CPA REG: Federal Taxation of Individuals

CPA means Certified Public Accountant. REG means Taxation and Regulation. Use this focused page when your CPA REG misses are about individual gross income, exclusions, adjustments, deductions, credits, filing status, or tax computation. Drill this topic before returning to mixed practice.

Topic snapshot

What this topic tests

This topic tests whether you can classify individual tax facts and follow them through the return. Strong answers distinguish gross income, exclusions, adjustments, itemized deductions, credits, filing status, dependency, and timing.

Common traps

• confusing adjusted gross income, taxable income, tax liability, and amount due
• treating all deductions as itemized deductions or all credits as refundable
• missing filing-status, dependency, phaseout, or limitation facts
• answering from memory before deciding whether the item is income, exclusion, adjustment, deduction, or credit

How to reason through these questions

Put each fact into the return sequence: income, exclusion, adjustment, deduction, credit, payment, or penalty. Then apply limits and phaseouts only after the category is correct. Many wrong answers use the right number in the wrong part of the return.

Sample questions

These questions are original Mastery Exam Prep practice items aligned to this topic area. They are designed for self-assessment and are not official exam questions.

Question 1

Topic: Federal Taxation of Individuals

A CPA is reviewing Lin’s draft Form 1040 and supporting documents. The draft reports $1,200 of taxable interest and $2,500 of ordinary dividends. The supporting documents include a Form 1099-INT showing $900 of interest from a city general obligation bond, which was not entered anywhere on the draft return. How should the $900 be characterized for the Form 1040 review?

• A. Tax-exempt interest that should be reported on Form 1040 but excluded from taxable income
• B. Taxable interest that should be included with bank interest in gross income
• C. Nontaxable income that is neither reported nor considered in reviewing Form 1040 completeness
• D. Qualified dividend income eligible for preferential tax rates

Best answer: A

What this tests: Federal Taxation of Individuals

Explanation: The $900 is municipal bond interest, which is generally excluded from federal gross income. However, Form 1040 still requires tax-exempt interest to be reported, so omitting it makes the return incomplete even though it does not increase taxable income.

When reviewing Form 1040 for income completeness, supporting tax forms should be traced to the proper return lines. Interest from a state or local government obligation is generally tax-exempt for federal income tax purposes. That means it is not included in taxable interest or federal gross income, but it is still disclosed as tax-exempt interest on Form 1040. Lin’s draft correctly avoids including the $900 as taxable interest, but it is incomplete because the tax-exempt interest line was left blank.

• Treating the amount as taxable bank interest incorrectly ignores the municipal bond exclusion.
• Treating the amount as qualified dividends confuses interest income with dividend income.
• Treating the amount as not reportable overlooks the Form 1040 disclosure requirement for tax-exempt interest.

Interest on a municipal general obligation bond is generally federally tax-exempt but still must be reported on the tax-exempt interest line of Form 1040.

Question 2

Topic: Federal Taxation of Individuals

During 2026, Maren received the following amounts while preparing her individual federal income tax return:

• $2,400 interest on City of Albany municipal bonds
• $15,000 cash from her aunt as a graduation gift
• $100,000 life insurance proceeds paid in a lump sum because of her spouse’s death
• $1,200 interest paid by the insurer because payment of the life insurance proceeds was delayed

What amount should Maren exclude from federal gross income?

• A. $102,400
• B. $115,000
• C. $117,400
• D. $118,600

Best answer: C

What this tests: Federal Taxation of Individuals

Explanation: Maren excludes the municipal bond interest, the cash gift from her aunt, and the life insurance death benefit. The separate interest paid by the insurer is taxable interest income, so it is not part of the exclusion.

For federal income tax purposes, interest on state and local municipal bonds is generally excluded from gross income. A transfer received as a detached and disinterested gift is also excluded by the recipient, although gift tax consequences may apply to the donor. Life insurance proceeds paid by reason of the insured’s death are generally excluded when received as a lump sum. However, any separate interest paid because the insurer delayed payment is taxable interest income. Therefore, Maren’s exclusion is $2,400 + $15,000 + $100,000 = $117,400.

