Chapter 4 of 522–32% of exam

Area IV: Federal Taxation of Individuals

Area IV follows Form 1040 from gross income to credits: what is included and excluded, items flowing from pass-through entities, adjustments and itemized deductions, loss limitations, filing status and the tax computation. The 2026 blueprint tests current law, including the 2025 changes, and supplies inflation-indexed figures rather than expecting them to be memorized.

Gross income: inclusions and exclusions

Gross income includes all income from whatever source unless a Code section excludes it. The frequently tested exclusions are gifts and inheritances, life insurance paid at death, state and local bond interest, compensatory damages for physical injury, qualified scholarships and certain fringe benefits. Partners and S corporation shareholders report their shares of entity income whether or not it is distributed.

Common exclusions

Gifts, life insurance proceeds paid by reason of death, and interest on state or local bonds are excluded; unemployment compensation is included.

IRC 101(a); IRC 102(a); IRC 103(a); IRC 85(a)

Damages

Compensatory damages for personal physical injury or sickness are excluded, including the lost-wage portion; punitive damages are taxable.

IRC 104(a)(2)

Scholarships and fringes

Scholarships used for tuition, required fees and course materials are excluded, but not room and board; group-term life coverage above $50,000 and employee discounts above the statutory limits are taxable.

IRC 117; IRC 79(a); IRC 132(c)

Alimony

For divorce or separation instruments executed after 2018, alimony is neither deductible by the payer nor taxable to the recipient.

Pub. L. 115-97 sec. 11051

Pass-through and decedent income

Guaranteed payments and a partner's distributive share are income whether or not distributed; income received after death is income in respect of a decedent, taxed to the recipient.

IRC 702; IRC 707(c); IRC 691(a)

Adjustments and deductions

Adjustments reduce gross income to AGI and are available whether or not the taxpayer itemizes; itemized deductions compete with the standard deduction. The 2025 law changed several amounts and added new deductions, so the exam gives the indexed figures and expects the mechanics.

Above-the-line items

Include one-half of self-employment tax, self-employed health insurance (not for months eligible for an employer-subsidized plan), and HSA contributions.

IRC 62(a); IRC 164(f); IRC 162(l); IRC 223

Medical and taxes

Medical expenses are deductible above 7.5 percent of AGI. For 2025 the state and local tax cap is $40,000, reduced by 30 percent of modified AGI over $500,000 but not below $10,000.

IRC 213(a); IRC 164(b)(6)-(7)

Home interest, gifts and casualties

Interest on up to $750,000 of acquisition debt incurred after December 15, 2017 is deductible; cash gifts to public charities are limited to 60 percent of AGI with a 5-year carryover; personal casualty and theft losses are limited to declared disasters.

IRC 163(h)(3)(F); IRC 170(b)(1)(G); IRC 165(h)(5)

Senior deduction

For 2025 through 2028, $6,000 for each taxpayer aged 65 or older, reduced by 6 percent of modified AGI over $75,000 ($150,000 joint), available whether or not the taxpayer itemizes.

IRC 151(d)(5)(C); IRC 63(b)

QBI deduction

Generally 20 percent of qualified business income, limited to 20 percent of taxable income minus net capital gain; wage and property limits apply above an indexed threshold.

IRC 199A(a)-(b)

Loss limitations

Several limits stack on the same loss. A capital loss is limited by netting and the $3,000 allowance; a pass-through loss by basis, then at-risk, then the passive activity rules. Losses on personal-use property and hobby expenses are simply not deductible.

Capital losses

Individuals deduct capital losses against capital gains plus up to $3,000 ($1,500 married filing separately); the rest carries forward indefinitely with its character.

IRC 1211(b); IRC 1212(b)

Basis limit

A partner's share of loss is allowed only to the extent of the basis of the partnership interest at year-end; the excess carries forward.

IRC 704(d)

Rental real estate

An individual who actively participates may deduct up to $25,000 of rental losses against other income, reduced by 50 percent of modified AGI over $100,000.

IRC 469(i)

Hobby and personal losses

Hobby income is taxable, and the hobby expenses are miscellaneous itemized deductions that are not allowed. Losses on personal-use property are not deductible.

IRC 183(b); IRC 67(g); IRC 165(c)

Filing status, tax computation and credits

Filing status depends on marital status at year-end and on who lives in the taxpayer's home. The tax computation adds the net investment income tax for higher-income taxpayers, and credits are either refundable or limited to the tax. Estimated tax safe harbors decide whether an underpayment penalty applies.

Filing status

Marital status is set at year-end, and a divorced taxpayer is unmarried. A qualifying surviving spouse keeps joint rates for two years after the spouse's death if a dependent child lives at home; head of household requires an unmarried taxpayer maintaining a home for a qualifying person (a dependent parent may live elsewhere).

IRC 7703(a); IRC 2(a)-(b)

Dependents

A qualifying child must meet relationship, residence (more than half the year), age (under 19, or a student under 24) and support tests; there is no gross income test for a qualifying child.

IRC 152(c)

Net investment income tax

3.8 percent of the lesser of net investment income or modified AGI over $250,000 (joint) or $200,000 (single); the thresholds are not indexed.

IRC 1411

Credits

Refundable credits, such as the earned income credit, can exceed the tax and be paid out; nonrefundable credits are limited to the tax. For 2025 the child tax credit is $2,200 per qualifying child plus $500 per other dependent.

IRC 6401(b); IRC 24(h)

Estimated tax safe harbor

Pay the lesser of 90 percent of current-year tax or 100 percent of prior-year tax (110 percent if prior-year AGI exceeded $150,000); no penalty if the balance due is under $1,000.

IRC 6654(d)-(e)

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