Chapter 7: Investments

Net investment income

(for determining deductibility of investment interest expense) gross investment income reduced by deductible investment expenses

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

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

Section 1202 provides that owners of qualified small business stock that is sold during 2021 and has been held for at least five years can exclude up to _______ percent of the gain from taxation depending on the acquisition date.

100

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.

25000

Which one of the following tax rates does NOT currently apply to long-term capital gains? Multiple choice question. A. 37% B. 28% C. 25% D. 15% E. 20%

A. 37% Reason: This is the highest ordinary marginal tax rate.

Which of the following choices describe collectibles? (Check all that apply.) Multiple select question. A. Alcoholic beverages held over a year can qualify as a collectible. B. A gain on collectibles is taxed at a maximum rate of 15 percent. C. Coin collections and stamp collections may qualify as collectibles. D. A gain on collectibles is taxed at a maximum rate of 25 percent. E. Collectibles held less than twelve months may still qualify for preferential tax treatment. F. A gain on collectibles is taxed at a maximum rate of 28 percent. G. Corporate stock held in an investment portfolio may qualify as a collectible.

A. Alcoholic beverages held over a year can qualify as a collectible. C. Coin collections and stamp collections may qualify as collectibles. F. A gain on collectibles is taxed at a maximum rate of 28 percent.

Which of the following choices determine the amount and the timing for recognizing interest income? (Check all that apply.) Multiple select question. A. The actual interest payments received are included in gross income. B. If bonds are purchased at a discount in the secondary market, the discount is recognized as interest income at maturity. C. 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. D. If bonds were issued at a premium, special original issue discount rules apply. 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.

A. The actual interest payments received are included in gross income. B. If bonds are purchased at a discount in the secondary market, the discount is recognized as interest income at maturity. C. 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.

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

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

Please choose the statement that is INCORRECT? Multiple choice question. A. The tax advantages of holding an asset for more than a year overrides the risk of declining values in the investment. B. Gains on the sale of capital assets are taxed at rates lower than a taxpayer's marginal rate if the assets were held for more than one year. C. Investing in capital assets allows taxpayers to defer recognizing gains until the assets are sold resulting in a lower PV of capital gains tax. D. Taxpayers should balance the tax benefits of holding assets with the risk that the asset values will have declined by the time they are sold.

A. The tax advantages of holding an asset for more than a year overrides the risk of declining values in the investment.

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

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

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

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

Which of the following types of transactions result in capital losses that are NOT deductible for tax purposes? (Check all that apply.) Multiple select question. A. Wash sales B. Sales to related parties C. Sales of personal-use assets D. Sale of land held for investment

A. Wash sales B. Sales to related parties C. Sales of personal-use assets

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 ______. Multiple choice question. A. long-term capital loss because Bob must first use the short-term loss to offset ordinary income B. capital loss carryforward and Bob can choose how much of the gain to allocate to short-term versus long-term C. short-term capital loss because Bob must first use the long-term loss to offset ordinary income D. capital loss pro-rated between short-term ($300) and long-term ($700)

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

Chad incurred capital gains and losses during the current year. He has a $7,000 net short-term capital gain; a $14,000 long-term capital loss in the 15% category; and a $10,000 long-term capital gain taxed at 28%. How will these transactions be taxed after the gains and losses are combined? Multiple choice question. A. $3,000 will be taxed at 28%. B. $3,000 will be taxed at marginal rates. C. $3,000 will be taxed at 15%. D. $7,000 will be taxed at taxed at the marginal rate, and the $4,000 excess long-term capital loss will be carried forward.

