Tax Accounting - Chapter 7

Investments held for appreciation potential

-Growth stocks (stocks in corporations that reinvest their earnings to grow the company as opposed to distributing them to shareholders in the form of dividends) -Land -Mutual funds -Other assets (precious metals, collectibles, etc.)

A taxpayer's income or loss for the year is classified into one of three categories:

1: passive or passive activity 2: portfolio 3: active or active business

Loss Harvesting

A productive strategy for managing investments in capital assets is to sell investments with build-in losses. •$3,000 offsets against ordinary income •Offset other (short-term) capital gains •Must balance tax with nontax factors -What happened to the stock market in 2008?

Assets that are held for investment or personal use assets are referred to as?

Capital Assets

True or false: All net capital gains are included in the definition of net investment income.

False Reason: Net investment income only includes net short-term capital gains and non-qualified dividends. It does not include capital gains or qualified dividends taxed at a preferential rate unless taxpayers elect to include them.

28 Percent Capital Gains

Long-term capital gains from collectibles and qualified small business stock are taxed at this maximum rate

Which of the following answers pertain to net short-term capital gains and losses?

The holding period is one year or less. The gains are taxed at ordinary tax rates.

Which of the following choices describes the tax treatment for qualified dividends? (Check all that apply.) Multiple select question. A. The income is taxed at the lower of the taxpayer's marginal rate or at a maximum 15%. B. The income may be taxed at a rate as high as 20%, depending on the taxpayer's taxable income. C. The income may be taxed as low as 0%, depending on the taxpayer's ordinary income rate. D. The income is always taxed at the taxpayer's ordinary income tax rate.

The income may be taxed at a rate as high as 20%, depending on the taxpayer's taxable income. The income may be taxed as low as 0%, depending on the taxpayer's ordinary income rate.

Passive Activity

This activity is a trade, business, or rental activity in which the taxpayer does not materially participate

Wash Sale Rule

This 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)

Which of the following statements is CORRECT regarding the sale of qualified small business stock (Sec. 1202 stock)? Multiple choice question. A. The effective capital gains tax rate is 28%. B. The stock must have a long-term holding period of at least one year. C. The taxable gain is taxed as ordinary income D. Up to 100% of the gain could be excluded depending on the acquisition date

Up to 100% of the gain could be excluded depending on the acquisition date.

Net long-term capital gains are taxed at

• 0, 15, 20% (generally) • 25% (specific gains) • 28% (specific gains)

Capital asset is any asset other than:

•Asset used in trade or business •Accounts or notes receivable acquired in business from the sale of services or property •Inventory

Which of the following investments do NOT pay periodic interest payments, but rather accumulate interest over the life? A. U.S. savings bonds B. Certificate of deposits C. Mutual funds D. Corporate bonds

A. U.S. savings bonds

Which of the following investments do NOT pay periodic interest payments, but rather accumulate interest over the life? Multiple choice question. A. U.S. savings bonds B. Certificate of deposits C. Mutual funds D. Corporate bonds

A. U.S. savings bonds

Which of the following types of investments generate dividend income? (Check all that apply.) Multiple select question. A.Mutual fund investments B. Corporate stock C. Savings accounts D. Government bonds E. Certificates of deposit F. Corporate bonds

A.Mutual fund investments B. Corporate stock

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.

When a taxpayer does NOT materially participate in the business activities of a trade or business (including rental activities) in which he is a partial owner, any loss that flows through to the taxpayer is subject to_____ ________ the loss rules.

Blank 1: passiveBlank 2: activity

In order for a taxpayer to be able to deduct up to $25,000 in rental losses against other types of income, her or she must be a(n) ______ participant in the rental activity. A. material B. full-time C. regular D. active

D. active

Losses on wash sales

Losses on these sales are not deductible but added to the basis of new shares acquired.

True or false: A suspended loss on a passive activity can be used to offset active and portfolio income in the year the taxpayer sells or divests of the activity.

