Lesson 10: Taxation of Investments
Advantage of passive income:
Taxed at the ordinary income tax rate but is not subject to employment taxes (Social Security and Medicare taxes)
If an investor purchases a bond at its par value and holds the bond to maturity, ______________ is taxable If the investor purchases the bond for more or less than its par value, _________________________
only the interest income additional tax issues must be considered
Some types of portfolio income are taxed at ordinary rates, while other types of portfolio income receive more favorable tax treatment. Interest income is taxed at ____________ tax rates and sources of interest income include earnings on:
ordinary Demand deposits CDs Bonds
Passive income is taxed at the same rates that apply to
ordinary income.
Options give investors the right to buy or sell stocks at a given price. Taxation then resembles the taxation of
any stock investment held for a short period of time. Income made from issuing options is also taxed as short-term capital gains.
When property is received as a gift, the donor's__________________________ are usually transferred to the recipient. If the value of the property on the date of the gift is lower than the donor's basis, the donee will have a _____________, which will limit the gain or loss when the donee subsequently sells the property.
basis and holding period double basis
Qualified dividends and long-term capital gains are taxed at the _____________________________________-
capital gains tax rate.
The alternative minimum tax (AMT) was originally designed to
curb abuses by high-income taxpayers.
section 1031
Allows investors to engage in like-kind exchanges to defer taxation on the gain for the sale or other disposition of a particular piece of real property. To qualify, the real property exchanged must be held for investment or for productive use in a trade or business, and must be exchanged solely for like-kind property. Non-like-kind property received in the exchange is called "boot;" if boot is received in a transaction, the gain on the real property transferred is recognized to the extent of boot received
The _________________ was devised to ensure that all individuals with a certain amount of income will pay some income tax on an annual basis.
Alternative Minimum Tax (AMT)
taxation of options
Call options give the purchaser the right to buy a specified stock at the strike price during the option period. Put options give the purchaser the right to sell a specified stock at the strike price during the option period. The taxation of option contracts depends on three separate issues: Was it a long or short position in the option contract The type of option held, and The manner in which the investor disposes of the option
closed end mutual fund taxation
Closed-End Mutual Fund Shares are purchased and sold in the secondary market. Gain or loss on the shares is determined by market prices. Closed-end funds generate their return from capital appreciation and investment income. A closed-end fund can elect to be taxed as a regulated investment company In this case, the taxation of gains and income in a closed-end fund is identical to that of the open-end mutual fund
3 exceptions to the capital gains tax
Collectibles are taxed at a maximum rate of 28% Section 1202 provides an incentive for individuals to invest in new start-up businesses by excluding from gross income up to 100 percent of the gain from the sale or exchange of qualified small business stock held for more than five years. Any taxable portion of gains on the sale of Section 1202 stock are also subject to tax at the 28 percent rate. Gains on real estate that has been depreciated using straight-line depreciation. The portion of a gain that is equal to depreciation is taxed at 25%
Kelsey engaged in several capital transactions this year. She had a short-term capital gain of $500, a short-term capital loss of $200, a long-term capital gain of $600, and a long-term capital loss of $800. How will Kelsey report these items on her income tax return?
Kelsey will report a net short-term capital gain of $100.
Muni bond tax rules
Generally, the interest or coupon payments received from municipal bonds are not subject to federal income tax. At the federal level, some or all of the municipal bond income may be subject to alternative minimum tax. The amount subject to the AMT is determined by the type of municipal bonds that the investor holds. Second, most states impose an income tax on municipal bond interest earned on bonds issued by other states. Some bonds issued by state and local governments after August 1986 are taxable. Public purpose municipal bonds are issued to support governmental functions. They are not subject to federal taxation and also ARE NOT considered a preference item for the AMT. Private activity bonds are used to finance certain private activities, subsidized housing, and student bonds. They are not subject to federal taxation but they ARE considered a preference item for the AMT. An AMT taxpayer may deduct investment interest expense incurred to acquire the municipal bonds, which is not deductible for regular income tax purposes.
