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Free Questions › CPA › Tax Compliance and Planning
Free CPA Tax Compliance and Planning Practice Questions & Answers
400 exam-style Tax Compliance and Planning questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 301
The MORTALITY RISK in a GRAT is that:
Select an option first.
Correct answer: D — If the GRANTOR DIES during the term, the assets are pulled BACK INTO the estate — defeating the strategy
Explanation: If the grantor DIES during the GRAT term, some or all of the trust assets are INCLUDED in their estate — the strategy fails. This is why SHORT-TERM, ROLLING GRATs are often used: they limit mortality exposure while still capturing appreciation, and can simply be repeated.
Question 302
A FAMILY LIMITED PARTNERSHIP is used to:
Select an option first.
Correct answer: C — Transfer interests to family at DISCOUNTED values — reflecting lack of control and lack of marketability
Explanation: An FLP holds family assets; the senior generation gifts LIMITED PARTNERSHIP INTERESTS to children. Those interests are VALUED AT A DISCOUNT (typically 20-40%) for LACK OF CONTROL and LACK OF MARKETABILITY — so more value is transferred per dollar of exemption used. The IRS scrutinises these heavily, and a genuine non-tax business purpose is essential.
Question 303
VALUATION DISCOUNTS in an FLP require:
Select an option first.
Correct answer: B — A GENUINE non-tax BUSINESS PURPOSE and real economic substance — the IRS attacks purely tax-motivated structures
Explanation: The IRS aggressively challenges FLPs formed purely for discounts, using §2036 to pull the assets back into the estate. A DEFENSIBLE FLP requires a genuine business purpose (pooling assets for investment efficiency, consolidated management, creditor protection), respect for formalities, and the senior generation NOT retaining control or enjoyment.
Question 304
A QUALIFIED PERSONAL RESIDENCE TRUST (QPRT) transfers:
Select an option first.
Correct answer: C — A RESIDENCE at a DISCOUNTED gift value, with the grantor retaining the right to LIVE there for a term
Explanation: A QPRT: the grantor gifts the residence but RETAINS the right to live in it for a term of years. Because the beneficiaries' interest is deferred, its GIFT VALUE IS DISCOUNTED. If the grantor SURVIVES the term, the home (and all its appreciation) is out of the estate. If they die during the term, it comes back — the same mortality risk as a GRAT.
Question 305
After a QPRT term ends, the grantor who wishes to remain in the home must:
Select an option first.
Correct answer: A — PAY FAIR MARKET RENT to the beneficiaries — which is itself a further tax-free transfer of wealth
Explanation: After the term, the grantor must PAY MARKET RENT to continue living there. This is a FEATURE, not a bug: the rent shifts additional wealth to the beneficiaries WITHOUT using any gift tax exemption. Failing to pay rent risks estate inclusion under §2036.
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Question 306
A SALE to an IDGT is superior to a GRAT in that it:
Select an option first.
Correct answer: D — Has NO MORTALITY RISK (the assets are out even if the grantor dies) and can benefit GRANDCHILDREN (GST-exempt)
Explanation: The IDGT sale has TWO advantages over a GRAT: (1) NO mortality risk — the assets are out of the estate even if the grantor dies during the note term; and (2) it can be made GST-EXEMPT, benefiting grandchildren, which a GRAT cannot. The trade-off is greater complexity and a need for 'seed' capital.
Question 307
The GRANTOR's payment of an IDGT's income tax is:
Select an option first.
Correct answer: C — A TAX-FREE TRANSFER of wealth to the trust — the grantor is legally obliged to pay it, so it is NOT an additional gift
Explanation: Because the IDGT is a GRANTOR TRUST for income tax, the GRANTOR pays the tax on the trust's income. That payment DEPLETES the grantor's estate while the TRUST compounds UNBURDENED — and it is NOT treated as an additional gift, because the grantor is legally obliged to pay it. It is a tax-free wealth transfer engine that runs every year.
Question 308
A taxpayer selling a rental property with $200,000 of depreciation taken faces:
Select an option first.
Correct answer: D — UNRECAPTURED §1250 GAIN of up to $200,000 at 25%, plus LTCG on the remainder
Explanation: The depreciation taken comes BACK as UNRECAPTURED §1250 GAIN, taxed at up to 25% — a rate HIGHER than the 15/20% LTCG rate. Sellers routinely forget this and are surprised by the bill. A §1031 exchange DEFERS it; death ERASES it.
Question 309
A taxpayer who took NO depreciation on a rental property:
Select an option first.
Correct answer: B — STILL faces recapture on depreciation ALLOWED OR ALLOWABLE — you are taxed on what you SHOULD have taken
Explanation: Recapture applies to depreciation ALLOWED OR ALLOWABLE. Failing to claim depreciation does NOT avoid recapture — you are taxed on what you SHOULD have deducted, having received no benefit from it. It is the worst of both worlds, and the fix is a Form 3115 change of accounting method to claim the missed deductions.
Question 310
A taxpayer converting a RENTAL to a PRINCIPAL RESIDENCE, then selling:
Select an option first.