True

Dividends on stock

Typically taxed at preferential/lower capital gains rate

Investment expenses

•Expenses (other than interest) incurred to generate investment income •Not deductible

Investments held for appreciation potential gains and losses treatment

•Gains deferred for tax purposes until taxpayer sells or otherwise disposes of the asset •Gains are generally taxed at preferential rates •Special loss rules apply •These types of investments are generally investments in capital assets.

Basic Tax Planning Strategies

•Hold capital assets for more than a year before selling. • Sell loss capital assets to offset gains.

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.

Investment interest expense

•Interest expense on loans used to acquire investments •Deductible as an itemized deduction •Limited to taxpayer's investment income •Carryover indefinitely

At-risk amount calculated like tax basis except:

•May not include investor's share of debt she is not responsible to repay •However, usually include investor's share of mortgage debt secured by real estate because it is "qualified nonrecourse financing"

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 a year or less

Annette is currently in the 24% marginal tax bracket. She had a long-term capital gain from the sale of stock and another capital gain from a coin collection. Assuming that the combined gains are not large enough to push her into a higher marginal bracket, she will be taxed _________ % on the gain from the sale of stock and ___________ % on the gain from the coin collection.

15 & 24

If a taxpayer is an active participant in a rental activity, she may be allowed to deduct up to $______in rental losses against other types of income.

25,000 or 25000

What is the rate of the additional tax that is assessed on net investment income when it exceeds specified thresholds?

3.8%

Which of the following statements regarding material participation is TRUE?

A taxpayer can be materially participating by being involved in more than one activity if the total hours of involvement meet certain levels.

Which of the following statements regarding material participation is FALSE? A. A taxpayer's involvement does NOT have to exceed 500 hours a year in one activity to be considered materially participating if other tests are met. B. A taxpayer can be materially participating by being involved in more than one activity if the total hours of involvement meet certain levels. C. A taxpayer can be deemed to be materially participating due to prior years of service. D. A taxpayer must be involved in a business on a full-time basis throughout the year to be considered materially participating.

A taxpayer must be involved in a business on a full-time basis throughout the year to be considered materially participating.

Which of the following choices determine the amount and the timing for recognizing interest income? (Check all that apply.) A. The actual interest payments received are included in gross income. B. If bonds were issued at a premium, taxpayers may amortize the premium over the life of the bond resulting in a decrease in interest income. C. If bonds were issued at a premium, special original issue discount rules apply. D. If bonds are purchased at a discount in the secondary market, the discount is recognized as interest income at maturity. E. If bonds are purchased at a premium in the secondary market, the premium cannot be amortized, but is added to the basis of the bonds.

Answer: If bonds are purchased at a discount in the secondary market, the discount is recognized as interest income at maturity. If bonds were issued at a premium, taxpayers may amortize the premium over the life of the bond resulting in a decrease in interest income. The actual interest payments received are included in gross income.

Bailey has $8,000 to invest. She has a 24% marginal tax rate and is planning to reinvest her dividends and leave the investment in place for three years. If she can invest the money in taxable securities that earn qualified dividends with a 6% rate of return before tax, how much will she have at the end of the third year?

Answer: $9,287 6% x (1 -.15) = 5.1%; $8,000 x (1+.051)3 = $9,287. Qualified dividends are taxed at 0%/15%/20%, and for all single taxpayers with a marginal rate of 24%, the qualified dividends rate is 15%.

True or false: Short-term capital gains are subject to preferential tax treatment when the capital gains rates are lower than the taxpayer's marginal income tax rate

Answer: False Reason: Short-term capital gains are taxed as ordinary income. Long-term capital gains may receive preferential tax rates.

Which of the characteristics below BEST describes the treatment of investment interest expense? (Check all that apply.) A. Any amount of this expense that is NOT deducted in the current year due to the investment income limitations may be carried forward indefinitely. B. This expense is deductible as an itemized deduction in the interest expense category. C. This expense is deductible as a for AGI deduction (adjustment) D. Any amount of this expense that is NOT able to be deducted in the current year cannot be carried forward. E. The interest deduction is limited to the taxpayer's net investment income for the year. F. This expense is NOT deductible.