Three years ago, George purchased 1,000 shares of ABC, Inc., for $10 per share. He signed an agreement with the company that allowed the company to use his dividend payments to purchase additional shares for him. Over the last 5 years, George received a total of $1,200 in dividend payments, which purchased an additional 100 shares of stock. If George sells all of his shares for $24,000, what is his taxable gain?
George's adjusted basis in the shares equals the initial purchase price of the shares, $10,000, plus the reinvested dividends of $1,200 since George was required to pay tax on the dividend payments the year they were made. When he sells the shares, he has an amount realized of $24,000, less his adjusted basis of $11,200, which equals a taxable gain of $12,800.
double basis rules
Gifted assets can have a so-called "double basis" to discourage opportunistic giving. If a donor gives an asset with an original basis of $100,000 to a beneficiary when the fair price is now $80,000, the beneficiary can't use the original larger basis if the asset loses money. And if the asset increases in value, the recipient must use the original $100,000 basis.
Al has stock with a basis of $100,000 and gives it to his son Beau when the fair market value is $80,000. Beau will have a double basis in the stock. If Beau sells the stock for $50,000, If Beau sells the stock for $120,000, If Beau sells at a price between $80,000 and $100,000,
If Beau sells the stock for $50,000, he will use the FMV on the date of the gift, $80,000, as his basis, and his loss will be $30,000 If Beau sells the stock for $120,000, he will use Al's carryover basis of $100,000 as his basis, and his gain will be $20,000 If Beau sells at a price between $80,000 and $100,000, his basis will be equal to the sale price and there will be no gain or loss.
Original Issue Discount tax rules
If a long-term bond is issued at a price lower than its value, the difference between the par value and the issue price is the Original Issue Discount (OID). Example: a zero- coupon bond. OID rules require the accrued interest on the bond to be included in the investor's taxable income (ordinary income tax rate) as it accrues each year OID tax rules cause the investor to have phantom income until the year when the bond matures
When a principal residence is sold, all or part of the gain on the sale may be excluded from income if certain requirements are met:
If a taxpayer used the real estate as a principal residence for two out of the five years prior to sale, up to $250,000 of the gain ($500,000 for married filing jointly) is excluded from taxation. Any gain in excess of these amounts is taxable at capital gains tax rates.
investment expense and taxes
Investment interest expense incurred on money borrowed to purchase investments is deductible subject to a few limitations. If interest is incurred to purchase securities that will generate tax-exempt income, it is not deductible The investment interest expense deduction is limited to the investor's net investment income Interest expense related to the acquisition of passive activities, and interest expense that is capitalized, is not eligible for deduction Examples of deductible investment expenses include: Investment advisory fees Tax preparation fees and advice Custodial fees paid to asset managers and brokers Investment research costs Subscriptions to investment advisory services
REIT dividends
REIT dividends are taxed as ordinary income. They are not "qualified dividends" that receive favorable capital gains tax treatment
FIFO
The First-In-First-Out (FIFO) method may be used to determine the basis on the sale of stock purchased in multiple lots. Whenever making a sale, a taxpayer is assumed to be selling the first share purchased.
Net Investment Income Tax
The net investment income tax (NIIT) applies at a rate of 3.8% to certain net investment income of individuals, estates, and trusts that have income above the statutory threshold amounts. This tax applies to either the lesser of the income that exceeds these thresholds or the net investment income.
Dividends may be taxed at ordinary income tax rates or at a capital gains tax rate.
"Qualified dividends" are taxed at the long-term capital gains tax rate Dividends that are not "qualified dividends" are taxed at the taxpayer's marginal income tax rate (ordinary income tax rates covered above)
Which of the following are qualified dividends eligible for the special capital-gain rate?
Domestic stock dividends distributed from a mutual fund to the shareholders
three types of income (for taxation purposes)
Ordinary income Portfolio income Passive income
active/ordinary income
Ordinary income is income generated from active work at a trade or business Salary payments Receipt of royalty payments Federal ordinary income tax rates range from 10% to 37%. wages salaries business income self employment income
Tim gave his nephew, Luke, 100 shares of AHS Corporation stock that he purchased six months ago for $20,000. At the time of the gift, the fair market value of the stock was $24,000. Which of the following statements concerning the stock is correct?