• Excluding only municipal bond interest and life insurance proceeds omits the aunt’s true gift.
• Excluding the gift and life insurance proceeds but omitting municipal bond interest incorrectly treats tax-exempt interest as taxable.
• Including the insurer’s $1,200 interest overstates the exclusion because that interest is taxable.

Municipal bond interest, a true gift received, and life insurance death proceeds are excluded, but interest on delayed payment is taxable.

Question 3

Topic: Federal Taxation of Individuals

A CPA is reviewing a draft Form 1040 for a taxpayer who was HSA-eligible all year. The support file shows:

Which correction should the CPA recommend?

• A. Remove the $3,600 Schedule 1 HSA deduction because the code W amount was already excluded from wages.
• B. Move the $3,600 from Schedule 1 to Schedule A as an itemized medical deduction.
• C. Deduct only the $3,000 employee salary reduction portion on Schedule 1 and remove the $600 employer portion.
• D. Keep the $3,600 Schedule 1 HSA deduction because the taxpayer was HSA-eligible for the full year.

Best answer: A

What this tests: Federal Taxation of Individuals

Explanation: The draft return duplicates the tax benefit for the HSA contributions. Amounts reported on the W-2 with code W were made through payroll or by the employer and were already excluded from box 1 wages, so they are not deductible again on Schedule 1.

An above-the-line HSA deduction is available for eligible contributions made directly by the taxpayer with after-tax funds. Employer HSA contributions, including employee salary reductions made through a cafeteria plan, are treated as employer contributions for this purpose. They are reported on Form 8889 but are not deducted on Schedule 1 because they have already reduced taxable wages. Here, the taxpayer made no additional after-tax HSA contributions, so the Schedule 1 HSA deduction should be zero. The $3,600 code W amount should not be reclassified as an itemized medical deduction.

• Full-year HSA eligibility does not permit a second deduction for payroll or employer-funded contributions.
• The employee salary reduction portion is also excluded from wages, so it is not separately deductible on Schedule 1.
• HSA contributions are not Schedule A medical expenses merely because the HSA may later be used for qualified medical costs.

HSA contributions made through payroll salary reduction or by the employer are excluded from wages and are not also deductible as an adjustment to income.

Question 4

Topic: Federal Taxation of Individuals

A CPA is reviewing Nia’s draft individual income tax return. Nia received a lawsuit settlement for bodily injuries suffered in an auto accident, and she deducted no related medical expenses in any prior year. The source documents show:

The draft return includes none of the $100,000. Which is the best interpretation of this source-data discrepancy?

• A. The return should exclude all $100,000 because the settlement arose from a physical-injury claim.
• B. The return should include all $100,000 because the Form 1099-MISC reports the full settlement as other income.
• C. The return should exclude the settlement unless the insurer issues a corrected Form 1099-MISC allocating the payment.
• D. The return should include $28,000 of punitive damages in gross income and exclude the $72,000 physical-injury compensatory damages.

Best answer: D

What this tests: Federal Taxation of Individuals

Explanation: The signed settlement agreement provides the specific allocation needed to resolve the discrepancy. The compensatory amount for physical injuries is excludable because no prior medical deduction was taken, but the punitive damages portion must be included in gross income.

When source documents conflict, the tax return should reflect the correct tax character supported by the underlying facts, not merely the broad label on an information return. Damages received on account of personal physical injuries are generally excluded from gross income, assuming there is no recovery of previously deducted medical expenses. Punitive damages are different: they are taxable even when awarded in the same case as physical-injury compensatory damages. Here, the Form 1099-MISC reports the full $100,000, but the settlement agreement shows that only $28,000 is punitive damages. The taxpayer should include $28,000 in gross income and retain the agreement to support excluding the $72,000.

