Vous êtes sur la page 1sur 69

Chapter 7

Investments

McGraw-Hill Education

Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.

Investments Overview

Before-tax rate of return on investment


After-tax rate of return on investment
Depends on when investment income is taxed
Relates

to timing tax planning strategy

Depends on the rate at which the income is


taxed
Relates

to the conversion tax planning

strategy

Portfolio vs. Passive investments

Portfolio losses deferred until investment is sold


Passive investment losses may be deducted annually

Portfolio Income: Interest and


Dividends
Usually

taxable when received


Interest from bonds, CDs, savings accounts

Ordinary income taxed at ordinary rate unless


municipal bond interest
Interest from U.S. Treasury bonds not taxable by
states

Dividends

on stock

Typically taxed at preferential capital gains rate

Example 7-1
Assume on January 1 of year 1 the Suttons invest the
$50,000 earmarked for the Park City vacation home in
General Electric (GE) bonds that mature in exactly five
years and the $50,000 designated for Lea's education
in GE bonds that mature in exactly 18 years. They will
purchase both bonds at face value, and both bonds
will pay 8 percent interest annually. How much interest
income will Nick and Rachel report from this
investment at the end of the first year?
Answer: $8,000. $4,000 of interest income ($50,000
.08) from each bond in the first year of the
investment.

Assuming they reinvest their annual after-tax


interest payments in the GE bonds, what
annual after-tax rate of return will they earn on
the bonds over the 5- and 18-year investment
periods, and what amount will the Suttons
receive 5 and 18 years from now when the
bonds mature? (Remember from the opening
story-line, the Sutton's marginal tax rate is
30%.)

Corporate and U.S. Treasury Bonds

Special rules apply for determining the timing and amount of interest
from bonds when there is a bond discount - the result of issuing
bonds for less than their maturity value. (bonds are issued at an
amount below the maturity value) or a bond premium the result of
issuing bonds for more than their maturity value. (bonds are issued
at an amount above the maturity value).
Corporate bonds, Treasury bonds and Treasury notes, - debt
instruments issued by the U.S. Treasury at face value, at a discount,
or at a premium, with a set interest rate and maturity date that pays
interest semiannually.
Treasury bonds have terms of 30 years., Treasury notes have
terms of 2, 5, or 10 years. Treasury bonds and Treasury notes pay a
stated rate of interest semiannually.
Corporate bonds may pay interest at a stated coupon rate or they
may not provide any periodic interest payments.
Zero-coupon bonds are Corporate bonds that do not pay periodic
6
interest and pay interest only at maturity..

Corporate and U.S. Treasury Bonds


(1) interest from Treasury bonds is exempt from state taxation while interest from
corporate bonds is not and
(2) Treasury bonds always pay interest periodically while corporate bonds may
or may not.
The tax rules for determining the timing and amount of interest income from
corporate and U.S. Treasury bonds are as follows:
Taxpayers include the actual interest payments they receive in gross income.
If the bond was issued at a discount, special original issue discount a type of
bond issued for less than the maturity or face value of the bond. (OID) rules
apply.
Taxpayers are required to amortize the discount and include the amount of the
current year amortization (the method of recovering the cost of intangible assets
over a specific time period) in gross income in addition to any interest
payments the taxpayer actually receives.
Corporate zero-coupon bonds, - taxpayers must report and pay taxes on
income related to the bonds even though they did not receive any payments
from the bonds. Bond issuers or brokers are responsible for calculating the
yearly amortization of original issue discount and providing this information to
investors using Form 1099-OID.

Bonds issued at a Premium


Taxpayers

may elect to amortize the bond

premium.
Taxpayers are responsible for determining the
yearly amortization of bond premium.
The amount of the current year amortization
offsets a portion of the actual interest payments
that taxpayers must include in gross income.
The original tax basis of the bond includes the
premium and is reduced by any amortization of
bond premium over the life of the bond.
8

Example 7-2
Assume that Nick and Rachel decided to invest the $50,000
earmarked for the Park City vacation home in either:
(1) Series EE savings bonds that mature in exactly five years, (At
the end of the first year, the redemption value of the EE
savings bond would be $54,080)
(2) original issue AMD Corporation zero-coupon bonds that mature
in exactly five years. ( Taxpayers would receive a Form 1099-OID
from AMD reporting $4,080 of OID amortization for the year) or
(3) U.S. Treasury bonds that pay $46,250 at maturity in five years
trading in the secondary bond market with a stated annual interest
rate of 10 percent. (Taxpayers would receive two semiannual
interest payments of $2,312.50 from the Treasury bonds).
Further, assume that all bonds yield 8 percent annual before-tax
returns compounded semiannually.
Under the general rules, how much interest income from each bond
would Nick and Rachel report at the end of the first year?
9

ANSWER
$0 from the Series EE savings bonds, $4,080 from the AMD bonds, and

$4,625 (two semiannual payments of $2,312.50) from the Treasury bonds.