Since Tim transferred appreciated property to Luke by gift, his basis carries over to Luke. Luke has a $20,000 basis in the stock.
If the asset is held for more than one year before its sale, the gain will be classified as a long-term capital gain and _______________________ rates will apply If the asset is held for one year or less before it was sold, the gain will be classified as a short-term capital gain and will be subject to the ________________________ rate
long-term capital gains taxpayer's ordinary marginal tax
As the end of the year was approaching, Quentin reviewed his stock portfolio and decided to sell his holdings in General Corp. on December 28 of Year 1. The shares were purchased 2 years ago. His basis in the shares was $40,000, and the market value of the shares was $38,000. Quentin wanted to use the $2,000 loss to help him minimize taxes for Year 1. On January 10, Year 2, General Corp. announced new initiatives, and Quentin has second-guessed his decision to sell the shares in the company. He buys back the 1,000 shares for $37,000 on January 11. How much of the $2,000 loss may Quentin claim on his Year 1 tax return and why?
$0 because he purchased the shares back within 30 days of sale
Six years ago, Addie purchased 3,000 shares of LMN, Inc., for $12 per share. She signed an agreement with the company that allowed the company to use her dividend payments to purchase additional shares for her. Over the last 6 years, Addie received a total of $1,900 in dividend payments, which purchased an additional 145 shares of stock. If Addie sells all of her shares for $52,000, what is her taxable gain?
$14,100 Addie's adjusted basis in the shares equals the initial purchase price of the shares, $36,000, plus the dividends that were reinvested of $1,900 since Addie was required to pay tax on the dividend payments the year they were made. When she sells the shares, she has an amount realized of $52,000 less her adjusted basis of $37,900, which equals a taxable gain of $14,100.
Ferdinand sold his home this year and is preparing his income tax return. He sold the house for $650,000. It was purchased 20 years ago (after he was married to Sofia) for $250,000, and they have used it as their principal residence ever since. Ferdinand ran a business from the home, using one room regularly and exclusively for business purposes. Over the 20-year holding period, Ferdinand had claimed $15,000 of depreciation deductions on the home office. What portion of the gain, if any, will be subject to income tax?
$15,000 Even though the home was Ferdinand and Sofia's principal residence and they otherwise meet the qualification rules for the Section 121 exclusion of gain on the sale of a home, Ferdinand depreciated the property. Real property that has been depreciated on a straight-line basis is subject to recapture at a flat 25 percent rate (and is referred to as unrecaptured Section 1250 depreciation). Therefore $15,000 will be subject to income tax at a 25 percent rate, and the remaining gain will be eligible for the Section 121 exclusion.
A taxpayer bought 100 shares of a company's stock in Year 1 for $50. In Year 2, she bought 100 more shares for $100. In Year 3, she bought another 100 shares for $200. In Year 4, the stock crashed to $75 per share, and she sold 100 shares. If she uses the FIFO method, she will report a capital gain of
$25 ($75 - $50).
Capital losses may be used to offset capital gains. If the losses exceed gains in a tax year, the maximum capital loss that can be used to offset ordinary income is _____________ If the net capital loss for the year exceeds $________, the excess amount can be carried forward to future tax years and used to offset capital gains in those years, or alternatively, up to $_________ of ordinary income in those years
$3,000
Two months after Tim purchased Blackacre for $40,000, he died. The fair market value (FMV) of Blackacre as of the date of Tim's death was $45,000. He left Blackacre to his son, Kelvin. Since Kelvin was the only beneficiary of the estate and there were no estate taxes due, the title to the property was transferred to Kelvin within one month of Tim's death. Two weeks after receiving the title to the property, Kelvin sold Blackacre for $48,000. What is the amount and type of income that Kelvin will report on the sale?
