — argue both.
(c) 2026 income; 2028 relief. Claim of right: received without restriction under a claim of right → income in 2026 despite the dispute (North American Oil); the repayment is a 2028 deduction, not a reopening of 2026 (Lewis; annual accounting, Sanford & Brooks). Because the repayment exceeds $3,000, § 1341 lets Ida take the better of (i) deducting $50,000 in 2028 or (ii) reducing 2028 tax by the 2026 tax the $50,000 generated — curing the rate mismatch.
Dr. Okafor (37% bracket) tries three moves: (a) she contracts with the hospital that half her salary be paid directly to her 20-year-old son; (b) she detaches the next two years of interest coupons from her bonds and gives the coupons to him; (c) she deeds him a rental duplex outright, and he collects the rents thereafter.
Who is taxed on each stream, and why?
(a) Dr. Okafor. Earned income is taxed to the earner; an anticipatory contract cannot attribute the fruit to a different tree (Lucas v. Earl).
(b) Dr. Okafor. Income from property is taxed to the owner of the underlying property; carving off ripening income (coupons) while keeping the tree assigns income, not property (Horst — enjoyment through the power to dispose).
(c) The son. Transferring the entire income-producing property shifts its future income (Blair). Two statutory backstops to flag: if the son were under the § 1(g) age cutoffs, the kiddie tax would tax his unearned income at his parent's rates anyway; and any below-market "loan" version of the plan would trigger § 7872 imputation.
Farmer Gene sells unimproved farmland (basis $120,000) to an unrelated buyer for $400,000: $80,000 down in 2026 and $80,000 in each of the next four years. His lawyer also pitches a "costless" plan: momentarily contribute the land to a shell entity, have the shell "exchange" it for marketable securities, and liquidate — "§ 1031, no gain."
(i) Compute Gene's 2026 gain under § 453 and his total gain over the term. (ii) Evaluate the lawyer's plan.
(ii) The plan fails several ways. Post-TCJA § 1031 covers only real property held for productive use or investment — marketable securities cannot be like-kind replacement property at all. Even in a world where the mechanics fit, a transitory shell with no business purpose is disregarded (Gregory v. Helvering); the steps collapse under the step-transaction doctrine; and § 7701(o) requires a meaningful non-tax change in economic position plus a substantial non-tax purpose, on pain of a strict-liability accuracy penalty (§ 6662(b)(6)). Planning within § 453 is respected; this is form without substance.