Suttons could elect to include the $4,080 increase in redemption value of
the Series EE bond in interest income. (NOT A GOOD IDEA)
They also could elect to amortize $637.50 of the $3,750 premium ($50,000
purchase price less the $46,250 maturity value) on the Treasury bond to
offset the $4,625 in actual interest payments they received on the bond
(probably a good idea).
The calculations required to amortize the premium on the Treasury bond for
the first year are reflected in the following table:

10

BOND IS PURCHASED IN THE SECONDARY MARKET AT A


DISCOUNT

Taxpayer treats some of or all of the market discount (the


difference between the amount paid for a bond in a market
purchase rather than at original issuance when the amount
paid is less than the maturity value of the bond.) as interest
income when the bond is sold or matures.
The maturity of a debt instrument is generally the life of the
instrument at which a payment of the face value is due or the
instrument terminates.,
A ratable amount of the market discount (based on the
number of days the bond is held over the number of days until
maturity when the bond is purchased), is called the accrued
market discount and is treated as interest income when a
bond with market discount is sold before it matures. If the
bond is held to maturity, the entire bond discount is treated as
interest income at maturity.
11

BOND IS PURCHASED IN THE


SECONDARY MARKET
If the bond is purchased in the secondary bond market at a
premium, the premium is treated exactly like original issue
bond premiums.
The taxpayer may elect to amortize the market premium (the
difference between the amount paid for a bond in a market
purchase rather than at original issuance when the amount
paid is greater than the maturity value of the bond.) to reduce
the annual interest income received from the bond.
Otherwise, the premium remains as part of the tax basis of
the bond and affects the capital gain or loss the taxpayer
recognizes when the taxpayer sells or redeems the bond

12

U.S. Savings Bonds


U.S.

savings bonds such as Series EE or Series I bonds are issued at


either face value or at a discount.
These bonds do not pay periodic interest; rather, interest accumulates
over the term of the bonds and is paid when investors redeem them at
maturity or earlier.
The amount of interest income taxpayers recognize when they redeem
the bonds is the excess of the bond proceeds over the taxpayer's basis
(purchase price) in the bonds.
BASIS is a taxpayer's unrecovered investment in an asset that provides
a reference point for measuring gain or loss when an asset is sold.
Taxpayers may elect to include the increase in the bond redemption
value in income each year, but this is generally not advisable because it
accelerates the income from the bond without providing any cash to pay
the taxes.
interest from Series EE and Series I bonds may be excluded from gross
income to the extent the bond proceeds are used to pay qualifying
educational expenses. However, this exclusion benefit is subject to
phase-out based on the taxpayer's AGI.
13

U.S. Savings Bonds Vs Corporate Bonds


U.S. Savings Bonds Compare favorably with
corporate bonds because any interest related to
the original issue discount on savings bonds is
deferred until the savings bonds are cashed in.
In comparison, any original issue discount on
corporate bonds must be amortized and
included in the investors annual tax returns.
Also, interest from savings bonds used to pay
for qualifying educational expenses may be
excluded entirely from income whereas interest
from corporate bonds must eventually be
reported.

14

Exhibit 7-2
Timing of Interest Payments and Taxes

15

Portfolio Income: Dividends

Qualified Dividends

Dividends must be paid by domestic or certain foreign


corporations that are held for a certain length of time
Subject to preferential tax rate
15% generally
0% if would have been taxed at 10% or 15% if it had been
ordinary income
20% if would have been taxed at 39.6% if it had been
ordinary income
After tax rate of return assuming 8% before-tax rate of
return

.08(1 - .15) = 6.8%

Nonqualified dividends are taxed as ordinary income

Portfolio Income: Interest and


Dividends
Why

invest in assets yielding interest or


dividends?
Non-tax factors
Risk
Diversification
Others

DIVIDENDS AND INTEREST


Both the interest from Treasury bonds and dividends
are taxed by cash method taxpayers in the year they
are received.
Interest is taxed using ordinary rates while qualified
dividends are taxed at lower capital gains rates.
The interest from Treasury bonds is exempt from state
income taxes while dividends are subject to state
income taxes.
Qualified dividends are taxed at capital gains rates to
mitigate the effect of double taxation on corporate
earnings.