• Including all $100,000 treats the information return as controlling, but the settlement agreement supports different tax treatment for the components.
• Excluding all $100,000 ignores the separate punitive damages allocation, which is taxable.
• Waiting for a corrected Form 1099-MISC is not required to file a supportable return that reports the taxable portion.

Punitive damages are taxable even when related to a physical-injury case, while compensatory damages for physical injuries are excludable on these facts.

Question 5

Topic: Federal Taxation of Individuals

When preparing Dana’s Form 1040, a CPA has the following current-year information:

• Dana received $64,000 of wages, and her employer paid $2,500 of premiums for coverage under a nondiscriminatory group health plan.
• Dana received $1,200 of interest on U.S. Treasury bonds and $800 of interest on municipal bonds issued by her city.
• Dana received $100,000 of compensatory damages for physical injuries and $20,000 of punitive damages from the same lawsuit.

What amount should Dana include in federal gross income from these items?

• A. $65,200
• B. $86,000
• C. $85,200
• D. $185,200

Best answer: C

What this tests: Federal Taxation of Individuals

Explanation: The includible amount is $85,200. Federal gross income includes Dana’s wages, taxable U.S. Treasury interest, and punitive damages, while specific exclusions apply to the employer-paid health premiums, municipal bond interest, and physical-injury compensatory damages.

For federal income tax purposes, wages are included in gross income unless a specific exclusion applies. Interest on U.S. Treasury bonds is taxable for federal purposes, while interest on municipal bonds is generally excluded from federal gross income. Employer-provided coverage under a nondiscriminatory health plan is excluded. Damages received on account of personal physical injuries are excluded, but punitive damages are taxable even when awarded in connection with a physical-injury lawsuit. Therefore, Dana includes $64,000 of wages, $1,200 of Treasury interest, and $20,000 of punitive damages, for a total of $85,200.

• Excluding the punitive damages incorrectly treats them the same as compensatory damages for physical injuries.
• Including the municipal bond interest ignores the federal exclusion for municipal interest.
• Including the physical-injury compensatory damages would overstate gross income because those damages are excluded.

Dana includes wages, U.S. Treasury interest, and punitive damages, but excludes employer health coverage, municipal bond interest, and compensatory damages for physical injuries.

Question 6

Topic: Federal Taxation of Individuals

Morgan, a single taxpayer, had the following capital transactions during the year. All assets were capital assets, and Morgan had no other capital transactions.

Assume the maximum deductible net capital loss against ordinary income is $3,000. What amount of capital loss deduction is Morgan allowed for the year?

• A. $3,000
• B. $4,500
• C. $2,600
• D. $0

Best answer: C

What this tests: Federal Taxation of Individuals

Explanation: Morgan first nets short-term items and long-term items separately, including the long-term carryforward. The resulting short-term loss is offset by the net long-term gain, leaving a $2,600 overall net capital loss, which is below the $3,000 annual deduction limit.

Capital gains and losses are first netted within the short-term and long-term categories. Morgan’s short-term result is a $4,500 loss: $5,200 − $9,700. The long-term result is a $1,900 gain: $7,100 − $1,000 − $4,200. The $1,900 net long-term gain offsets part of the $4,500 net short-term loss, leaving an overall net capital loss of $2,600. Because the net capital loss is less than the $3,000 annual limit for deduction against ordinary income, Morgan may deduct the full $2,600.

• $0 ignores the long-term capital loss carryforward, which changes the overall result from a net gain to a net loss.
• $3,000 applies the maximum deduction limit without first computing the actual net capital loss.
• $4,500 deducts the short-term net loss before offsetting it against the net long-term capital gain.

Morgan’s net capital loss after category netting and cross-netting is $2,600, which is fully deductible because it does not exceed the $3,000 limit.

Question 7

Topic: Federal Taxation of Individuals

Elena, a cash-basis individual, received $18,000 from her employer’s group long-term disability insurer after she was unable to work. The CPA concludes that the $18,000 should be included in Elena’s Form 1040 gross income. Which record best supports that conclusion?