Any amount of this expense that is NOT deducted in the current year due to the investment income limitations may be carried forward indefinitely. This expense is deductible as an itemized deduction in the interest expense category. The interest deduction is limited to the taxpayer's net investment income for the year.

Darin is a 25% owner in a partnership in which he has a tax basis of $7,000 and an at-risk basis of $5,000. Darin materially participates in the operations of the partnership which incurred a loss of $40,000 in the current year. Based on these facts, ______. A. $10,000 of the loss will flow-through to Darin, and he will be able to deduct $10,000. B. $10,000 of the loss will flow-through to Darin, and he will be able to deduct $5,000. C. $40,000 of the loss will flow-through to Darin, and he will be able to deduct $10,000. D. $10,000 of the loss will flow-through to Darin, and he will be able to deduct $7,000.

B. $10,000 of the loss will flow-through to Darin, and he will be able to deduct $5,000.

LLCs, S Corporations, and partnerships do NOT pay taxes at the organization level; rather these types of activities are________ ________ entities whose operating income and losses are allocated to the owners of the entities.

Blank 1: flow or pass Blank 2: through

Taxpayers must (include/exclude) gains but (include/exclude) losses on the disposal of personal use assets from gross income.

Blank 1: include Blank 2: exclude

When taxpayers borrow money to acquire investments, the interest expense they pay on the loan is ___ expense and the deduction is limited to the taxpayer's ____income for the year.

Blank 1: investment Blank 2: interest Blank 3: net Blank 4: investment

In order for a taxpayer to be able to deduct the loss on a business activity in which she is an owner, she must demonstrate that she_______ _________ in the conduct of the business. If she does NOT, the activity is considered to be a passive activity.

Blank 1: materially Blank 2: participates or participated

Passive activity losses may only offset_______ income, but NOT active business or_______ income.

Blank 1: passive or passive activity Blank 2: portfolio

What is included in the calculation of the amount realized upon the sale of a capital asset? (Check all that apply.) A. The original cost of the capital asset being sold B. Fair market value of any other property received by the seller C. Cash received by the seller D. Depreciation taken on the asset in prior years is deducted E. Broker's fees and other selling costs are deducted

C. Cash received by the seller B Fair market value of any other property received by the seller E. Broker's fees and other selling costs are deducted

Which of the following statements is correct? A. Dividend income is generally taxed at ordinary rates. B. Dividend income from tax exempt organizations is exempt from tax. C. Interest income is typically taxed at ordinary rates. D. Interest income may be deferred and recognized in a later year.

C. Interest income is typically taxed at ordinary rates.

25 Percent Capital Gains

Certain gains from the sale of depreciable real estate held long term are taxed at this maximum rate (unrecaptured §1250 gain).

Which of the following types of investments generate interest income? (Check all that apply.) A. Corporate stock B. Corporate bonds C. Certificates of deposit D. Mutual fund investments E. Government bonds F. Savings accounts

Corporate bonds Certificates of deposit Government bonds Savings accounts

A taxpayer may use the specific identification method for determining the tax basis of stock being sold rather than the FIFO method when the taxpayer ______. A. Is a stockbroker (i.e. dealer in securities) and the sale is related to his business B. Needs to create capital losses in order to offset capital gains C. Is selling a variety of stock investments, rather than stock from the same company D. Has maintained sufficient records to document which batch of stock is being sold

D. Has maintained sufficient records to document which batch of stock is being sold

Regarding portfolio investments, which types of income generally are taxed at a rate lower than the taxpayer's marginal tax rate? (Check all that apply.) A. Interest on corporate bonds B. Short-term capital gains C. Nonqualified dividends D. Long-term capital gains E. Qualified dividends

D. Long-term capital gains E. Qualified dividends

Please choose the statement that is INCORRECT regarding portfolio and passive investments? Multiple choice question. A. Losses from portfolio investments are deferred until the investment is sold. B. Losses from passive investments may be deducted immediately or they may have to be deferred. C. Losses from passive investments not subject to at-risk limits will be deducted at ordinary rates. D. Losses from portfolio investments are deductible in full against ordinary income.

