individual taxes chapt 7
All else being equal, would a taxpayer with passive losses prefer to have wage income or passive income?
A taxpayer in this situation would prefer passive income because the taxpayer's passive losses could be applied currently against the passive income to reduce the amount of tax paid currently. If the taxpayer had received wage income, the passive losses would have been suspended, and the tax benefits associated with the passive losses would be deferred.
{Research, Planning} When should investors consider making an election to amortize market discount on a bond into income annually? [Hint: see §1278(b)
A taxpayer may elect under §1278(b) to amortize market discount on a bond into income currently (as ordinary income) rather than wait to recognize the accrued market discount as ordinary income when the bond is sold or matures.
What is a "wash sale"? What is the purpose of the wash sale tax rules?
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
Describe how interest income and dividend income are taxed. What are the similarities and differences in their tax treatment?
Because they are cash method taxpayers, individual investors typically are taxed on interest and dividends when they receive them. However, interest income is taxed using ordinary rates while qualified dividends are taxed at lower capital gains rates.
Compare and contrast the tax treatment of interest from a Treasury bond and qualified dividends from corporate stock.
For cash method taxpayers, both the interest from Treasury bonds and dividends are taxed in the year they are received. However, interest is taxed using ordinary rates while qualified dividends are taxed at lower capital gains rates. An additional difference between these types of income relates to their state income tax treatment. The interest from Treasury bonds is exempt from state income taxes while dividends are subject to state income taxes.
How are Treasury notes and Treasury bonds treated for federal and state income tax purposes?
Generally, interest from Treasury bonds and notes is taxed annually as it is received at ordinary rates for federal income tax purposes. However, interest from Treasury bonds and Treasury notes is exempt from state income taxes
{Planning}This year, David, a taxpayer in the highest tax rate bracket, has the option to purchase either stock in a Fortune 500 company or qualified small business stock in his friend's corporation. All else equal, which of the two will he prefer from a tax perspective if he intends to hold the stock for six years? Which would he prefer if he only plans to hold the stock for two years?
If David holds the stock in his friend's corporation for more than five years, 100% of his gain will be excluded. In contrast, gains from the sale of stock in the Fortune 500 company would be taxed at the prevailing maximum capital gains rate (maximum of 20% currently). Thus, David would prefer to purchase stock in his friend's corporation if taxes are the only consideration. If the stocks are only held for two years, the stock in his friend's corporation would not be treated as qualified small business stock and he would be indifferent, from a tax perspective, between purchasing the two stocks.
] What is the definition of a capital asset? Give three examples of capital assets.
In general, a capital asset is any asset other than an asset used in a trade or business (i.e., equipment, buildings, inventory, etc.), or accounts or notes receivable generated from the sale of services or property by a trade or business.
What tests are applied to determine if losses should be characterized as passive?
In general, losses from trade or business activities are passive unless individuals are material participants in the activity. Regulations provide seven separate tests for material participation, and individuals can be classified as material participants by meeting any one of the seven tests. The seven tests are as follows: 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 the individuals including non-owners. 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 five 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.
What happens to capital losses that are not deductible in the current year?
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
What limitations are placed on the deductibility of capital losses for individual taxpayers?
Individual taxpayers with a net capital loss for the year may deduct up to $3,000 of the capital loss against ordinary income. Taxpayers can deduct up to $3,000 ($1,500 if married filing separately) of net capital losses 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
What is the underlying policy rationale for the current tax rules applicable to interest income and dividend income?
Interest and dividends are typically taxed annually when received because taxpayers have the wherewithal to pay the tax at that time. Interest income is taxed at ordinary rates because it is viewed as a less risky type of income compared to other more risky forms of income such as the expected appreciation in capital assets. Qualified dividends are taxed at capital gains rates to mitigate the effect of double taxation on corporate earnings.
When taxpayers borrow money to buy municipal bonds, are they allowed to deduct interest expense on the loan? Why or why not?
Interest expense incurred on loans used to purchase municipal bonds is not deductible. The interest income from the municipal bonds is not included in income; therefore, the interest expense incurred to produce the tax exempt income is not deductible
ed for a taxpayer with investment expenses and other noninvestment miscellaneous itemized deductions?
Investment expenses and miscellaneous itemized deductions are subject to the 2% of AGI limitation. So, when the two types of expenses are added together, only the amount in excess of 2% of AGI is deductible. The amount in excess of 2% of AGI is first considered to be the investment expenses. If these expenses are fully deductible, the remaining miscellaneous itemized deduction consists of the non-investment expenses. This sequence maximizes the deductibility of the investment expenses. The sequence is unfavorable for the taxpayer because maximizing the deductible investment expenses minimizes net investment income, which minimizes the investment interest expense deduction.
What limitations are placed on the deductibility of investment interest expense? What happens to investment interest expense that is not deductible because of the limitations?
Investment interest expense is deductible, as an itemized deduction, to the extent of net investment income. Net investment income is investment income minus deductible investment expenses. Investment interest expense that is not deductible because of the net investment income limitation is carried forward and treated as though it is incurred in the next year. Unused investment interest expense can be carried forward indefinitely.
3] Are dividends and capital gains considered to be investment income for purposes of determining the amount of a taxpayer's deductible investment interest expense for the year?