• A. A bank statement showing $18,000 in deposits from the insurer to Elena.
• B. Employer benefits and payroll records showing the disability premiums were paid entirely by the employer and were not included in Elena’s W-2 wages.
• C. An insurance policy declaration identifying the payments as disability benefits under a group policy.
• D. A physician certification stating that Elena was unable to perform her job duties during the covered period.

Best answer: B

What this tests: Federal Taxation of Individuals

Explanation: The decisive tax fact is how the disability insurance premiums were paid. If the employer paid the premiums and the employee was not taxed on those premiums, the resulting disability benefits are included in the employee’s gross income.

Gross income includes taxable compensation and benefits unless a specific exclusion applies. For disability insurance payments, taxability generally depends on the tax treatment of the premiums. Benefits are taxable to the extent they are paid under coverage funded by employer-paid premiums that were not previously included in the employee’s wages. Here, the benefits and payroll records directly establish that the employer funded the coverage on a pretax basis, which supports including the $18,000 in Elena’s Form 1040 gross income.

• A physician certification supports medical eligibility for the benefits, not their federal income tax treatment.
• A bank statement proves receipt and amount, but it does not establish whether the payments are taxable.
• A policy declaration identifies the type of benefit, but it does not show who paid the premiums or whether they were taxed to Elena.

Disability benefits attributable to employer-paid, pretax premiums are included in the employee’s gross income.

Question 8

Topic: Federal Taxation of Individuals

Jordan, a cash-method individual investor, sold 200 shares of Lark Corp. common stock in a taxable brokerage account on November 20 for $8,000. His basis was $11,000. Jordan wants to report the $3,000 loss as a current capital loss, but the CPA concludes the loss is disallowed under the wash-sale rules. Which record best supports the CPA’s conclusion?

• A. Form 1099-B showing sale proceeds of $8,000 and cost basis of $11,000 for the November 20 sale.
• B. Brokerage trade confirmations showing Jordan bought 200 shares of Lark Corp. common stock on December 5.
• C. A year-end brokerage summary showing Jordan’s total capital losses exceeded his capital gains by $7,000.
• D. A client email stating Jordan expected Lark Corp.’s stock price to recover after the loss sale.

Best answer: B

What this tests: Federal Taxation of Individuals

Explanation: The decisive evidence for a wash sale is a purchase of substantially identical stock or securities within the 30-day period before or after a loss sale. The December 5 purchase of the same common stock occurred 15 days after Jordan’s November 20 loss sale.

A wash-sale loss is not currently deductible when a taxpayer sells stock or securities at a loss and acquires substantially identical stock or securities within 30 days before or after the sale. Here, Jordan sold Lark Corp. common stock at a $3,000 loss on November 20 and repurchased the same corporation’s common stock on December 5. That replacement purchase falls within the wash-sale window and supports disallowing the current capital loss deduction, rather than treating the loss as merely subject to the normal capital loss limitation. The disallowed loss is generally reflected through basis in the replacement shares.

• The Form 1099-B showing proceeds and basis supports that a realized loss occurred, but it does not prove a replacement purchase.
• Jordan’s expectation that the stock price would recover explains motive, not the wash-sale elements.
• A net capital loss summary relates to the annual capital loss limitation, not whether this specific loss is disallowed as a wash sale.

The confirmations show Jordan acquired substantially identical stock within 30 days after selling the same stock at a loss.

Question 9

Topic: Federal Taxation of Individuals

Jordan owns 25% of Blue LLC, which is taxed as a partnership for federal tax purposes. Blue filed Form 1065 and issued Jordan a Schedule K-1 showing $18,000 of ordinary business income and $4,000 of net long-term capital gain. Jordan also received a $10,000 cash distribution, and his outside basis is sufficient to cover the distribution. Which treatment is correct for Jordan’s Form 1040?