18

Portfolio Income:
Capital Gains and Losses
Investments

held for appreciation potential

Growth stocks
Land
Mutual funds
Other assets (precious metals, collectibles, etc.)

Portfolio Income:
Capital Gains and Losses
Investments

held for appreciation potential

Gains deferred for tax purposes


Generally taxed at preferential rates
Special loss rules apply

These

types of investments are generally


investments in capital assets

DEFER ACCRUED GAINS

Taxpayers are allowed to defer accrued gains on capital


assets until the date of sale because the investment
doesnt provide the wherewithal (i.e., cash) to pay the tax
on the accrued gains until after it is sold.
When the taxpayer sells the asset, the investment
should provide the cash necessary to pay the taxes due
on the gain.
These preferential rates are meant to encourage
taxpayers to invest in those assets and to hold those
assets for the long term. The government believes this
will help the national economy by stimulating the
demand for risky investments.

21

TAX BASIS

When a taxpayer sells a capital asset for more than its


tax basis (the amount of a taxpayer's unrecovered cost
of or investment in an asset.,) the taxpayer recognizes a
capital gain;
If a taxpayer sells a capital asset for less than its tax
basis, the taxpayer recognizes a capital loss (to the
extent the loss is deductible).
The amount realized or selling price of a capital asset
includes the cash and fair market value of other property
received, less broker's fees and other selling costs.
The basis of any asset, including a capital asset, is
generally the taxpayer's cost of acquiring the asset,
including the initial purchase price and other costs
incurred to purchase or improve the asset.
22

Portfolio Income:
Capital Gains and Losses

Capital asset is any asset other than:


Asset used in trade or business
Accounts or notes receivable acquired in business from sale of services
or property
Inventory
Sale of capital assets generates capital gains and losses
Specific identification vs. FIFO
Long-term if capital asset held more than a year
Short-term if capital asset held for year or less
Holding a capital assets for more than one year before selling utilizes
two basis strategies.

(1) defers recognizing capital gains thereby reducing the present


value of the capital gains tax due when the asset is sold.

(2) by converting the capital gain into a long-term capital gain, the
gain is taxed at a preferential tax rate of 0%/15%/20% instead of
ordinary income tax rate

Portfolio Income:
Capital Gains and Losses

Capital gains

Net short-term capital gains taxed at ordinary rates


Generally net capital gains (net long-term capital gains in
excess of net short-term capital losses) taxed at a
maximum preferential rate of 0, 15, or 20% depending on
the rate at which the gain would have been taxed if it had
been ordinary income.
Unrecaptured 1250 gain from the sale of depreciable real
estate is taxed at a maximum rate of 25%
Long-term capital gains from collectibles and qualified small
business stock are taxed at a maximum rate of 28%.

Capital Gains
Capital gains

(Taxpayers must maintain accurate records to track their


basis in capital assets.)
Taxpayers who haven't adequately tracked the basis in their
stock are required to use the first-in first-out (FIFO) method
(an accounting method that values the cost of assets sold under
the assumption that the assets are sold in the order purchased
(i.e., first purchased, first sold). for determining the basis of the
shares they sell.
If Taxpayer maintains good records, they can use the specific
identification method (an elective method for determining the
cost of an asset sold).
Under this method, the taxpayer specifically chooses the assets
that are to be sold. to determine the basis of the shares they
25
sell.

Example 7-4

After Rachel's car broke down, Nick and Rachel decided


to buy a new one. To fund the down payment, they sold
200 shares of Cisco stock at the current market price of
$40 per share for a total amount realized of $8,000. The
Suttons held the following blocks of Cisco stock at the
time of the sale:
How much capital gain will the Suttons recognize if they
use the FIFO method of computing the basis in the Cisco
shares sold?

26

Answer 7-4
$3,000.

