Welcome back. So far we've looked at items that are includable gross income. In this video, we'll begin looking at items that are excludable from gross income, or exclusions income that's not subject to tax. Recall the Section 61 of the Internal Revenue Code states that, except as otherwise stated, gross income means all income from whatever source derived. That is, taxpayers should assume everything is income and thus must report that income on the tax return as such, unless congress has said that the item is not income. Exclusions fall into this as otherwise stated portion of Section 61. Exclusions appearing codes Sections 101-150, as well as are scattered around the Code. Exclusions are modified to reflect new court decisions and to respond to specific events. For example, in the previous set of videos, we learned that during the Great Recession, congress allowed individuals to exclude the first $2,400 of their unemployment compensation from income. Therefore, this $2,400 was an exclusion that responded to economic hardships. In this video, we'll look at various exclusion items including municipal bond interest income, gifts received, and life insurance proceeds. Let's start with municipal bond interest income. First, let's define it. Municipal bond interest income is interest earned on state, county, and municipal, or other local bonds. For example, the city of Chicago might issue bonds in order to pay for new schools or roads. What happens when an individual receives the interest payments from the city of Chicago bonds? Well, the interest on these local bonds is excludable from federal gross income. Note that the interests is excludable, but might be includable on one's state tax return, because the municipal bond interest income is excluded from gross income, then any expenses incurred in earning that income is not deductible. For example, if you pay a fee to an investment adviser to manage your portfolio of the municipal bonds then the fees charged by the advisor are not deductible. This is an example of symmetric tax treatment because the interest is already tax-free, congress will not also allow a deduction. That's a double tax benefit. On the other hand, if the interest is taxable or includable in the gross income, then the costs associated with generating that income is indeed deductible. If you pay your advisor to manage your portfolio of corporate bonds, those fees are deductible against a interest income. Also note that the exclusion does not apply to the gains on the sale of the tax exempt bonds. That is, if you sell the city of Chicago bond for more than what you paid for, that gain is still includable and subject to federal income tax, just like the gain on the stock would be. It's just the interests that's tax-free. Finally, interest on most US government bonds, foreign government bonds, and corporate bonds as well as interests from your bank account are not excluded from gross income. Taxpayers must include this interest in their gross income and it will be subject to tax. Another important federal exclusion is when a person receives a gift or an inheritance. Congress allows the recipient of a gift or inheritance to exclude the value of the property from his or her own gross income. This applies to gifts made during the life of the donor, that is inter vivos gifts, as well as the gifts made after the death of the donor in the case of a bequeath or inheritance. What qualifies as a gift? Well, a gift has to be a voluntary transfer of property from one person to another without adequate consideration or compensation. This means that if the payment from one person to another is for compensation related to services rendered or payment for a product, then the payment is not actually a gift. In fact, in this case, the payment is not a gift even if the payment is made without a legal obligation, and even if the payer receives no economic benefit from the transfer. Bottom line, a gift has to be made out of affection, respect, admiration, charity, or like impulses. When you make a gift, you will not expect to receive anything in return and if you receive a gift, you're not obliged to perform a service or deliver a good after receiving the gift. Here's an interesting example of this concept at work. There was a US Supreme Court decision in 1960 called Commissioner versus Duberstein. Here Duberstein was an individual taxpayer and gave to a business acquaintance upon requests the names of potential customers. The information was valuable, so the corporation reciprocated, and gave Duberstein a Cadillac automobile. In fact, the corporation deducted the cost of the Cadillac on his tax return as a business expense. However, Duberstein did not include the value of the car on his personal tax return because he interpreted the Cadillac as a gift and did not even expect any compensation for helping his business acquaintance. However, Duberstein did accept the automobile. The US Tax Court supported by the Supreme Court, decided that the car was not actually a gift excludable from gross income. The Supreme Court concluded that, "Despite the characterization of the transfer of the Cadillac by the parties as a gift and absence, any obligation, even of a moral nature to make it, it was at the bottom of a recompense for Duberstein past service, or an inducement for him to be a further service in the future." The lesson here is that if there is an exchange of property or services between two individuals, it looks like a transaction, not a gift, because with a gift, the recipients of the gift is not required or should not be required to give anything in return for the gift. The third income exclusion relates to life insurance proceeds. The general rule here is that income received by a beneficiary upon the death of a person with life insurance will be excludable from the beneficiaries income. That means that if an owner cancels a life insurance policy and receives the value of the policy, gain must be recognized to the extent the amount received exceeds the basis represented by the premiums paid on the policy. In fact, no losses are recognized here. Definitely asymmetric treatment taxed on the upside if you liquidate, but no deduction on the downside, if you liquidate. Now, there are a few exceptions here where the insured person doesn't necessarily need to die before having tax-free access to the funds within the policy. If the insured person is drawing on the insurance policy before death and the reason is related to medical hardship, then the federal tax law will allow tax-free access and use of the funds while they insured person is still alive. If the owner of the policy is terminally ill, any gains on the cash surrender value of the policy, or the transfer of the policy to a third party is excluded from gross income. Here a person is considered terminal if a medical doctor certifies that a person has an illness that will reasonably cause death within 24 months. In this situation, the person can use the funds for whatever they'd like, tax-free. They can spend it on their medical care or on something else. If the policy owner is chronically ill, that is, a doctor certifies that the person is unable to perform some daily activities without assistance, then there's also no gain on the proceeds. They are excluded from gross income but only if those proceeds are used for the long-term care of the insured. For example, if a person has emphysema and has trouble with daily activities, the person can cash out their life insurance policy and the proceeds will be tax-free if the person uses the proceeds for care such as paying for oxygen treatments or a nurse. In all municipal bond interest income, gifts received, and life insurance proceeds are important examples of items excludable from federal gross income.