Correct answer: C — Cannot exclude gain allocable to NON-QUALIFIED USE, and NEVER excludes depreciation recapture
Explanation: §121 does NOT shelter: (1) DEPRECIATION recapture (ever); or (2) gain allocable to periods of NON-QUALIFIED USE (generally non-principal-residence use after 2008), which is PRORATED. Converting a rental to a residence does not wipe the slate clean, and the calculation is genuinely fiddly.
Question 311
A taxpayer converting a PRINCIPAL RESIDENCE to a RENTAL, then exchanging it under §1031:
Select an option first.
Correct answer: B — May use §1031 (it is now business property) — and may potentially COMBINE it with §121 if the residence tests were met
Explanation: Converting a residence to a RENTAL makes it §1031-eligible. If the §121 ownership and use tests were also met within the lookback period, the taxpayer may potentially EXCLUDE up to $250k/$500k of gain under §121 AND DEFER the remainder under §1031 — stacking both provisions on one property.
Question 312
A §1031 exchange into a property later converted to a PRINCIPAL RESIDENCE:
Select an option first.
Correct answer: D — Has a 5-YEAR OWNERSHIP requirement before §121 may apply, and the §121 exclusion is REDUCED for non-qualified use
Explanation: Property acquired in a §1031 exchange and LATER converted to a principal residence requires FIVE YEARS of ownership before §121 may be claimed (not the usual 2-of-5). And the exclusion is still reduced for non-qualified use, and never covers depreciation recapture. The rules deliberately blunt this combination.
Question 313
The estate planning implication of §1031 deferral is:
Select an option first.
Correct answer: C — The STEP-UP at death ERASES the entire deferred gain — deferral becomes PERMANENT EXCLUSION
Explanation: This is the crux. §1031 DEFERS the gain; §1014 ERASES it at death. A taxpayer who exchanges repeatedly for decades and dies holding the property passes it to heirs at a FULL STEP-UP — and the entire accumulated deferred gain is NEVER TAXED. Deferral has become elimination.
Question 314
A taxpayer with a large deferred §1031 gain who needs CASH should consider:
Select an option first.
Correct answer: C — A CASH-OUT REFINANCE — borrowing against the property is NOT a taxable event, and the gain remains deferred
Explanation: BORROWING is NOT a taxable event. A CASH-OUT REFINANCE extracts cash from the appreciated property WITHOUT triggering the deferred gain — which remains deferred until sale, or is erased at death. 'Buy, borrow, die' is the strategy, and this is the 'borrow' step.
Question 315
The 'BUY, BORROW, DIE' strategy works because:
Select an option first.
Correct answer: A — BORROWING is not taxable, and DEATH erases the gain via the step-up — so the appreciation is NEVER taxed
Explanation: BUY appreciating assets. BORROW against them for liquidity (not a taxable event, and the interest may even be deductible). DIE holding them — §1014 STEPS UP the basis and ERASES the gain permanently. The appreciation funds a lifetime of consumption and is never taxed. The step-up is the linchpin.
Question 316
An heir receiving property with a stepped-up basis who sells IMMEDIATELY:
Select an option first.
Correct answer: A — Owes LITTLE OR NO TAX — the basis equals FMV at death, so there is essentially no gain
Explanation: The step-up sets basis at FMV AT DEATH. Selling immediately produces essentially ZERO gain (only post-death appreciation). Decades of accumulated gain simply VANISH. This is why the step-up is the single most important provision in property tax planning.
Question 317
IRD (income in respect of a decedent) — such as a traditional IRA — receives:
Select an option first.
Correct answer: A — NO STEP-UP — it is taxed as ORDINARY income to the heir
Explanation: IRD (a traditional IRA, unpaid wages, accrued interest, instalment note payments) gets NO STEP-UP and is taxed as ORDINARY income to the heir. This is why an IRA is the WORST asset to leave to family and the BEST to leave to CHARITY — a charity pays no tax on it, while heirs pay ordinary rates.
Question 318
The best asset to leave to CHARITY is generally:
Select an option first.
Correct answer: B — A TRADITIONAL IRA (IRD) — the charity pays NO tax, whereas heirs would pay ORDINARY rates
Explanation: Leave the IRA to CHARITY (which pays no tax on it) and the APPRECIATED STOCK to HEIRS (who get a full step-up). Reversing this — leaving the IRA to heirs and the stock to charity — wastes both benefits, and is a genuinely expensive mistake.
Question 319
The best asset to leave to HEIRS is generally:
Select an option first.
Correct answer: D — APPRECIATED TAXABLE ASSETS — they receive the STEP-UP, erasing the gain entirely
Explanation: Leave HEIRS the APPRECIATED TAXABLE ASSETS — the §1014 step-up ERASES decades of gain. Leave the IRA (IRD, no step-up, ordinary income) to CHARITY. Matching the ASSET to the BENEFICIARY according to its tax character is one of the highest-value moves in estate planning.
Question 320
A CHARITABLE BENEFICIARY of an IRA pays:
Select an option first.
Correct answer: A — NO TAX — a qualified charity is tax-exempt, so the full IRA passes intact
Explanation: A charity is TAX-EXEMPT, so it receives the FULL IRA balance with NO income tax. An individual heir would pay ORDINARY income tax on every dollar (and must empty it within 10 years). The IRA is therefore worth substantially MORE to a charity than to an heir — which is precisely why it should go to the charity.
