ACCY 312 Chap.4 The Individual Income Tax Formula
The Individual Income Tax Formula
Gross income is all-inclusive
The formula starts with gross income, which the law defines as all realized income from whatever source derived. Income is realized when a transaction with another party produces a measurable change in property rights, so wages, business income, rents, royalties, interest and dividends all count, while the rise in value of shares a taxpayer still holds does not.
Two groups of realized income stay out. Exclusions are left out permanently: municipal bond interest, gain on the sale of a personal residence, gifts, inheritances and life insurance proceeds. Deferrals are taxed in a later year, as with installment sales and like-kind exchanges.
Income from a student-athlete's name, image and likeness is gross income and must be reported.
Two kinds of deduction
Nothing is deductible unless a specific provision allows it.
Deductions for AGI, also called above the line, are mostly tied to business or investment: business expenses, rental and royalty expenses, half of self-employment tax, contributions to qualified retirement accounts and health savings accounts, interest on qualified education loans, alimony under divorces executed by the end of 2018 and net capital losses up to $3,000 a year.
Subtracting them gives adjusted gross income, a line the slides flag as very important because many other deductions and credits are measured against it.
Deductions from AGI, below the line, come next.
The taxpayer takes the greater of the standard deduction and itemized deductions, then any of the newer items: charitable gifts for non-itemizers, the deduction for seniors, qualified car loan interest, qualified tip income, qualified overtime pay and the qualified business income deduction.
Several were created by the One Big Beautiful Bill Act, signed on July 4, 2025. The 2026 standard deduction is $16,100 for a single filer and $32,200 for a married couple filing jointly.
From taxable income to the amount due
Taxable income times the rates gives the income tax liability, and the rate depends on filing status and on the character of income.
Other taxes such as self-employment tax are added to reach total tax. Credits then reduce the tax dollar for dollar, and prepayments such as withholding and estimated payments settle the account as tax due or a refund.
Why the order matters
A deduction and a credit of the same size are not worth the same. A deduction is worth its amount times the marginal rate; a credit is worth its full amount.
Likewise a for-AGI deduction lowers AGI and can open access to AGI-tested benefits, while a from-AGI deduction does not. Placing each item on the right line is the skill every later chapter relies on.
What this chapter covers
- 01
Realized income and gross income
- 02
Exclusions and deferrals
- 03
Deductions for AGI
- 04
Adjusted gross income as a reference point
- 05
Standard deduction or itemized deductions
- 06
Newer deductions from AGI
- 07
Credits and prepayments
Worked example · free
Sort items onto the right lines of the formula
- 2Gross income: $58,000 salary plus $600 taxable interest is $58,600; the municipal interest, the gift and the unrealized gain stay out.
- 2AGI: $58,600 less $1,000 HSA and $3,000 IRA deductions for AGI is $54,600.
- 2Taxable income: the $16,100 standard deduction exceeds $7,500 itemized, so $54,600 less $16,100 is $38,500.
Key terms
- Gross Income
- All realized income from whatever source derived, before any deduction.
- Realized Income
- Income produced by a transaction with another party that changes property rights.
- Exclusion
- A realized income item permanently left out of taxable income, such as municipal bond interest.
- Deferral
- A realized income item taxed in a later year, such as gain on an installment sale.
- Deduction for AGI
- An above-the-line deduction, usually tied to business or investment, subtracted to reach AGI.
- Itemized Deductions
- Listed personal deductions such as medical costs, state and local taxes, mortgage interest and charitable gifts.
- Prepayment
- Tax paid before the return is filed, such as employer withholding or an estimated payment.
The Individual Income Tax Formula FAQ
Is a gift of cash from parents taxable income to the child?
No. Gifts and inheritances are exclusions, so the recipient leaves them out of gross income entirely. The gift tax, where it applies, falls on the person who gives, not on the person who receives.
Why does it matter whether a deduction is taken for AGI or from AGI?
A for-AGI deduction lowers AGI, and AGI is the base for many limits and phase-outs. A from-AGI deduction lowers taxable income only, and the itemized kind helps only when the total beats the standard deduction.
Is income from name, image and likeness deals taxable?
Yes. The class slides state that all NIL income must be reported, whether received in cash or in kind. An athlete treated as self-employed also owes self-employment tax on it.
What happens to a net capital loss larger than $3,000?
Up to $3,000 a year can be deducted against other income as a deduction for AGI. The remainder carries forward to later years, while a loss on personal-use property cannot be deducted at all.
Exam move
Copy the formula onto one card and keep it beside you for every practice problem. For each fact in a question, write the line it belongs on before touching a calculator, then check your labels against the worked solution.
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