D. Losses from portfolio investments are deductible in full against ordinary income.

Losses may not exceed an investor's tax basis in the activity.

Excess loss carried over until an event occurs to create a more tax basis.

Which of the following choices concerning the recognition of interest income for corporate bond are CORRECT? (Check all that apply.) Multiple select question. A. If bonds are purchased at a discount in the secondary market, the discount is amortized over the remaining life of the bond. B. If bonds were issued at a discount, special original issue discount rules apply. C. If bonds were issued at a premium, taxpayers must amortize the premium over the life of the bond resulting in an increase in interest income. D. The actual interest payments received are included in gross income. E. If bonds are purchased at a premium in the secondary market, the premium can be amortized or added to the basis of the bond.

If bonds were issued at a discount, special original issue discount rules apply. The actual interest payments received are included in gross income. If bonds are purchased at a premium in the secondary market, the premium can be amortized or added to the basis of the bond.

Tests for Material Participation

Individuals are generally considered material participants for the activity if they meet any one of these tests: 1.The individual participates in the activity more than 500 hours during the year. 2. The individual's activity constitutes substantially all of the participation in such activity by all individuals, including nonowners 3.The individual participates more than 100 hours during the year, and the individual's participation is not less than any other individual's participation in the activity. 4.The activity qualifies as a "significant participation activity" (more than 100 hours spent during the year) and the aggregate of all "significant participation activities" is greater than 500 hours for the year. 5.The individual materially participated in the activity for any 5 of the preceding 10 taxable years. 6.The individual materially participated for any three preceding years in any personal service activity (personal services in health, law, accounting, architecture, etc.) 7.Taking into account all the facts and circumstances, the individual participates on a regular, continuous, and substantial basis during the year.

Which of the following types of income are generally included in the calculation of investment income? (Check all that apply.) A. Net long-term capital gains B. Interest income C. Qualified dividends D. Nonqualified dividends E. Net short-term capital gains

Interest income Nonqualified dividends Net short-term capital gains

What term is used to denote the interest incurred on loans used to acquire investments? A. Investment interest expense B. Net investment income C. Investment expense D. Net investment expense

Investment interest expense

Portfolio income: Capital gains and losses

Investments held for appreciation potential

Qi, Julian, and Omar are all in the 24% tax bracket. Qi has received $3,000 in corporate bond interest, Omar $2,500 in savings account interest, and Julian $2,500 in dividends from a US corporation. Rank the taxpayers by their tax liability from the amounts received, from least to greatest.

Julian's $2,500 Omar's $2,500 Qi's $3,000

Which of the following assets would qualify as capital assets? (Check all that apply.) A. Warehouse used in a business B. Inventory in a business C. Land held for investment D. Corporate stock E. Personal residence F. Coin collection

Land held for investment Corporate stock Personal residence Coin collection

Net Capital Gains

Net long-term capital gains in excess of net short-term capital losses

Please choose the statement that is INCORRECT when referring to net passive income? Net passive income may be subject to the net investment income tax A. of 3.8% in addition to regular income tax. B. Net investment income includes net passive income. C. Net passive income is taxed at long-term capital gains rates.

Net passive income is taxed at long-term capital gains rates.

Net short-term capital gains are taxed at

Ordinary Rates

Passive Activity Limitations

THIS LIMITATION is 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

How is a capital asset's tax basis calculated? (Check all that apply.) A. The tax basis includes the the sales proceeds generated at the time the taxpayer sells the asset. B. The tax basis includes costs to substantially improve the asset. C. The tax basis includes the original cost (or other basis) in the asset. D. The tax basis includes costs incurred in preparing the asset for initial use. E. The tax basis is reduced by depreciation taken on the asset in prior years.

