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Chapter 16

Chapter 16. Investment and Personal Financial Planning. Objectives. Interest and dividends Tax deferral: life insurance and annuities Capital gains and losses Qualified small business stock & Sec. 1244 stock Investment interest expense Passive activity losses Estate and gift tax rules.

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Chapter 16

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  1. Chapter 16 Investment and Personal Financial Planning

  2. Objectives • Interest and dividends • Tax deferral: life insurance and annuities • Capital gains and losses • Qualified small business stock & Sec. 1244 stock • Investment interest expense • Passive activity losses • Estate and gift tax rules

  3. Business versus Investment • Business activity • The taxpayer commits time and talent on regular basis • Profit is partially attributable to personal involvement • Investment activity • Taxpayer assumes a passive role as owner of income-producing property • Profit is primarily due to invested capital • Even a taxpayer who devotes substantial time to managing income-producing property is still engaging in an investment activity

  4. Investments in Financial Assets • Securities include • Common and preferred stock • Savings accounts, CDs, notes, and bonds • Individuals who invest in financial assets can own the assets directly or indirectly through a mutual fund • Mutual fund – diversified portfolio of securities owned and managed by a regulated investment company (RIC); the most popular investment vehicle on the market

  5. Investments in Financial Assets • Return on investment includes • Interest • Dividends • Reinvested dividends taxable but increase basis • Jobs Act of 2003 created new 15% (5% for those in the lowest two tax brackets) preferential rate for qualified dividend income earned by noncorporate shareholders • Gains (losses) • Mutual funds may report ‘distributed’ capital gains/losses; these are still taxable and increase basis even if no cash received

  6. Interest Income • Municipal bond interest income is tax-free at federal level for regular tax • If the bond is a private activity bond, the interest is an AMT preference • U.S. debt (bills, notes, bonds) interest is taxable at federal level (often exempt at state level) • Most pay interest every six months – taxable on receipt

  7. Interest Income - Bond Discount • Cash basis taxpayers generally recognize income when cash is received • Interest income rules are an exception - must recognize when earned, such as when original issue discount accrues • Exception for Series EE U.S. savings bond - delay income tax until bond is cashed (or may elect to be taxed currently) • OID is amortized using effective interest method • Market discount recognized when bond sold or matured

  8. Bond Discount Example • Mr. Ed bought a publicly-traded corporate bond for a price less than the face value of the bond. When is the discount recognized as interest income? • When the bond is sold or redeemed • What if Mr. Ed purchased a bond through a new public offering. When is the discount recognized as interest income? • Over the life of the bond even though no cash interest is received by Mr. Ed

  9. Deferral with Life Insurance or Annuities • Life insurance proceeds are not taxable income at death • Life insurance policies (but not term life policies) build up cash surrender value (CSV) for every year that the policy remains in effect • The owner does not recognize the annual increase in value – inside buildup – as taxable income unless the policy is liquidated; then the excess of CSV over premiums paid is taxable

  10. Deferral with Life Insurance or Annuities • Annuity contracts are not taxed until annuity payments are made • Taxation is like installment sales rules • Portion of annuity excluded = payment x ratio of (investment in annuity / expected return on annuity)

  11. Gains/Losses on Securities • Realization requires a sale or exchange • Gain/loss = [Proceeds – selling expenses] - adjusted basis • Character is capital - time period matters for favorable tax treatment

  12. Gains/Losses on Securities • Basis issues • Reinvested dividends increase total basis, while nontaxable distributions reduce total basis • Sale of stock uses either specific ID or FIFO method of matching basis with sales • Mutual fund shares sold typically use an average basis

  13. Sale of Securities Example • Mr. Ed owns 100 shares of Oats Inc. for which he paid $100 in 1980. He also purchased an additional 100 shares in 1990 for $250. Oats has paid dividends only twice - $1 per share in 1985 (when FMV was $1.25 per share) and $2 per share in 1995 (when FMV was $2.50 per share), both of which were reinvested. Mr. Ed sells 200 shares in the current year for $490, paying selling expenses of $49. He can’t determine which specific shares were sold. Calculate gain or loss on the sale of securities.