$8,000 amount realized ($40 200) minus $5,000 FIFO


basis ($25 200). As indicated in the table above, under the FIFO
(oldest first) method, they are treated as though they sold the stock
held for five years.

What

if: How much capital gain will the Suttons recognize if they
use the specific identification method of computing the basis in the
shares sold to minimize the taxable gain on the sale?

Answer:

$1,600. $8,000 amount realized ($40 200) minus


$6,400 ($32 200). To minimize their gain on the sale under the
specific identification method, the Suttons would choose to sell the
200 shares with the highest basis. As indicated in the table above,
the shares with the higher basis are those acquired and held two
years for $32 per share.
27

EXHIBIT 7-4
Classification of Capital Gains by Maximum Applicable Tax Rates

*Lower rates will apply when the taxpayers ordinary rate is less than the rates reflected in this exhibit.
+This gain is taxed at 0 percent to the extent it would have been taxed at a rate of 15 percent or less if it were ordinary
income, taxed at 20 percent to the extent it would have been taxed at 39.6 percent as ordinary income, and taxed at 15
percent otherwise.

28

Unrecaptured 1250 Gain


Unrecaptured

1250 gain (gain from the sale of real estate held


by a noncorporate taxpayer for more than one year in a trade or
business or as rental property attributable to tax depreciation
deducted at ordinary tax rates.)
This gain is taxable at a maximum 25% capital gains rate.
Generally the lesser of (1) the recognized gain or (2) the
accumulated depreciation on the property.
Gains from depreciable real property in excess of this
unrecaptured 1250 gain amount may be treated as long-term
capital gains subject to a maximum 25 percent tax rate.
Even though unrecaptured 1250 gains are treated as long-term
capital gains, they are taxed at a rate higher than most other longterm capital gains because the depreciation deductions
responsible for these gains previously reduced the seller's
ordinary income taxable at higher ordinary rates
29

Collectibles and 1202 Gain

Gains from two types of capital assets are taxable at a


maximum 28 percent rate.

The first type, collectibles consists of works of art, any rug or


antique, any metal or gem, any stamp or coin, any alcoholic
beverage, or other similar items held for more than one year.
The second type is qualified small business stock In general.
1202 defines qualified small business stock as stock received at
original issue from a C corporation with a gross tax basis in its
assets both before and after the issuance of no more than
$50,000,000 and with at least 80 percent of the value of its assets
used in the active conduct of certain qualified trades or businesses.
After holding Stock for more than five years, taxpayers may exclude
half of the gain on the sale from regular taxable income (100 percent
if the stock was acquired after September 27, 2010, and before
January 1, 2014). Capital gain not excluded from income is taxed at
28 percent.
Recaptures a portion of the benefit from the 50 percent exclusion
available when stock is sold after five years
30

Portfolio Income:
Capital Gains and Losses
Capital

losses

Individuals (including MFJ) are allowed to deduct


up to $3,000 of net capital loss against ordinary
income. Remainder carries over indefinitely to
subsequent years.

Capital losses

Capital losses
Individuals

allowed to deduct up to $3,000 of net capital


loss against ordinary income.

Individual capital losses that are not deducted in the current


year are carried forward indefinitely and treated as though
they were incurred in the subsequent year.
A third strategy is to sell investments with built-in
losses.
Selling loss assets reduces taxes by providing up to a $3,000
deduction against ordinary income and by reducing the
amount of capital gains that would otherwise be subject to tax
during the year.
This is particularly beneficial for a taxpayer with short-term
capital gains that would be taxed at high ordinary rates absent
offsetting capital losses.
32

Capital Gain/Loss Netting


Process
Step 1: Combine all short-term capital gains and losses for
the year and any short-term capital loss carryforward. If
negative, a net short-term capital loss or if positive a net
short-term capital gain.
Step 2: Combine all long-term capital gains and losses for the
year and any long-term capital loss carryforward. If negative,
a net long-term capital loss or if positive a net long-term
capital gain.
Step 3: If the results from steps 1 and 2 are both positive or
negative, stop the netting process. Otherwise, net the results
from steps 1 and 2.