Question 321
A SECTION 1244 loss on small business stock is:
Select an option first.
Correct answer: A — ORDINARY (up to annual limits) — far more valuable, as it escapes the $3,000 capital loss cap
Explanation: §1244 converts what would be a CAPITAL loss into an ORDINARY loss (up to $50,000, or $100,000 MFJ, per year). Ordinary losses offset ordinary income WITHOUT the $3,000 annual cap. The stock must be C or S corporation stock, and the taxpayer must be the ORIGINAL holder. It is the downside protection that complements QSBS's upside.
Question 322
§1244 and §1202 together provide:
Select an option first.
Correct answer: B — UPSIDE (a §1202 gain exclusion) and DOWNSIDE (a §1244 ordinary loss) protection on the same small business stock
Explanation: An elegant pairing. If the venture SUCCEEDS, §1202 potentially EXCLUDES the gain. If it FAILS, §1244 converts the loss into an ORDINARY deduction. Heads you exclude the gain, tails you deduct the loss at ordinary rates. Both require careful attention to the entity type and holding requirements at FORMATION.
Question 323
A WORTHLESS SECURITY is deemed sold on:
Select an option first.
Correct answer: D — The LAST DAY of the tax year — which can convert a short-term loss into a long-term one
Explanation: A WORTHLESS SECURITY is deemed sold on the LAST DAY OF THE TAX YEAR. This can extend the holding period — stock bought in March and worthless in October is deemed sold on 31 December. The taxpayer must prove COMPLETE worthlessness, which is a genuinely high bar (a near-zero value is not enough).
Question 324
A taxpayer holding property with a LARGE built-in loss should:
Select an option first.
Correct answer: B — SELL it to REALISE the loss — gifting DESTROYS it, and death ERASES it (a step-DOWN)
Explanation: Loss property must be SOLD during life to capture the loss. GIFTING destroys it (the dual-basis rule limits the donee's loss basis to FMV). DEATH also destroys it — §1014 steps basis DOWN to FMV, erasing the loss just as it would erase a gain. The step-up cuts both ways.
Question 325
The §1014 basis rule at death is a STEP-DOWN when:
Select an option first.
Correct answer: A — The asset has DECLINED in value — basis is reset DOWN to FMV, DESTROYING the built-in loss
Explanation: §1014 sets basis to FMV at death — UP or DOWN. For a DEPRECIATED asset, that is a STEP-DOWN, permanently DESTROYING the built-in loss. The planning implication: SELL loss assets BEFORE death to capture the loss; HOLD gain assets to capture the step-up. The direction of the strategy depends on the direction of the gain.
Question 326
A §1031 exchange requires the taxpayer to acquire replacement property of:
Select an option first.
Correct answer: B — EQUAL OR GREATER VALUE, with EQUAL OR GREATER DEBT, and ALL proceeds reinvested — otherwise BOOT arises
Explanation: To FULLY defer: (1) buy EQUAL OR GREATER value; (2) reinvest ALL the equity; and (3) replace the DEBT (or add cash). Trading DOWN in value, or reducing debt without adding cash, creates BOOT and triggers gain to that extent.
Question 327
A taxpayer exchanging a $1m property with a $400k mortgage for an $800k property with a $200k mortgage has:
Select an option first.
Correct answer: A — BOOT — they traded DOWN in value and REDUCED debt, both of which are boot
Explanation: TRADING DOWN creates boot TWICE OVER: the $200,000 reduction in VALUE, and the $200,000 reduction in DEBT (debt relief is boot). Gain is recognised to the extent of the boot. To fully defer, you must trade UP in both value and debt — or add cash.
Question 328
Adding CASH to a §1031 exchange to offset debt relief:
Select an option first.
Correct answer: D — OFFSETS the debt relief — cash paid can be netted against debt relieved
Explanation: NETTING: debt RELIEF is boot RECEIVED; debt ASSUMED and CASH PAID are boot GIVEN. They are NETTED. So a taxpayer whose mortgage falls by $200,000 can offset it by contributing $200,000 of cash — restoring full deferral.
Question 329
A taxpayer's basis in §1031 replacement property is:
Select an option first.
Correct answer: D — Old basis + boot GIVEN - boot RECEIVED + gain RECOGNISED (equivalently, FMV less the DEFERRED gain)
Explanation: New basis = Old basis + boot given − boot received + gain recognised. Or, more intuitively: FMV of the new property MINUS the deferred gain. The deferred gain is EMBEDDED in the LOW basis — which means LOW depreciation going forward, a real cost of the deferral.
Question 330
The LOW basis in §1031 replacement property means:
Select an option first.
Correct answer: B — LOWER DEPRECIATION deductions going forward — a genuine ongoing cost of the deferral
Explanation: §1031 carries the OLD (low) basis forward. So the replacement property generates LESS DEPRECIATION than a property purchased outright at the same price. This is the hidden cost of exchanging: you defer the gain but sacrifice depreciation. The comparison must weigh both.
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