$3,000 long-term capital gain When Tim died, the basis of Blackacre qualified for step to fair market value under IRC Section 1014. Kelvin's basis in the property is therefore $45,000. Since he sold the property for $48,000 and his basis was $45,000, Kelvin's gain is $3,000. Even though Tim purchased the property 3.5 months before it was sold, Kelvin's gain will be a long-term capital gain. Any property received through the estate of a decedent automatically qualifies for long-term capital-gains treatment.
Last year Katie purchased a 9 percent corporate bond for its par value of $1,000. This year Katie received coupon payments totaling $90. What is the tax consequence for Katie this year, and what is her cost basis at the end of this year?
$90 ordinary income this year, cost basis $1,000 Coupon payments received are taxed as ordinary interest income and do not result in an adjustment to cost basis.
A REIT is exempt from tax at the entity level if it:
-Derives a minimum of 75% of its income from real estate -Distributes at least 90% of its income in the form of cash dividends to its owners on an annual basis
Which of the following events involving the receipt and recognition of investment income would be taxed at the lowest rate? 1. A Single taxpayer with taxable income of $205,000 receives $5,000 of interest income. 2. A MFJ taxpayer with taxable income of $205,000 receives $5,000 of interest income. 3. A Single taxpayer with taxable income of $490,000 recognizes a long-term capital gain of $5,000. 4. A MFJ taxpayer with taxable income of $490,000 recognizes a long-term capital gain of $5,000.
1. A Single taxpayer with taxable income of $205,000 receives $5,000 of interest income. 32% 2. A MFJ taxpayer with taxable income of $205,000 receives $5,000 of interest income. 24% 3. A Single taxpayer with taxable income of $490,000 recognizes a long-term capital gain of $5,000. 23.8% 4. A MFJ taxpayer with taxable income of $490,000 recognizes a long-term capital gain of $5,000. 18.8%
Taxes learning objectives
1. Determine the basis of an investment in various situations, including when stock is inherited or received by gift. 2. Apply the correct income tax rate to an investment transaction. 3. Identify various types of portfolio income and evaluate situations in which long-term capital gains tax treatment will apply, including capital and passive losses as well as net investment income. 4. Determine the taxation of equities and bonds. 5. Evaluate the taxes imposed on mutual funds, real estate, and other investments.
The tax rates that apply to ordinary income currently range from
10% to 37%.
The maximum tax rate that applies to dividends and long-term capital gains is ______%
20%
The maximum capital gains tax rate (excluding the 3.8% net investment income tax) is _____%. For some taxpayers with low income, the capital gains tax rate is set at ____%.
20% 0%
wash sale
A wash sale is a technique that was used by investors to generate losses for income tax purposes without substantially changing the securities positions in their portfolios. A wash sale is a two-part transaction, whereby an investor sells a security that will generate a tax loss and repurchases the same (or a substantially similar) security within 30 days before or after the sale. Current tax laws disallow tax losses from a wash sale
Market Premium Bond tax rules
Bonds trading at a price in excess of par are called market premium bonds. If interest rates decline, bond values rise Upon the purchase of a premium bond, the investor must elect the tax treatment that will apply to the bond premium. Two options are available: Amortizing the premium over the bond's remaining life or possibly to an earlier call date, or Not amortizing the premium and adding the premium to the bond's basis
(T/F) there is a limit for amount of ordinary loss that can be used to offset gain
FALSE. There is no limit on the amount of ordinary loss that can be offset against other income.
Interest on Loans Used to Acquire Real Estate: Taxation of Investor-Owned Real Estate
If a taxpayer obtains a mortgage to purchase a principal residence and up to one additional residence, the interest becomes an itemized deduction. The interest on loans used to obtain rental real estate is deducted from the income generated by the real estate Rental real estate is a passive activity for most investors. If a loss is generated, the loss may not be deductible in the current tax year but can be carried forward until the property is disposed of or until passive income can be generated. If real estate is purchased for investment but will not be rented, the interest incurred on loans can not be deducted in the tax year the interest is paid. Instead, the investor will capitalize the interest (add the interest expense to his or her basis in the property).
A loss incurred while conducting activities for a trade or business is an ordinary loss and may offset ordinary income
In many instances, it may be ideal to classify a loss as "ordinary" (instead of capital or passive). There is no limit on the amount of ordinary loss that can be offset against other income.