Capital Gain/Loss Netting


Process
If additional netting is required in Step 3, four outcomes are possible:

Net short-term capital gain if net short-term capital gains exceed


net long-term capital losses

Net long-term capital gain (also referred to as net capital gain) if


net long-term capital gains exceed net short-term capital losses

Net short-term capital loss if net short-term capital losses exceed


net long-term capital gains

Net long-term capital loss if net long-term capital losses exceed


net short-term capital gains

Netting Gains and Losses from 0%/15%/20% , 25 Percent, and 28


Percent Capital Assets Continued
Step

4: Separate all long-term capital gains and losses into the three
separate rate groups. Any long-term capital loss carried forward from the
previous year is placed in the 28 percent group. By definition the 25
percent group includes only gains.
Step 5: Net the gains and losses in the 0%/15%/20% group. If the result is
a net loss, move the net loss into the 28 percent group. If the result is a
net gain, leave the net gain in the 15 percent group and proceed to Step
9.
Step 6: If the Step 1 result is a short-term capital loss, move the loss into
the 28 percent rate group. Otherwise, ignore this step.
Step 7: Net the gains and losses in the 28 percent rate group to
determine if there is a net gain or loss in this group. Net gains in this group
are taxed at a maximum rate of 28 percent. Net losses move to the 25
percent group.
Step 8: Net the 25 percent gains with the net loss determined in Step 7.
Net gains are taxed at a maximum rate of 25 percent. Net losses move to
the 15 percent rate group.
Step 9: Net the 0%/15%/20% net gain from Step 5 with the net loss from
35
Step 8. This gain is taxed at a maximum 15 percent rate.

Report Gains and Personal Use


Assets

Reporting Capital Gains. When taxpayers sell capital assets,


they report their sales on Schedule D of Form 1040 (dates of sale
and purchase are additional items provided on Schedule D).

The gain from the sale of a personal-use asset is taxable


even though it was not purchased for its appreciation
potential. The tax rate on the gain depends on the amount of
time between the date of the purchase and the date of sale.

Losses on the Sale of Personal-Use Assets


losses on the sale of personal-use assets are not deductible,
and therefore never become part of the netting process.
Capital Losses on Sales to Related Parties When taxpayers sell
capital assets at a loss to related parties, they are not able to
deduct the loss.
36

Capital Gain/Loss Question


Ferdinand

has the following gains/losses:

Short-term capital gain: $13,000


Short-term capital loss: ($8,000)
Long-term capital gain: $3,000
Long-term capital loss: ($12,000)

What is the amount and character of


Ferdinands gains and/or losses for the year?

Capital Gain/Loss Solution

Steps 1 and 2: Combine short-term items and longterm items

Net short-term gain: $5,000


Net long-term loss: ($9,000)

Step 3: Because they are of opposite sign, combine


the net short-gain with the net long-term loss.

Net long-term capital loss: ($4,000)


Ferdinand can deduct ($3,000) of the loss as a for AGI
deduction this year. The remaining ($1,000) loss will carry
forward indefinitely but will retain its character as a longterm capital loss.

Limitations on Capital Losses


Special

rules apply to the sale of personaluse assets

Gains are taxable as capital gains


Losses are not deductible

Capital

losses from sales to related persons


are not deducted currently.

The related person may subsequently be able to


deduct, all, a portion, or none of the disallowed
loss on a subsequent sale of the property by the
related party.

Limitations on Capital Losses


The

wash sale rule disallows the loss on


stocks sold if the taxpayer purchases the
same or substantially identical stock within
a 61-day period centered on the date of sale.

30 days before the sale


the day of sale
30 days after the sale

Intended

to ensure that taxpayers cannot


deduct losses from stock sales while
essentially continuing their investment.

Wash Sale
A

wash sale is a tax term that applies to transactions in which a


taxpayer purchases the same stock or substantially identical
stock to the stock they sold at a loss within a 61-day period
centered on the date of the sale.
A wash sale occurs when an investor sells or trades stock or
securities at a loss and within 30 days either before or after the day
of sale buys substantially identical stocks or securities. Because
the day of sale is included, the 30 days before and after period
creates a 61-day window during which the wash sale provisions
may apply.
The purpose of the wash sale tax rules is to prevent taxpayers
from accelerating losses on securities that have declined in value
without actually changing their investment in the securities. The
61-day period ensures that taxpayers cannot deduct losses from
stock sales while essentially continuing their investment in the
stock.

41

Wash Sale Question


Kim

owns 10 shares of Tower, Inc. with a


basis of $40 per share. On December 5 of
the Year 1, she acquires 10 more shares of
Tower, Inc. for $30 a share. On December 31
of year 1, she sells her original 10 shares for
$30 a share.
What loss does Kim recognize on the sale?
What is the basis in Kims remaining 10
shares of Tower, Inc.?