The tax basis includes costs to substantially improve the asset. The tax basis includes the original cost (or other basis) in the asset. The tax basis includes costs incurred in preparing the asset for initial use.

True or false: Capital losses retain their character as short-term or long-term when they are carried forward to subsequent years.

True Reason: If the loss is a short-term loss, it will NOT become a long-term loss when it is carried forward even though it was not deducted in the year the loss was incurred.

Portfolio Income: Interest and Dividends

Usually taxable when received 1. Interest from bonds, CDs, savings accounts 2. Dividends on stock

Wash Sale

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 a(n)

Bob has capital losses of $4,000 that exceed his capital gains in the current year. Of this amount, $1,200 is a short-term capital loss and $2,800 is a long-term capital loss. The capital loss carryforward will be a $1,000 ______. A. long-term capital loss because Bob must first use the short-term loss to offset ordinary income B. short-term capital loss because Bob must first use the long-term loss to offset ordinary income C. capital loss pro-rated between short-term ($300) and long-term ($700) D. capital loss carryforward and Bob can choose how much of the gain to allocate to short-term versus long-term

long-term capital loss because Bob must first use the short-term loss to offset ordinary income

Investment 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

Decreases to tax basis

•Cash distributions •Prior-year losses

Increases to tax basis

•Cash invested •Share of undistributed income •Share of debt

Special rules apply to the sale of personal-use assets.

•Gains are taxable as capital gains. •Losses are not deductible. •Capital losses from sales to "related parties" are not deducted currently. •The related party may eventually be able to deduct all, a portion, or none of the disallowed loss on a subsequent sale of the property.

Passive Participants

•Generally participants in rental real estate and limited partners (flow-through entity) •All other participants are considered to be passive unless their involvement is "regular, continuous, and substantial." •Seven factors for testing material participation

Portfolio versus passive investments

•Portfolio losses deferred until the investment is sold •Passive investment losses may be deducted annually

Qualified Dividends rates

•Subject to a preferential tax rate -15 percent generally -0 percent if income is below the maximum 0 percent amount -20 percent if income is above the maximum 15 percent amount •After-tax rate of return assuming 8 percent before-tax rate of return 0.08(1 − .15) = 6.8%

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?

•Taxpayers like Mom and Pop may currently deduct up to $25,000 of losses from rental real estate even if they don't 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

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.

The net investment income tax is imposed on the of (a) net investment income or (b) the excess of AGI over a specific level depending on filing status.

(a) lesser (b) modified

Two tracking Basis of Stock sold

1. FIFO method (default) 2. Specific Identification allowed. (Specific identification method will result in lower capital gain taxes currently and thereby minimize the present value of the taxes paid on stock sales)

1. Other Investment expense 2. Investment Interest expense

1. Not deductible 2. Interest expense itemized deduction

Ordinary losses may be deducted currently if able to overcome:

1. Tax-basis limitation 2. At-risk limitation 3. Passive loss limitation

What are the two tax benefits when holding capital assets for more than a year?

1. taxpayers are able to defer taxes recognizing gains on the capital assets until they sell them. 2. Taxpayers pay taxes on the gains at preferential rates.

If a taxpayer has a long-term capital loss in the 15% category, how is it used to offset capital gains in the other rate categories? A. The loss will first offset gains in the 28% category, then the 25% category; then the taxpayer may use it to offset short-term capital gains. B. The loss should offset gains in the 25% category, then the 28% category; then the taxpayer can offset the short-term capital gains. C. The loss will first offset the short-term capital gains. Then it can be used to offset gains in the 28% category; then it may offset 25% gains. D. The loss will first offset the short-term capital gains. Then it can be used to offset gains in the 25% category; then in the 28% category.

A. The loss will first offset gains in the 28% category, then the 25% category; then the taxpayer may use it to offset short-term capital gains.

True or false: Income from passive investments may be taxed at ordinary rates, preferential rates, or may be exempt from taxation while income from portfolio investments will be taxed at ordinary rates.

