Part 1 — Individuals
Part 1 of the Special Enrollment Examination covers the federal income taxation of individuals from the first line of Form 1040 to the last: who must file and under what status, what counts as income, which subtractions the law allows, how credits cut tax dollar-for-dollar, how gains and basis are measured, and the specialized rules for retirement accounts, self-employment, home sales, and transfers of wealth. This chapter teaches the durable rules that survive from year to year. Where a dollar figure is indexed for inflation each year — the standard deduction, IRA and 401(k) contribution limits, the annual gift-tax exclusion, the tax brackets — you should learn the rule and the structure, then confirm the current-year number in the IRS instructions or the relevant Revenue Procedure before you rely on it. Stable statutory rules (the 7.5%-of-AGI medical floor, the $250,000/$500,000 home-sale exclusion, the 10% early-distribution penalty, required minimum distributions beginning at age 73) are stated here as fixed because Congress wrote them into the Code as fixed.
Filing Requirements and Filing Status
A taxpayer's filing status is fixed by their marital and household situation on the last day of the tax year — December 31 for a calendar-year filer — not by the day the return is filed or the day they were paid. The five statuses are single, married filing jointly (MFJ), married filing separately (MFS), head of household (HoH), and qualifying surviving spouse (QSS). A couple legally married at year-end may file jointly even if they married on December 31; a couple whose divorce is final by December 31 is treated as unmarried for the entire year. Marriage to a nonresident alien makes a U.S. citizen married for filing purposes, but absent a special election to treat the spouse as a resident, the practical choices are MFS or, if a qualifying person lives with the taxpayer, HoH. Head of household is the workhorse status for unmarried people supporting a household: the taxpayer must be unmarried or 'considered unmarried' (living apart from a spouse for the last six months of the year and maintaining a home for a qualifying child), and must pay more than half the cost of keeping up a home in which a qualifying person lived for more than half the year. HoH carries a larger standard deduction and wider brackets than single or MFS. MFS is usually the costliest status — it disqualifies the taxpayer from the earned income credit, most education credits, and the deduction for student loan interest, and if one separate-filing spouse itemizes, the other must itemize too (their standard deduction becomes zero). The QSS status lets a surviving spouse who has not remarried and who maintains a home for a dependent child use the favorable joint brackets and standard deduction for the two years following the year of death; in the year of death itself the taxpayer may still file jointly with the decedent.
Dependents: Qualifying Child and Qualifying Relative
A dependent is either a qualifying child (QC) or a qualifying relative (QR), and each has its own tests. A qualifying child must satisfy relationship (child, stepchild, foster child, sibling, or a descendant of any of these), age (under 19, or under 24 if a full-time student, or permanently and totally disabled at any age), residency (lived with the taxpayer more than half the year), support (the child did not provide more than half of their own support), and joint-return tests. A qualifying relative must meet a relationship-or-member-of-household test, a gross-income test (the dependent's gross income must be below a modest inflation-indexed threshold — verify the current-year figure), a support test (the taxpayer provided more than half of the person's total support), and the not-a-qualifying-child test. A non-relative, such as a family friend, can be a qualifying relative only if they lived with the taxpayer as a member of the household for the entire year. Two tie-breaker situations recur on the exam. When a child is the qualifying child of both divorced or separated parents, the child is generally treated as the qualifying child of the custodial parent (the one with whom the child lived the greater number of nights); the custodial parent may release the dependency claim to the noncustodial parent by signing Form 8332. Under a multiple-support agreement, a group who together provide more than half of a person's support — but no one of whom provides more than half alone — may designate one member (who paid more than 10%) to claim the dependent. Finally, a person who can be claimed as a dependent generally cannot claim their own dependents on the same return and gets a reduced standard deduction, and a married person who files a joint return with their spouse usually cannot be claimed by anyone else (unless the joint return was filed only to claim a refund).