Wash Sale Solution


Because

Kim purchased Tower stock within


30 days of the day she sold the Tower stock
at a loss, the wash sale provisions apply to
disallow the entire ($100) loss.
Kim adds the disallowed loss of ($100) to the
basis of the 10 shares she acquired on
December 5. Her basis in these shares is
increased from $300 to $400.

Wash Sale Solution


If

Kim had purchased the stock on November


30 or earlier or if she had purchased the
stock on January 31 of year 2 or later she
would have been able to deduct the entire
loss.

TAX PLANNING STRATEGIES

Tax planning strategies


Hold capital assets for more than a year
Taxed at preferential rate
Tax deferred
Loss harvesting - a productive strategy for managing investments in
capital assets is to sell investments with built-in losses. By selectively
selling loss assets, taxpayers can reduce their taxes by deducting up to
$3,000 against their ordinary income and by reducing the amount of
capital gains that would otherwise be subject to tax during the year.
This is particularly beneficial for taxpayers who have short-term capital
gains that will be taxed at higher ordinary rates absent offsetting capital
losses.
Offset other (short-term) capital gains
Individual taxpayers with a net capital loss for the year may
deduct up to $3,000 of the capital loss against ordinary income.
Net capital losses in excess of $3,000 ($1,500 if married filing
separately) retain their short or long-term character and are
carried forward.
- Must balance tax with nontax factors
What happened to the stock market in 2008?
45

Taxes in the Real World Seeking LongTerm Capital Gains and Diversification
Investors seeking long-term capital gains and diversification of their
investments frequently invest in so-called tax efficient mutual funds.
Like other mutual funds, tax efficient mutual funds invest in a portfolio
of stock and other securities; but, unlike other mutual funds, they
actively employ tax planning strategies to reduce current distributions
and to increase the likelihood that recognized investment gains will be
taxed at favorable long-term capital gains rates. One basic tax
planning strategy they employ is a simple buy and hold strategy
rather than frequently trading securities the way other mutual funds do.
Exchange traded funds, or ETFs, are also popular among traditional
investors in tax efficient mutual funds. ETFs are securities that typically
derive their value from an investment index such as the S&P 500.
Thus, like tax efficient mutual funds, they provide a measure of
investment diversification. However, unlike tax efficient mutual funds
whose actions determine when and how investment returns are taxed,
investors in ETFs have greater control over the timing and character of
investment returns from ETFs because ETFs are treated like
individual stocks for tax purposes.
46

Municipal Bonds
Offer

a lower rate of interest because the


interest is tax exempt.
Differences in rates of returns of municipal
bonds and taxable bonds are sometimes
referred to as implicit taxes.
This is different than explicit taxes which
are actually levied by and paid to
governmental entities.
In choosing between taxable and nontaxable
bond marginal tax rate is important
Natural

clienteles
47

Municipal bonds
Municipal

bonds are debt instruments issued


by state and local governments to build roads,
schools, and for other governmental needs.
Similar to U.S. Treasury securities, municipal
bonds are generally considered to be less
risky than corporate bonds.
In most cases, municipal bond interest is not
subject to federal income tax.
However, it may be subject to state income
taxes if the bondholder holds municipal bonds
from a state that is not the state of his primary
48
residence.

Implicit Tax
The

price of tax-advantaged assets like municipal bonds is bid up in


competitive markets relative to the price of similar assets, like
corporate bonds, without tax advantages. The higher price paid for
tax-advantaged assets reduces the rate of return on these assets
relative to other similar assets without tax advantages. This
difference in rates of return represents an implicit tax on taxadvantaged assets.

taxpayer would have to calculate weather her implicit tax rate is


greater than or less than her individual marginal tax rate (explicit
rate) before deciding to purchase municipal bonds. If her explicit
tax rate exceeds her implicit tax rate on municipal bonds, she will
prefer municipal bonds over taxable bonds all else being equal.

Taxpayers

with high marginal tax rates prefer tax-favored


investments like municipal bonds because the explicit tax that
taxpayers with high marginal tax rates avoid is greater
than the
49
implicit tax they incur when purchasing municipal bonds.