Answer: False Reason: Passive investments generate ordinary income or losses. Portfolio income may be taxed a various rates or be exempt from taxation altogether.

Which of the following types of transactions results in capital losses that are deductible for tax purposes? A. Sales of personal-use assets B. Sales of investment assets C. Wash sales D. Sales to related parties

B. Sales of investment assets

Carly sold land that she purchased 10 years ago for $3,000. The selling price of the land was $7,000 and Carly paid broker's fees of $420. When she originally purchased the land, she paid $1,000 to clear some of the brush in order to make a walking path down to a nearby lake. In the ten years since the purchase, Carly paid $200 per year to keep the path maintained. Carly's amount realized on the sale was $____and her tax basis was $______and her tax basis was $______ for the year

Blank 1: 6,580 or 6580 Blank 2: 4,000 or 4000 Blank 3: 2,580 or 2850

Which of the following types of investments generate interest income? (Check all that apply.) A. Certificates of deposit B. Corporate stock C. Savings accounts D. Mutual fund investments E. Corporate bonds F. Government bonds

Certificates of deposit Savings accounts Corporate bonds Government bonds

Assets such as works of art, antiques, stamps, and coins held for more than one year are referred to as _______The maximum capital gains tax rate applied to the gain on the sale of these assets is _______ percent.

Collectibles 28

0, 15, or 20 Percent Capital Gains

Depending on the taxpayer's filing status and income, generally, net capital gains are taxed at this maximum preferential rate

Qualified Dividends

Dividends must be paid by domestic or certain foreign corporations that are held for a certain length of time.

Which of the following types of investments generate dividend income? (Check all that apply.) Multiple select question. A. Government bonds B. Savings accounts C. Corporate bonds D. Certificates of deposit E. Corporate stock F. Mutual fund investments

E. Corporate stock F. Mutual fund investments

Losses may not exceed an investor's amount at risk in the activity.

Excess loss carried forward until the event occurs to create an additional amount at risk.

Why invest in assets yielding interest or dividends?

Nontax factors: •Risk •Diversification •Others

Nonqualified dividends

Not eligible for the reduced rate and are therefore taxed at ordinary rates

Which of the following types of income is generated from passive investments rather than portfolio investments? Multiple choice question. A. Operating income B. Capital gains C. Dividend income D. Interest income

Operating income

Which of the following statements is INCORRECT regarding flow-through entities? A. Operating income from flow-through entities may or may NOT be taxable in the current year, depending on certain limits imposed on the taxpayer. B. Operating losses from flow-through entities are deductible in the current year. C. Operating income from flow-through entities is taxed as ordinary income to the taxpayer-owners of the entities. D. Operating losses are treated as ordinary losses for taxpayers to the extent they are deductible.

Operating income from flow-through entities may or may NOT be taxable in the current year, depending on certain limits imposed on the taxpayer.

Which of the following statements is true when considering the deductibility of a suspended passive loss? A. The suspended loss can only be deducted against passive income from the same passive activity that generated the loss. B. The suspended loss can reduce short and long-term capital gains, but NOT ordinary income. C. The taxpayer will lose the tax benefit of the suspended loss if he sells or divests of the passive activity. D. The suspended loss may be deducted when a taxpayer generates passive income from that activity or another passive activity.

The suspended loss may be deducted when a taxpayer generates passive income from that activity or another passive activity.

Which of the following characteristics of a wash sale are CORRECT? A. The unrecognized loss is added to the basis of the newly acquired stock. B. Substantially identical securities as those sold at a loss are repurchased in the period beginning 15 days before and ending 15 days after the sale. C. The unrecognized loss is subtracted from the basis of the newly acquired stock. D. The loss generated by a wash sale is NOT deductible. E. Any gain realized on the wash sale is deferred until the newly acquired stock is sold at a later date.

The unrecognized loss is added to the basis of the newly acquired stock. The loss generated by a wash sale is NOT deductible.