• A. Report $18,000 as pass-through ordinary business income and $4,000 as long-term capital gain; treat the $10,000 distribution as nontaxable.
• B. Report Blue LLC’s gross receipts and expenses directly on Schedule C because Jordan owns an LLC interest.
• C. Report $22,000 as ordinary business income because all partnership items become ordinary income to the owner.
• D. Report only the $10,000 cash distribution as income because partnership income is taxed when distributed.

Best answer: A

What this tests: Federal Taxation of Individuals

Explanation: A partnership is a pass-through entity, so Jordan reports his Schedule K-1 distributive share on his individual return whether or not cash was distributed. The ordinary business income and long-term capital gain retain their separate character, while the cash distribution is not taxable because basis is sufficient.

An LLC taxed as a partnership files Form 1065 at the entity level, but that filing generally reports information rather than paying federal income tax on the partnership’s income. Each owner reports the Schedule K-1 items on Form 1040 based on the item’s character. Here, Jordan reports $18,000 of ordinary business income and $4,000 of net long-term capital gain. The $10,000 cash distribution is a separate event; because Jordan has sufficient outside basis, it is generally a nontaxable return of basis rather than additional income.

• Reporting only the cash distribution ignores that partners are taxed annually on their distributive share, even if not distributed.
• Reporting gross receipts and expenses on Schedule C confuses a partnership interest with a sole proprietorship activity.
• Treating all K-1 items as ordinary income ignores that separately stated items, such as long-term capital gain, retain their character on the owner’s return.

A partner reports the Schedule K-1 distributive share by character, and a cash distribution is generally nontaxable to the extent of outside basis.

Question 10

Topic: Federal Taxation of Individuals

Rae asks a CPA to prepare her current-year federal Form 1040 using the most favorable filing status she is legally entitled to use. The CPA has confirmed these facts: Rae was still legally married to Drew on December 31; Drew moved out on May 20 and did not live in Rae’s home at any time from July 1 through December 31; Rae and Drew will not file a joint return; Rae’s 8-year-old daughter, Mia, lived with Rae for the entire year; Rae paid 65% of the cost of maintaining the household; Mia had no income and Rae may claim Mia as a dependent. What should the CPA do next for Rae’s filing status?

• A. Prepare Rae’s return using qualifying surviving spouse filing status.
• B. Prepare Rae’s return using single filing status.
• C. Prepare Rae’s return using married filing separately filing status.
• D. Prepare Rae’s return using head of household filing status.

Best answer: D

What this tests: Federal Taxation of Individuals

Explanation: Rae meets the special rule that treats some married taxpayers as unmarried for head of household purposes. Because she maintained a household for her qualifying child, paid more than half the costs, and her spouse did not live with her during the last six months, head of household is the most favorable allowable status.

Filing status is generally based on marital status at the end of the tax year, but a married taxpayer may qualify as head of household if treated as unmarried. The key requirements include filing a separate return, paying more than half the cost of maintaining the home, having the home be the principal home of a qualifying child for more than half the year, and the spouse not living in the home during the last six months of the year. Rae satisfies each requirement: she will not file jointly, paid 65% of household costs, Mia lived with her all year and is her dependent, and Drew was absent from July 1 through December 31.

• Married filing separately focuses only on Rae’s legal marriage, but it overlooks the special head of household rule for certain married taxpayers living apart.
• Single is unavailable because Rae was still legally married on December 31.
• Qualifying surviving spouse is not supported because the facts do not state that Drew died in a prior year.

Rae is treated as unmarried for head of household purposes because she lived apart from her spouse for the last six months, will not file jointly, paid over half the home costs, and maintained the home for her qualifying child.

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Related focused pages

• Free CPA REG Full-Length Practice Exam
• CPA REG: Ethics and Federal Tax Procedures
• CPA REG: Business Law
• CPA REG: Federal Taxation of Property Transactions
• CPA REG: Entity Taxation and Tax Preparation

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