  14. Sale of Securities Example (continued) • Cost of shares purchased in 1980 $ 100 • Reinvested dividends ($100 / $1.25 = 80 sh.) 100 • Basis of 180 shares in 1985 $ 200 • Cost of shares purchased in 1990 $ 250 • Reinvested dividends ($360 / $2.50 = 144 sh.) 360 • Basis of 424 shares in 1995 $810 • Amount realized on sale ($490 - $49) $441 • Basis of first 180 shares (200) • Basis of remaining 20 shares ($250/100)x20 ( 50) Gain on sale of securities $191

  15. Capital Losses on Worthless Securities and Bad Debts • Worthless securities are treated as if they are sold on the last day of the tax year for $0; capital loss results - often long-term • Nonbusiness bad debts (e.g., personal loans) are treated as a short-term capital loss

  16. Exchanging Securities • General rule is that exchanges are taxable (e.g. Intel for Nike) • Nontaxable if • The stocks are in the SAME corporation, or • Part of a nontaxable reorganization, such as a merger • Basis of original stock becomes basis of new stock - this creates deferral of gain or loss

  17. Exchange of Securities Examples • Identify the following exchanges as either nontaxable or taxable • Jay exchanged 5 shares of ABC common stock for 2 shares of XYZ common stock • Taxable exchange • Jay exchanged 5 shares of ABC Class A voting common stock for 7 shares of ABC Class B voting common stock • Nontaxable exchange

  18. Exchange of Securities Examples • Jay exchanged 2 shares of ABC common stock for 2 shares of ABC preferred stock • Taxable exchange • Jay exchanged 10 shares of ABC common stock for 5 shares of XYZ common stock as part of a reorganization • Nontaxable exchange

  19. Taxation of Capital Gains and Losses • SHORT TERM asset held for <= 1 year • LONG TERM asset held for > 1 year • Separate 28% rate category for collectibles and sale of qualified small business stock • Net the gains and losses in each class (net ST, net LT, net 28%)

  20. Netting and Tax Rates - Net Loss • Net the net ST gain/loss with the net LT gain/loss • IF the total net capital gain/loss is a LOSS • Deduct $3,000 against ordinary income • Carryforward remainder indefinitely • Ken sold ABC stock which he had owned for more than 12 months at a loss of $5,000. He earned $25,000 in wage income. What is Ken’s gross income? • $25,000 - $3,000 = $22,000 • $2,000 long-term capital loss carryover

  21. Netting and Tax Rates - Net Gain • IF the total net capital gain/loss is a GAIN • Any NET ST gain is taxed at regular rates • Any NET 28% is taxed at maximum 28% rate • Any other NET LT is taxed at 15% (5% if the individual is in 10/15% ordinary bracket) • Any Section 1231 gain treated as capital which is attributed to unrecaptured realty depreciation (Sec. 1250) is taxed at maximum 25%

  22. Capital Gains/Losses Example • Ken sold the following investments during the year PurchasedSoldBasisProceeds ABC stock 02/02/02 02/10/07 $ 500 $ 450 LMN stock 07/20/07 10/25/07 $1,000 $ 600 Coins 04/30/01 07/05/07 $ 200 $ 750 • If Ken is in the 35% tax bracket, how much tax will Ken pay on the above transactions?

  23. Capital Gains/Losses Example PurchasedSoldBasisProceeds ABC stock 02/02/02 02/10/07 $ 500 $450 ($50) LT LMN stock 07/20/07 10/25/07 $1,000 $600 ($400) ST Coins 04/30/01 07/05/07 $ 200 $750 $550 LT 28% Net gains/losses in each class: [$550 - $50] = $500 LT 28% gain; $400 ST capital loss Net the net ST gain/loss with the net LT gain/loss: [$500 - $400] = $100 LT 28% gain; $100 x .28 = $28 tax

  24. Capital Gains/Losses Example PurchasedSoldBasisProceeds ABC stock 02/02/02 02/10/07 $ 500 $450 ($50) LT LMN stock 07/20/07 10/25/07 $1,000 $600 ($400) ST Coins 04/30/01 07/05/07 $ 200 $750 $550 LT 28% • What if Ken were in the 15% tax bracket instead? • The netting remains the same, but the resulting $100 of 28% gain is taxed at 15% • $100 x .15 = $15 capital gain

  25. Investments in Small Business • To encourage individuals to invest in risky start-up corporations, the tax law contains two preferential provisions • Gain on Qualified small business stock (<=$50 million assets after issue; issued after 8/10/93) • Exclude 50% gain if held >5 years • Remaining gain is 28% rate gain • Only applies to the original purchaser of the stock • Loss on Section 1244 stock (1st $1million issued stock) is ordinary loss up to $100,000 for MFJ ($50,000 single, MFS) returns • Excess loss is capital loss • Gain on Section 1244 stock still qualifies as capital

  26. Investment Expenses • Other investment expenses (but not interest) are deductible to the extent they (with other miscellaneous expenses) exceed 2% of AGI • Investment fees, investment publications, seminars • Investment interest expense is deductible up to net investment income (investment income less investment expenses other than interest) • Investment income includes interest, dividend, annuities, STCG • PLUS, if elect to be taxed at ordinary rates, may include LTCG in investment income • Carry forward any excess interest expense indefinitely and deduct in future tax years