Investment Expenses

Taxpayers can deduct ordinary and necessary business


expenditures when conducting business activities,
Individual taxpayers are allowed to deduct ordinary and
necessary expenses they incur in investment activities to
produce or collect income and for expenses they pay or
incur to manage property held for producing income.
Such as safe deposit box rental fees, attorney and
accounting fees that are necessary to produce investment
income,
Expenses for investment advice,.
Investment expenses deducted as miscellaneous itemized
deductions are subject to the 2 percent of AGI floor.
Expenses other than interest incurred to generate
investment income.
No carryover of amounts not currently deductible.
50

Investment Interest Expense

When taxpayers borrow money to acquire investments,


the interest expense they pay on the loan is investment
interest expense.

Margin Interest on funds borrowed to buy stock, would be


considered investment interest expense.
Investment interest expense may be deductible as an itemized
deduction.
Unlike investment expenses, the investment interest expense
deduction is not a miscellaneous itemized deduction subject to
the 2 percent of AGI floor.
Investment Interest is subject to a different limitation.
A taxpayer's investment interest expense deduction for the
year is limited to the taxpayer's net investment income (That
is gross investment income reduced by deductible investment
expenses for the year.)
51

Net Investment Income


Net Investment Income is gross investment income reduced by
deductible investment expenses.
Deductible investment expenses are investment expenses that
actually reduce taxable income after applying the 2 percent of AGI floor.
Gross investment income includes interest, annuity, and royalty
income not derived in the ordinary course of a trade or business.
It also includes net short-term capital gains, net capital losses (shortand long-term), and nonqualified dividends.
Investment income generally does not include net long-term capital
gains and qualified dividends because this income is taxed at a
preferential rate.
Congress decided that it wasn't right to allow income that is taxed at a
preferential rate to increase the amount of deductions that offset
income taxed at an ordinary rate.
Congress allows taxpayers to elect to include preferentially taxed
income in investment income if they are willing to subject this income to
52
tax at the ordinary (not preferential) tax rates.

Portfolio Investment Expenses

Passive Investment Income and


Losses

Passive Investments

Typically an investment in a partnership, S corporation,


or direct ownership in rental real estate.
Ordinary income from these investments is taxable
annually as it is earned.
Ordinary losses may be deducted currently if able to
overcome:
Tax basis limitation
At-risk limitation
Passive loss limitation

Tax Basis Limitation

Losses may not exceed an investors tax basis in


the activity. Excess loss carried over until event
occurs to create more tax basis.
Increases to tax basis

Cash invested
Share of undistributed income
Share of debt

Decreases to tax basis

Cash distributions
Prior year losses

At-Risk Limitation

Losses may not exceed an investors amount atrisk in the activity.

Excess loss carried forward until event occurs to create


additional amount at-risk.

At-risk amount calculated like tax basis except:

May not include investors share of debt she is not


responsible to repay
However, usually include investors share of mortgage
debt secured by real estate because it is qualified
nonrecourse financing

Tax Basis and At-Risk Limitation


Question

Lon purchased an interest in a limited liability


company (LLC) for $50,000 and the LLC has no
debt. Lons share of the loss for the current year is
$70,000.
How much of the loss is limited by his tax basis?
How much of the loss is limited by his at-risk
amount?

Tax Basis and At-Risk Limitation


Solution

Lons tax basis is $50,000 consisting of his $50,000


investment As a result, $20,000 of his $70,000 loss
is limited by his tax basis leaving $50,000 of loss.
His at-risk amount is also $50,000 because the LLC
does not have any debt. Thus, there is no additional
loss limited by Lons at risk amount.

Passive Activity Income and Losses


Passive

Investments

Typically an investment in a partnership, S corporation, or direct


ownership in rental real estate.
Ordinary income from these investments is taxable annually as it is
earned.
Ordinary losses may be deducted currently if able to overcome:

Tax basis limitation


At-risk limitation

Passive

loss limitation
Losses from limited partnerships, and from rental
activities, including rental real estate, are generally
considered passive losses. In addition, losses from any
other activity involving the conduct of a trade or business
in which the taxpayer does not materially participate are
also treated as passive losses. Material participation is
defined as regular, continuous, and substantial.
59

Passive Activity Limitation

Applied after tax basis and at-risk limitations.


Losses from passive activities may only be
deducted to the extent the taxpayer has income
from passive activities or when the passive
activity is sold.
A passive activity is a trade or business or rental
activity in which the taxpayer does not materially
participate.

