Income Taxes Mini Project

56:054 Engineering Economy

Income Taxes Mini Project

DUE TUESDAY APRIL 7

Updated Sunday, April 03, 2005 06:46 PM

Note - April 3. You can assume that the total mortgage payment for Sue's apartment building is $13,000 and the mortgage payment on her home is $7500.

Objective

The objective is to gain experience in calculating income tax and investigating strategies that include income tax considerations.

This Project contributes 5% of your final grade.

In this project your task is to evaluate the tax consequences of decisions made by an individual. This individual recently graduated (3 years ago) from College of Engineering, University of Iowa, and and now earns $71,000. Your role is to investigate two paths that the individual may have taken on graduation: Path A and Path B. Path A being the simple case while Path B is the more complex.

Deliverables

You will need to:

	Work in teams of 3 (perhaps those used for Project I)
	Produce an income tax statement for each of the two paths.

	Detail how you obtained each figure on the tax return.
	Investigate the effects on wealth of the two strategies.
	Produce a report with max 6 pages single space, 12 point type, 1 in margins with figures. Completed tax forms are in addition to this. The contents of the report should be as shown below. The details of any additional analysis etc can be placed in an appendix.
	Note: ignore state income taxes (i.e. Do not complete state income tax forms) and social security taxes. DO include state income taxes as a deduction in Schedule A.
	Complete Form 1040, and associated schedules, for both cases.
	The details given below deliberately differ a little from the present tax regulations. Therefore, using tax software will give incorrect answers.

Resources

Given the tight time constraints, you will probably need to rely on the web plus using any information you can obtain from the library.

Information:

Forms and instructions available (in pdf format) are available (use forms etc for 2004) from
http://www.irs.gov
Warning: some of these can be relatively long, so be careful pressing that print button!

Content of Report

The report should contain the following sections (remember the page limitations above) (Note assumptions: Assume a single taxpayer with no dependents (i.e. a total of 1 exemption). You need only calculate the total tax for the year i.e. up to and including line 43 on form 1040. Note also that this is an approximate analysis and you will need to make some assumptions):

	Executive Summary - This should be a short (half page) summary of your main findings.
	Include a table of contents but don't count this toward the page limitations above.

	Tax for Path A (half page) -- indicate the major tax consequences and show how you obtained the tax figures. Include the completed tax forms in an Appendix. This will be a simple tax calculation with no IRA and taking the standard deduction (probably). The tax calculated will therefore be relatively large.
	Tax for Path B -- indicate the major tax consequences and show how you obtained the tax figures. Show the tax consequences of each major element. Include the completed tax forms in an Appendix. This will be a more complex tax calculation with the 401(k) amount deducted from wages, a negative income (a loss) for rental real estate from Schedule E, a deduction of $4,000 for a regular IRA (note that this assumes that recent proposed changes have been approved), itemized deductions on Schedule A that include medical deductions, home mortgage, state taxes and charitable contributions. The tax will consequently be less than Path A.
	Disposable Income -- Contrast the TOTAL spendable (disposable) income i.e. how much actual spending money does each path produce compared to each other. You need to subtract income tax, 401(k) & IRA deductions, car loan payments, credit card payments and house mortgage/rent from gross income. Note that the rental apartments produce a zero cash flow. You can ignore property taxes.
	Wealth -- Contrast the two paths in terms of wealth building i.e. particularly how the two paths build (or don't build) wealth. Examine the paths over a 25 year horizon. For Path A, there is zero wealth creation and so this part is simple! For Path B the assumptions are as follows: - Real estate prices (for the apartment and house) increase by 4% each year. - 401(k) and IRA funds are put in a diversified index fund with an expected return of 10% per year. (Don't forget to include the employers contribution to 401(k)!) - Mortgages are paid off by year 25. - For wealth building for Path B, you need only calculate the total future value of the 401(k) / IRA Account, the value of the apartment building and the value of the house (residence). - You can ignore property taxes. To do this part you need to calculate the total wealth (assets) from Plan B in Year 25 (i.e. the future value). You can do this either using equations or using Excel.

Grading

The grade will be allocated on the quality of the report, and the amount of research undertaken. Initiative is appreciated and rewarded. All team members will receive the same grade.

Do NOT use tax software such as TurboTax -- you'll lose the understanding that comes from this exercise if you use this "black box" sort of software and you will obtain incorrect answers, due to the increased IRA deduction allowed above. Your grade will also be adversely affected.

Path A - Incompetent Ivan on The Treadmill

This is the simple case. Note that the details given mix the tax aspects and wealth generation aspects together. Some of the expenses are not tax deductible!

The amounts given are for year 2004. You will need Form 1040, Tax Tables, Schedule A, together with instructions.

The income from wages etc is $71,000 gross with NO contribution to a 401(k) or equivalent.

The annual interest payment on credit cards for 2004 of $2609. (Note: interest on credit card debt is not deductible).

Ivan has purchased a new car with a loan with an interest payment of $4300 per year.

Ivan rents an apartment at $840 per month, has total medical costs (including insurance) of $4500, paid $2760 in state income taxes last year, and contributed $1640 to charity.

Ivan does not want to contribute to an IRA [or a 401(k)]-- "can't afford to" is the reason given.

Path B - Super Susan on The Millionaires Route

This is the more complex case. Note that the details given mix the tax aspects and wealth generation aspects together. Some of the expenses are not tax deductible!

The amounts given are for year 2004.

The income from wages etc is $71,000 gross but $5,000 is contributed to a 401(k) with 100% matching from the employer. The wages received for taxes are therefore $66,000.

$147 is received as taxable interest.

Susan has purchased a four year old car for cash.

Susan owns a rental apartment building with 4 apartments. The amount of rent received is $20,000. The expenses (excluding interest) total $7,000, the mortgage interest on the apartment building totals $13,000. The apartment building cost (including land) $375,000 when purchased (placed in service 1/1/2001), the land is valued at $100,000. Assume that the amount is "at risk", the person "actively manages" the apartments and that any loss is deductible (don't bother completing form 6198, 4562 or 8582). Don't forget to include depreciation, but only depreciate the building not the land! (note: IRS regulations are that rental real estate MUST be depreciated using the Straight Line method over 27.5 years. The amount of depreciation is therefore 3.636% per year after the first year). IRS Information on rental real estate (Pub 527) contains more (more than you need to know) information on Rental Real Estate. Don't bother depreciating furniture etc.

Susan pays $7500 in mortgage interest on their own home (which is valued at $250,000), has total medical costs (including insurance) of $4500, paid $1760 in state income taxes last year, and contributed $1640 to charity.

You can assume that the total mortgage payment for Sue's apartment building is $13,000 and the total mortgage payment on her home is $7500.

Susan contributes $4,000 to a regular IRA (non-Roth) (this is above the current limit but assume that the proposed change to allow this has been approved).

Note that the calculation of allowable deductions is a complex activity and this project is intended to give an overview of the process. Actual allowable deductions etc. may differ from the guidelines given in this project.

[ Professor O'Grady ]