Gross Income: Inclusions and Exclusions
Section 61 defines gross income sweepingly as 'all income from whatever source derived' unless a specific provision excludes it, so the analytical habit is to treat every inflow as taxable and then look for an exclusion. Includible items that trip up candidates include tips (taxable and reportable to the employer), gambling winnings (fully includible, with losses deductible only as an itemized deduction up to winnings), jury duty pay, unemployment compensation, a state income tax refund (taxable to the extent the prior-year state tax deduction produced a tax benefit — the 'tax benefit rule'), cancellation of nonbusiness debt (generally income unless an exclusion such as insolvency or bankruptcy applies), original issue discount on a bond (accrued into income over the bond's life even before cash is received), and the taxable portion of Social Security benefits (which depends on the taxpayer's combined income relative to base-amount thresholds). For dividends, the lower qualified-dividend rate requires a holding-period test and payment by a qualifying corporation; capital-gain distributions from a mutual fund reported on Form 1099-DIV are taxed as long-term regardless of how long the shareholder held the fund. Key exclusions to memorize: gifts and most inheritances (excluded to the recipient), interest on state and local municipal bonds (federally tax-exempt, though it can affect the Social Security computation and AMT), life insurance proceeds paid by reason of death, child support received, qualified scholarship amounts used for tuition and required fees (but amounts used for room and board are taxable), qualified distributions from Roth accounts and §529 education plans, and a list of tax-free fringe benefits (employer health coverage, qualified de minimis benefits, and similar). Interest on U.S. Treasury obligations is fully subject to federal tax but exempt from state tax — the mirror image of municipal bonds.
Adjustments to Income (Above-the-Line Deductions)
Adjustments to income, historically called above-the-line deductions, are subtracted from gross income to arrive at adjusted gross income (AGI). They matter out of proportion to their size because AGI is the base for dozens of phaseouts, floors, and eligibility tests downstream — a dollar of above-the-line deduction can unlock credits and reduce the AGI-based limits that a mere itemized deduction cannot. The common adjustments an enrolled agent applies include the deductible part of self-employment tax (one-half of SE tax), deductible contributions to a traditional IRA and self-employed retirement plans (SEP, SIMPLE, solo 401(k)), the self-employed health insurance deduction (which can reduce income tax but not SE tax), health savings account (HSA) contributions, the penalty on early withdrawal of savings (the bank's CD early-withdrawal penalty), student loan interest (a limited, phased-out deduction unavailable to MFS filers), and the eligible educator expense deduction for a limited amount of unreimbursed classroom supplies. Two post-Tax Cuts and Jobs Act (TCJA) changes recur: for divorce or separation agreements executed after 2018, alimony is neither deductible by the payer nor includible by the recipient (the reverse of the old rule), and the moving expense deduction is suspended for everyone except active-duty members of the Armed Forces moving under orders. Because several of these limits and the student-loan phaseout ranges are inflation-indexed, teach the mechanism and verify the current-year amounts.
Standard Deduction versus Itemized Deductions
Every taxpayer subtracts the greater of the standard deduction or total itemized deductions. The standard deduction is a fixed amount that depends on filing status, is larger for taxpayers who are age 65 or older or blind (an additional amount per condition), and is reduced for a person who can be claimed as a dependent (limited to earned income plus a small amount, but never more than the regular standard deduction). All of these figures are inflation-indexed — teach the structure and confirm the year's numbers. Itemized deductions on Schedule A include: unreimbursed medical and dental expenses to the extent they exceed 7.5% of AGI (a stable statutory floor); state and local taxes (income or sales, plus property tax) subject to the SALT cap enacted by TCJA; home mortgage interest on acquisition debt within the statutory principal limits; investment interest expense, deductible only up to net investment income with the excess carried forward; and charitable contributions, generally deductible up to a percentage-of-AGI ceiling that varies by the type of gift and recipient (cash to public charities carries the highest ceiling; a gift of long-term appreciated publicly traded stock is generally deductible at fair market value, subject to a lower ceiling). A cash gift of $250 or more requires a contemporaneous written acknowledgment from the charity. TCJA reshaped Schedule A in ways the exam tests: personal and dependency exemptions are suspended (set to zero), miscellaneous itemized deductions subject to the 2%-of-AGI floor — including unreimbursed employee business expenses and investment fees — are suspended, and a personal casualty loss is deductible only if attributable to a federally declared disaster.