Series EE bonds, Treasury Inflation Protection Securities (TIPS), and Inflation-Indexed Series I Bonds tax rules
Interest income earned on U.S. Government Bonds is subject to federal income tax. Exception: Interest earned on Series EE bonds may not be taxable (qualified education expenses) Interest income earned on U.S. Government Bonds is NOT subject to state and local income tax.
Kelsey engaged in several capital transactions this year. She had a short-term capital gain of $1,000, a short-term capital loss of $400, a long-term capital gain of $300, and a long-term capital loss of $700. How will Kelsey report these items on her income tax return?
Kelsey will report a net short-term capital gain of $200. Short-term capital losses can be netted against short-term capital gains, and long-term capital losses can be netted against long-term capital gains. Since there is a long-term loss of $400 and a short-term gain of $600, the short- and long-term summary results can be netted together. In this case, since the short-term capital gain was larger on an absolute basis, the character of the resulting net gain is a short-term capital gain.
Lucia purchased a home in Colorado 3 years ago for $300,000. She had been working in Colorado for the past 10 years. Yesterday, her employer decided to transfer her to the Missoula, Montana branch, effective next month. Unfortunately, the real estate market has weakened over the past few years, and Lucia is only able to sell her home for $270,000. Which of the following statements correctly identifies her tax consequences of the sale?
Lucia is not permitted to deduct the loss on her income tax return.
Market Discount Bond Tax rules
Market discount bonds are bonds that were initially issued at par value but have declined in value due to changes in market conditions. Unlike OID bonds, a taxpayer who purchases a bond with a market discount does not have to include the discount in taxable income before the sale or maturity of the bond. An investor could elect to report the market discount as it accrues on the bond as interest income each year If the investor makes this election, the amount included in income each year is added to the investor's basis in the bond Assuming that no election is made to amortize the discount, the investor would recognize the market discount on the bond when the bond is sold or when it matures. It will be taxed as interest income.
passive income
Passive income is income from a trade or business in which the taxpayer does not materially participate. Allows a person to profit directly from the effort of others. Limited partnerships S-corporations Limited-liability companies Real estate Passive income is taxed at the same rates that apply to ordinary income. An advantage of passive income is that it is not subject to employment taxes (such as Social Security and Medicare taxes). Passive losses may not be used to offset other income except in a few circumstances. Passive losses may be used to offset passive gains.
portfolio income
Portfolio income is income that is generated by capital. Interest Dividends Capital gains Certain types of portfolio income (such as interest, nonqualified dividends, and short-term capital gains) are subject to ordinary income tax rates. Qualified dividends and long-term capital gains are taxed at the capital gains tax rate. The maximum tax rate that applies to dividends and long-term capital gains is 20%
State and Local Taxation (Property Taxes): Taxation of Investor-Owned Real Estate
State and local governments often tax the value of real estate on an annual basis. Property taxes qualify as itemized deductions for the taxpayer for the year they are paid. TCJA 2017 limits deduction to $10,000 for 2018 and beyond
employment related stock options
Stock options are often used by corporations in structuring deferred compensation plans for their key employees. Two primary types of options used for this purpose: Nonqualified Stock Options (NQSOs) Incentive Stock Options (ISOs) Gains on employment-related options are subject to ordinary income tax and are included in the taxable income in the year the stock options are exercised.
Peter sold a farm with an adjusted basis of $400,000 to Jay for $700,000. In addition, Jay agreed to assume the note on the farm, which had a remaining balance of $50,000. Not taking into consideration any potential depreciation recapture, what is the gain realized in the transaction from Peter's perspective?
The amount realized equals the cash plus the value of liabilities shed, which in this case equals $750,000 ($700,000 in cash plus $50,000 of liabilities shed). Peter's basis of $400,000 can be subtracted from this amount to calculate his gain, which equals $350,000.
While dividends are usually paid by C Corporations (hence the double taxation treatment), S Corporations may pay dividends to shareholders as well but the tax treatment differs.