  27. Investment Interest Expense: Example • AGI = $100,000 • Investment advice fees = $3,000 • Investment interest expense = $15,000 • Dividends = $13,000 and LTCG = $5,000 • What is the maximum investment interest expense the taxpayer can deduct? • ($13,000 + $5,000) – [$3,000 – ($100,000 x .02)] = $17,000; the full $15,000 of investment interest may be deducted if elect to tax LTCG at ordinary rates • If taxpayer does not elect to include LTCG, how much investment interest expense can he deduct? • $13,000 – $1,000 = $12,000 deductible

  28. Real Estate Investments • Land is generally a capital asset - appreciation is taxed at favorable rates upon sale • Real estate taxes paid are deductible in determining investment income • Mortgage interest payments are investment interest expense • Frequent sales of land may cause land to be viewed asinventory: especially if substantial improvements are made

  29. Rental Real Estate • Report rental income and expenses on Schedule E • Rental property is depreciated using either a 27.5 or 39 year recovery period • While rental real estate activities may have many business characteristics, they are actually passive activities

  30. Passive Activities • Definition: an interest in a business where the owner does not materially participate • Material participation requires involvement in day-to-day operations on a regular, continuous and substantial basis • The classification of a business interest as a passive activity does not effect how income is taxed but does effect the deductibility of losses

  31. Passive Loss Limitation • Loss on passive activity is only deductible to the extent of other passive income • Excludes active income (wages, income from material activities), and excludes portfolio income (interest, dividends) • Excess losses are carried forward indefinitely • Taxpayer can deduct unused losses at disposition of the business interest

  32. Rental Activities • Rental activities in which revenues are mainly derived from the lease of tangible property for an extended period of time are passive • Passive rental activities do not include • Hotels • Automobile rentals • Tuxedo rentals • Videocassette or DVD rentals

  33. Passive Activity Exception for Rental Real Estate • Passive rental losses up to $25,000 can be deducted if the taxpayer • Actively manages the property and • Has MFJ AGI less than $100,000 (phases out fully at $150,000) • The passive activity loss rules are far more complex than this text explores

  34. Passive Activity Loss Example • Sue, a physician, bought shares in an S corporation; during the first year of operations, her share of S corporation losses were $20,000 and her wages were $150,000 • What is Sue’s gross income if the S Corporation operates a chain of laundromats? • $150,000; the S corporation income is passive and cannot be deducted against wage income • What is Sue’s gross income if she also owns a limited partnership interest generating $25,000 of passive income? • $155,000; the S corporation loss can be deducted against the passive income. Net passive income of $5,000 is taxable

  35. The Transfer Tax System • The federal transfer tax system has 3 components • Gift, estate, and generation skipping transfer taxes • The unified gift and estate tax is based on cumulative transfers during lifetime and at death • Graduated rates up to 45% in 2007 • In 2001, Congress repealed the estate and generation-skipping taxes effective in 2010 (but return in 2011 under ‘sunset’ provisions!)

  36. Gift Tax • Remember, all receipts of gifts are excluded from INCOME taxation. We are now discussing GIFT taxation • A donor may exclude $12,000 per year per donee from taxable gifts • No gift tax on gifts to spouse or charities, and payment of tuition or medical costs of another individual • Can treat gift by one spouse as made 1/2 by other spouse allowing a couple to gift $24,000 per donee

  37. Gift Tax Exclusion • If the FMV of a gift exceeds the annual exclusion, the excess is a taxable gift. However, a donor does not pay gift tax until the cumulative amount of taxable gifts exceeds the donor’s lifetime gift tax exclusion of $1 million

  38. Income Tax Effects of Gifts • Gift is not taxable income to donee • Donor’s adjusted basis in the property carries over to become the donee’s new basis • Exception - use FMV if less than donor’s adjusted basis • After the gift, any income derived from the property belongs to the donee and is taxable • Can result in significant tax savings within afamily

  39. Kiddie Tax • Unearned income of children < 14 years old in excess of $850 in 2007 is taxed at the parent’s marginal tax rate • Child’s standard deduction is limited to the GREATER of • $850, or • Earned income + $300 • Families can avoid the kiddie tax by giving assets that yield deferred rather than current income

  40. Estate Tax • The taxable estate includes the FMV of all assets owned by the decedent and transferred under a valid will and other property transferred because of death (e.g., life insurance) • Estate tax exclusion of $2 million (2007) reducedby use of lifetime gift tax exemption • Taxed at unified estate and gift rate schedule • Unlimited marital deduction is allowed • Reduce estate by taxes, charitable contributions, administrative expenses, and decedent’s debts

  41. Income Tax Effect of Bequests • Receipt of a bequest is not taxable income to heir • Basis = FMV at date of death • Appreciation in property is never taxed • In 2010, bequests will have a carryover basis

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