Tax Credits: Child, Earned Income, Education, and Dependent Care
A credit reduces tax dollar-for-dollar and is therefore worth more than a deduction of the same size, which only reduces the income on which tax is computed. The critical distinction is refundable versus nonrefundable: a nonrefundable credit can reduce tax only to zero, while a refundable credit can generate a payment beyond tax owed. The Child Tax Credit (CTC) is available for a qualifying child who is under age 17 at year-end, is claimed as a dependent, and meets a Social Security number requirement; it phases out at higher AGI, and a portion is refundable as the Additional Child Tax Credit. A separate, smaller nonrefundable Credit for Other Dependents covers dependents who are not CTC-eligible, such as a supported elderly parent. The Earned Income Tax Credit (EITC) is fully refundable and targeted at lower-income workers; it requires earned income, a valid SSN, investment income below a ceiling, and disqualifies MFS filers in most cases — a childless worker can claim a small EITC only within a specified age range. For education, the American Opportunity Tax Credit (AOTC) applies to the first four years of postsecondary education, is partly refundable, and is claimed per eligible student, while the Lifetime Learning Credit is nonrefundable, has no year limit, covers a broader range of courses, and is figured per return. Qualified expenses paid with tax-free scholarship funds do not count for either education credit. The Child and Dependent Care Credit offsets a percentage of work-related care costs for a child under 13 or a disabled dependent. Other credits the exam samples include the foreign tax credit (or the alternative deduction) on foreign taxes paid, the Saver's Credit for modest-income retirement savers, and the adoption credit. Because credit amounts, phaseout ranges, and the CTC refundable portion are indexed and adjusted by statute, verify current-year figures.
Retirement Accounts: IRAs, Employer Plans, Rollovers, and RMDs
Whether a traditional IRA contribution is deductible depends on whether the taxpayer (or spouse) is an active participant in an employer plan and on AGI relative to a phaseout range; contributions are always permitted (up to the annual limit, an indexed figure with a catch-up for those 50 and older) but the deduction may be limited or eliminated. Nondeductible traditional-IRA contributions create basis, tracked on Form 8606, so that later distributions are partly tax-free. Roth IRA contributions are never deductible, and the ability to contribute phases out at higher AGI; a Roth distribution is a tax-free 'qualified distribution' only if made after a five-year period and after age 59½ (or death, disability, or a first-time home purchase). Elective deferrals into a traditional 401(k) are excluded from current wages up to an annual indexed limit. Distributions before age 59½ from a traditional IRA are generally included in income and hit with a 10% additional tax (a stable statutory rate) unless an exception applies — for example, death, disability, substantially equal periodic payments, higher-education expenses, a first-time home purchase up to a lifetime cap, or unreimbursed medical costs above the AGI floor. Rollovers preserve tax deferral: a direct trustee-to-trustee transfer is unlimited and avoids withholding, while an indirect (60-day) rollover of an IRA distribution is subject to the once-per-12-months limitation and, from an employer plan, to mandatory 20% withholding on the eligible rollover distribution. Converting a traditional IRA to a Roth is fully taxable in the year of conversion but not subject to the 10% penalty. Required minimum distributions (RMDs) from a traditional IRA must begin by the required beginning date tied to age 73 under the SECURE Act changes; failing to take an RMD triggers an excise tax on the shortfall (recently reduced by statute, and further reducible if timely corrected). Excess contributions that are not timely withdrawn are subject to a 6% excise tax each year they remain.
Self-Employment Tax, Estimated Tax, AMT, and the NIIT
A self-employed individual owes self-employment (SE) tax — the combined employer and employee shares of Social Security and Medicare — once net earnings from self-employment reach $400. SE tax is computed on net SE earnings multiplied by 92.35% (which approximates the employer-share deduction), then by the SE tax rate; the 12.4% Social Security portion applies only up to the annual wage base (an indexed ceiling), while the 2.9% Medicare portion has no ceiling. The taxpayer deducts one-half of SE tax as an adjustment to income. High earners owe an Additional Medicare Tax of 0.9% on wages and SE income above a threshold that is not indexed and is not reduced for MFS. Because self-employment income is not subject to withholding, such taxpayers generally must pay quarterly estimated tax (Form 1040-ES) to avoid the §6654 underpayment penalty; the safe harbor is met by paying at least 90% of the current year's tax or 100% of the prior year's tax (110% for higher-income taxpayers), and withholding from wages is treated as paid evenly throughout the year regardless of when it was actually withheld. A taxpayer must generally pay estimates if they expect to owe at least $1,000 after withholding and credits. The Alternative Minimum Tax (AMT) is a parallel tax that recomputes income by adding back certain preferences and adjustments (such as private-activity municipal bond interest and the standard deduction), subtracting an exemption that phases out at higher income, and applying AMT rates; the taxpayer pays the AMT to the extent it exceeds the regular tax, and reports it on Form 6251. Finally, the Net Investment Income Tax (NIIT) of 3.8% applies to the lesser of net investment income or the excess of modified AGI over a fixed (non-indexed) threshold. The kiddie tax, a related anti-abuse rule, taxes a child's unearned income above a small threshold at the parents' marginal rate to prevent shifting investment income to children in lower brackets, and can reach a full-time student under age 24 whose earned income does not exceed half of their support.