Long-term capital gains and dividends that qualify for the preferential 20% (or lower) tax rate are not considered to be investment income for purposes of determining the investment interest expense deduction unless the taxpayer makes an election to tax this income at ordinary rates. If the taxpayer makes this election, the dividends and long-term capital gains count as investment income for this purpose. Dividends and capital gains that are not eligible for the preferential rate are included in investment income in determining the deductibility of investment interest expense
] Are all long-term capital gains taxable
Long-term capital gains may be taxed at one of five different rates (0, 15, 20, 25, or 28 percent). Unrecaptured §1250 gains from the sale of depreciable real estate investments are taxed at a 25% maximum rate, gains from collectibles held for more than one year are taxed at a 28% maximum rate, and recognized gains from the sale of qualified small business stock held for more than five years is taxable at a 28% maximum rate. The remaining long-term capital gains are taxed at 0, 15, or 20 percent depending on the taxpayer's ordinary income tax rate as follows: Ordinary Tax Bracket Capital Gains Tax Rate 10% or 15% 0% 25%, 28%, 33%, or 35% 15% 39.6% 20%
What types of losses may potentially be characterized as passive losses?
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."
What tax rate applies to net short-term capital gains?
Net short-term capital gains are taxed at the taxpayer's ordinary tax rates.
Why might investors purchase interest-paying securities rather than dividendpaying stocks?
Non-tax considerations may play a role. For example, investors may be willing to give up the tax rate benefit from receiving qualified dividend income in exchange for the certainty of receiving predicable interest payments. In addition, risk preferences might cause investors to prefer one investment over another. FDIC insurance guarantees the security of an investment in savings accounts and certificates of deposit up to a threshold amount; whereas, no guarantees exist for stock investments
What are the implications of treating losses as passive?
Passive losses may not be used to offset portfolio income or active income. Passive losses can only be used to offset passive income. Passive losses that are limited will be suspended until taxpayers have passive income or until the activity producing the passive loss is sold.
Nick does not use his car for business purposes. If he sells his car for less than he paid for it, does he get to deduct the loss for tax purposes? Why or why not?
Personal-use of assets falls within the category of capital assets. When a taxpayer sells a personal-use asset, the gain from the sale of the personal-use asset is taxable even though it was not purchased for its appreciation car for less than he paid for it, the loss from the sale of the personal-use asset is not deductible, and therefore never becomes part of the netting process potential. If a taxpayer sells a
Why does the tax law provide preferential rates on certain capital gains?
Preferential tax rates apply to gains on the sale of certain capital assets (e.g., capital assets held for more than one year). Among other things, 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.
Compare and contrast the tax treatment of dividend-paying stocks and growth stocks.
Qualified dividends from dividend paying stocks and long-term capital gains from growth stocks are both taxed at favorable capital gains rates. However, dividends are taxed when received in contrast to the appreciation in growth stocks, which is taxed only when growth stocks are sold. All else equal, growth stocks will have a higher after-tax rate of return because the tax is deferred into the future while dividend paying stocks are taxed annually.
] {Planning} Clark owns stock in BCS Corporation that he purchased in January of the current year. The stock has appreciated significantly during the year. It is now December of the current year, and Clark is deciding whether or not he should sell the stock. What tax and nontax factors should Clark consider before making the decision on whether to sell the stock now?
Tax factors: Clark should consider the rate at which the gain will be taxed. If he sells the stock in December of the current year, the gain is a short-term gain that will likely be taxed at his marginal ordinary income rate. If he waits until he has held the stock for more than a year, the gain will be taxed at a maximum of 0/15/20% (depending on income). Nontax factors: If Clark decides to hold the stock, there is risk that the value will decline. Likewise, the stock may appreciate in value if Clark decides to wait to sell. Clark should assess his risk of loss and appreciation potential of the stock before selling
Why does the tax law allow a taxpayer to defer gains accrued on a capital asset until the taxpayer actually sells the asset?
Taxpayers are allowed to defer accrued gains on capital assets until the date of sale because the investment doesn't 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
What methods may taxpayers use to determine the adjusted basis of stock they have sold?
Taxpayers can use the FIFO method to determine basis in the stock. That is, the first stock purchased (i.e., the stock the taxpayer has held for the longest time) is treated as though it is the first stock sold. Taxpayers can also use the specific identification method of determining the basis of the stock sold.
] Why would taxpayers generally prefer the tax treatment of market discount to the treatment of original issue discount on corporate bonds?
Taxpayers generally would prefer market discount to original issue discount on bonds because the ordinary income related to market discount is deferred until bonds are sold or until they mature. In contrast, taxpayers must report ordinary income from the amortization of original issue discount yearly until the bonds are sold or until they mature.
What is the deciding factor in determining whether a capital gain is a shortterm or long-term capital gain?
The deciding factor is the amount of time an asset has been held by the taxpayer. When a capital asset that has been held for more than one year is sold, it generates a long-term capital gain. When it has been held for one year or less it generates a short-term capital gain when sold.
] In what ways are U.S. savings bonds treated more favorably for tax purposes than 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 investor's annual tax returns.
Describe three basic tax planning strategies available to taxpayers investing in capital assets
When a taxpayer holds capital assets for more than one year before selling, she is actually utilizing two basic strategies. First, she defers recognizing capital gains thereby reducing the present value of the capital gains tax due when the asset is sold. Second, by converting the capital gain into a long-term capital gain, the gain is taxed at a preferential maximum tax rate of 0/15/20% (depending on her income) instead of her ordinary rate