Participants in rental real estate and limited partners are


generally considered to be passive participants
All other participants are considered to be passive
unless their involvement is regular, continuous, and
substantial
Seven factors for testing material participation

Testing for Material


Participation

Income and Loss Categories


Under

the passive activity loss rules, each item of a taxpayer's


income or loss for the year is placed in one of three categories.
Losses from the passive category cannot offset income from
other categories. The three different categories are as follows:
Passive activity income or lossincome or loss from an
activity in which the taxpayer is not a material participant. 63
Portfolio income income from investments including capital
gains and losses, dividends, interest, annuities, and royalties.
Active business income income from sources in which the
taxpayer is a material participant. For individuals, this includes
salary and self-employment income. Thus, an individual with
income in this category is no longer an investor with respect to
this source of income given that we define investors in this
chapter as individuals with portfolio and/or passive income and
losses.

62

Exhibit 7-9
Income and Loss Categories

63

3.8% Medicare Contribution Tax on


Net Investment Income

In 2013 and years after, a 3.8% Medicare Contribution


Tax is imposed on net investment income.
The tax imposed is 3.8 percent of the lesser of (a) net
investment income or (b) the excess of modified
adjusted gross income over $250,000 for married-joint
filers and surviving spouses, $125,000 for married
separate filers, and $200,000 for other taxpayers.
Modified adjusted gross income equals adjusted gross
income increased by income excluded under the foreign
earned income exclusion less any disallowed deductions
associated with the foreign earned income exclusion.
Net investment income includes net passive income
64

Passive Activity Loss Limitation


Question
In

addition to his interest in the LLC, Lon


owns a rental property that produced $5,000
of rental income during the year.
How much of Lons remaining $50,000 loss
(after applying the tax basis and at-risk
limitations) can he deduct currently?
What happens to any portion of the loss he
cant deduct?

Passive Activity Loss Limitation


Solution

Generally, income from rental real estate is considered


to come from a passive activity.
Lon may use $5,000 of his passive activity loss from the
LLC to offset his $5,000 of passive income from his
rental real estate.
He must carry forward the remaining $45,000 passive
activity loss until he either receives more passive income
or until he sells his interest in the LLC.
At the end of the day, Lon is able to deduct $5,000 of his
loss from the LLC currently, and he has a $20,000 tax
basis and at-risk carryforward and a $45,000 passive
activity loss carryforward.

Mom and Pop Exception for Rental


Estate

Mom and Pop own a home they rent out to students


at the local university. Pop approves new tenants
and makes repairs when needed. Their AGI before
considering any income or loss from the rental
property is $90,000. Their loss from the rental
property for the current year is $16,000.
If Mom and Pop have no other sources of passive
income, how much of the passive loss from the
rental home can they deduct currently?

Mom and Pop Exception for Rental


Estate Solution

Taxpayers like Mom and Pop may currently deduct


up to $25,000 of losses from rental real estate even
if they dont have passive income from other
sources.
However, their ability to deduct these losses phases
out by 50 cents for every dollar of AGI they earn
above $100,000. Once their AGI hits $150,000 they
will no longer be able to deduct the loss from their
rental property unless they have passive income
from another source.
Because their AGI is less than $100,000, Mom and
Pop may deduct all $16,000 of loss from their rental
property.

Rental Real Estate Exception to the Passive Activity


Loss Rules
A

taxpayer who is an active participant in a rental activity


owns at least 10% of a rental property and participates in the process of
making management decisions, such as approving new tenants, deciding
on rental terms, and approving repairs and capital expenditures may be
allowed to deduct up to $25,000 of the rental loss against other types of
income.
To be considered an active participant, the taxpayer must (1) own at least
10 percent of the rental property, and (2) participate in the process of
making management decisions such as approving new tenants, deciding
on rental terms, and approving repairs and capital expenditures.

Consistent

with a number of tax benefits, the exception amount for


active owners is phased out as adjusted gross income increases:

The $25,000 maximum exception amount is phased out by 50 cents for


every dollar the taxpayer's adjusted gross income (before considering the
rental loss) exceeds $100,000.
Consequently, the entire $25,000 deduction is phased-out when the
taxpayer's adjusted gross income reaches $150,000.
69

Vous aimerez peut-être aussi