Capital Gains, Losses, and Basis
Gain or loss on the sale of property equals the amount realized minus the property's adjusted basis. Basis generally starts at cost — including commissions and acquisition costs (a $5,000 stock purchase with a $50 commission has a $5,050 basis) — and is adjusted upward for capital improvements and downward for depreciation and returns of capital. Basis rules differ sharply by how property is acquired. Property inherited from a decedent takes a stepped-up (or stepped-down) basis equal to fair market value on the date of death and is automatically treated as long-term regardless of the actual holding period. Gifted property carries a dual basis: for computing gain, the recipient uses the donor's carryover basis; for computing loss, the recipient uses the lower of that carryover basis or fair market value at the date of gift; and the recipient generally tacks the donor's holding period. Holding period drives the rate: property held more than one year produces long-term capital gain, generally taxed at preferential rates (0%, 15%, or 20% depending on income) that also apply to qualified dividends; one year or less is short-term, taxed at ordinary rates. Netting proceeds in a set order — short-term against short-term, long-term against long-term, then across categories — before applying the results. A net capital loss offsets ordinary income only up to $3,000 per year ($1,500 MFS), with the remainder carried forward indefinitely; so a taxpayer with an $8,000 net long-term loss and no gains deducts $3,000 this year and carries $5,000 forward. Two special rules recur: the wash-sale rule disallows a loss when the taxpayer buys substantially identical securities within 30 days before or after the sale (adding the disallowed loss to the replacement's basis), and a loss on a personal-use asset such as a personal car is nondeductible even though a gain on the same asset would be taxable. A completely worthless security is treated as sold on the last day of the tax year.
Sale of a Home (§121), Estate and Gift Tax
Section 121 lets a taxpayer exclude gain on the sale of a principal residence — up to $250,000 for a single filer and $500,000 for a married couple filing jointly (stable statutory amounts) — if the taxpayer owned and used the home as a principal residence for at least two of the five years before the sale. The exclusion generally may be claimed only once every two years. A taxpayer who fails the two-year test because of a change in employment, health, or unforeseen circumstances may claim a reduced (prorated) exclusion. Gain in excess of the exclusion is taxed as long-term capital gain, and any gain attributable to depreciation claimed for a home office or rental use after May 6, 1997 (unrecaptured §1250 gain) cannot be excluded and is taxed at a maximum 25% rate. On the transfer-tax side, the federal gift tax is generally paid by the donor, not the recipient. The annual gift-tax exclusion lets a donor give a certain amount (an indexed figure — verify the current year) of present-interest gifts to each of any number of recipients free of gift tax and without using the lifetime exemption; the exclusion applies only to gifts of a present interest, not future interests. Gifts between spouses who are both U.S. citizens are unlimited (the marital deduction), and married couples may elect gift-splitting to treat gifts as made half by each spouse, doubling the available annual exclusion. A donor may also pay another person's tuition or medical expenses without limit if paid directly to the institution or provider. The lifetime unified credit shelters a large (indexed) amount of cumulative taxable gifts and estate transfers; a donor who makes gifts to any donee exceeding the annual exclusion must file Form 709, and a decedent's estate must file Form 706 only when the gross estate plus adjusted taxable gifts exceeds the exemption. The stepped-up basis that inherited property receives is the estate-tax counterpart to these rules, generally eliminating the appreciation that accrued during the decedent's life from income tax.
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