The dividends issued by an S Corporation are not taxable to the shareholder due to the pass-through nature of S Corporation taxation. The profits of an S Corporation are passed through to the shareholders and subject to income tax, so a subsequent distribution of a dividend will not be taxable.
All of the following statements regarding the basis and holding period of property received as a gift are true EXCEPT: -The holding period for property received as a gift is always long term. -If the value appreciated in the hands of the donor, then the donor's cost basis carries over to the donee. -If the value declined in the hands of the donor, then the donee has a double basis. -If the value declined in the hands of the donor and the donee later sells at a price that is between the donor's basis and the fair market value (FMV) on the date of the gift, then the donee has no taxable gain or loss.
The holding period for property received as a gift is always long term. The holding period for property received by inheritance is always long term; however, for property received as a gift we must first determine whether the gift had appreciated in the hands of the donor. If so, the donor's holding period is carried over to the donee of the gift. If the value had declined in the hands of the donor, the donee will have a double basis and the holding period is determined at the time the donee sells the property, as follows: If the sale price is higher than the donor's basis, then the donor's basis is used as the cost basis and the donor's holding period is carried over to the donee. If the sale price is lower than the fair market value on the date of the gift, then the FMV on the date of the gift is used as the cost basis and the holding period begins on the date of the gift.
taxation of futures contracts
The income taxation of futures contracts depends upon the type of contract held by an investor: For securities futures, the gain or loss on contracts follows the same tax rules that apply to the sale of the underlying property Commodities futures are grouped together with other Section 1256 contracts and include commodities futures contracts, forward contracts, and regulated futures contracts The tax law requires these contracts to be marked to market on the last day of the taxpayer's tax year.
As the end of the year was approaching, Ted reviewed his stock portfolio and decided to sell his holdings in XYZ on December 28 of Year 1. The shares were purchased two years ago. His basis in the shares was $20,000, and the market value of the shares was $18,000. Ted wanted to use the $2,000 loss to help him minimize taxes for Year 1. On January 10, Year 2, XYZ announced new initiatives, and Ted second-guessed his decision to sell the shares in the company. He buys back the 1,000 shares for $17,000 on January 11. Assuming that Ted had no other capital transactions for Year 1, what is the impact of this transaction on Ted's Year 1 income tax return?
The sale of XYZ will not impact Ted's AGI for Year 1. Since Ted purchased the same security within 30 days before or 30 days after that date on which it was sold for a loss, the sale is considered a wash-sale transaction, and the loss may not be claimed in the current period.
tax basis rules for inherited assets
The tax basis of an asset is the asset's fair market value on the date of the decedent's death. All assets inherited from a decedent that were included in the decedent's gross estate will have a long-term holding period in the beneficiary's hands. IRD (income in respect of decedent) assets represent deferred income for the decedent (such as IRAs, 401(k) and 403(b) plans, annuities, and savings bonds) IRD assets do not qualify for an adjusted basis. They are fully subject to income tax when distributed to the beneficiary.
True or false: If the real estate was used for personal purposes (such as for a principal or secondary residence) no loss deduction is allowed
True! If a loss (on the sale) is incurred, it will be deductible as a capital loss if the real estate was held for investment
UIT taxation
Unit Investment Trusts hold a portfolio of securities, and interests in that portfolio of securities are sold to investors. UITs are not usually actively managed. UIT returns come from distributions of income from the trust and from realization of gains upon sale of their units The taxation of gains or losses on sale of unit investment trust interests follows the normal rules for calculating capital gains and losses
Real estate held in a trade or business — treated as a Section 1231 asset. The depreciable portion of real estate (building and improvements) will generally be taxable at _________ rates, subject to adjustment for recapture of depreciation. Land held for personal use or for investment — will be classified as a capital asset and ________________ rates will apply.
capital gains tax
When a dealer holds the property as inventory for sale to customers, gains on the sale of real estate are treated as
ordinary income.
To receive the lower tax rate on a dividend distribution from an investment in corporate stock, the investor must
own the stock for a minimum of 60 days during the 120-day period commencing on the date that is 60 days before the stock's ex-dividend date.