B. $3,000 will be taxed at marginal rates.

Which of the following types of assets does NOT qualify as a capital asset? Multiple choice question. A. Assets held as investments B. Assets used in a trade or business C. Assets classified as "personal use"

B. Assets used in a trade or business

Bailey stood in line for hours and purchased the new game system the day it became available for $600. Knowing that there was a high demand for the game system and a limited supply, she decided to put the item on E-bay rather than keep it. She sold it for $950. She also sold her five-year old car for $5,000. She had purchased the car for $13,000. What is the taxable nature of these transactions? Multiple choice question. A. Bailey has a taxable short-term capital gain of $350 and a deductible long-term capital loss. B. Bailey has a taxable short-term capital gain of $350, but no deductible loss for the car. C. Bailey has no tax consequences for these transactions because the assets sold were "personal use" assets. D. Bailey does not have to pay tax on the game system, but she deductible long-term capital loss.

B. Bailey has a taxable short-term capital gain of $350, but no deductible loss for the car.

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

B. Investment interest expense

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

B. Operating income

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

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

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

B. U.S. savings bonds

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 $____ resulting in a capital gain of $___ for the year.

Blank 1: 7000 - 420 = 6,580 or 6580 Blank 2: 3000 + 1000 = 4,000 or 4000 Blank 3: 6580 - 4000 = 2,580 or 2580

U.S. ______ _______ do NOT pay periodic interest payments, but the interest accumulates over the term of the bond.

Blank 1: Savings or Saving Blank 2: Bonds or Bond

Although losses from rental property are classified as passive losses, there is an exception that allows a taxpayer who is a(n) _______ participant in a rental activity to deduct up to $____ of the rental loss against nonpassive income.

Blank 1: active Blank 2: 25000 or 25,000

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.

Blank 1: collectibles Blank 2: 28 or twenty-eight

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

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.

Blank 1: lesser, lower, least, or smaller Blank 2: modified or M

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, participated, or participate

Passive activity losses may only offset _____ income, but NOT active business or ____ income.

Blank 1: passive or passive activity Blank 2: portfolio

A taxpayer's income or loss for the year is classified into one of three categories: ________ income/loss, _______ income/loss, and ______ income/loss.

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

Regarding portfolio investments, _______ dividends generally are taxed at capital gains rates and _______ dividends are taxed at ordinary rates.

Blank 1: qualified or qualifying Blank 2: nonqualified, nonqualifying, ordinary, not qualified, non-qualified, or non qualified

Bridget, a single taxpayer, sold a building used in her business during the current year. The realized gain on the sale was $135,000. Of this amount, $95,000 is unrecaptured Section 1250 gain. How will Bridget be taxed on this gain assuming her marginal tax rate is 32 percent and her LTCG rate is 15%? Multiple choice question. A. $135,000 will be taxed at 32% B. $135,000 will be taxed at 25%. C. $95,000 will be taxed at 25 percent and $40,000 will be taxed at 15%. D. $95,000 will be taxed at 25 percent and $40,000 will be taxed at 32%.

C. $95,000 will be taxed at 25 percent and $40,000 will be taxed at 15%.

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

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

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.) Multiple select question. A. Interest on corporate bonds B. Nonqualified dividends C. Qualified dividends D. Short-term capital gains E. Long-term capital gains

C. Qualified dividends E. Long-term capital gains

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? Multiple choice question. A. The loss should offset gains in the 25% category, then the 28% category; then the taxpayer can offset the short-term capital gains. B. 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. C. 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. D. 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.

C. 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.

In order for a taxpayer to be able to deduct the loss on a business activity that he is involved in, which of the following must be true? Multiple choice question. A. The taxpayer must manage and direct the operations of the business. B. The taxpayer must actively participate in the business. C. The taxpayer must materially participate in the business. D. The taxpayer must own over half of the business.

C. The taxpayer must materially participate in the business.

What type of gain is taxed at a maximum long-term capital gains rate of 25%? Multiple choice question. A. Gain from the sale of intangible investments, such as stock B. Gain from the sale of personal use assets C. Unrecaptured Section 1250 gain from the sale of business property D. Gain from the sale of collectibles

C. Unrecaptured Section 1250 gain from the sale of business property

What is the rate of the additional tax that is assessed on net investment income when it exceeds specified thresholds? Multiple choice question. A. 1.45% B. 6.2% C. 15.3% D. 3.8%

D. 3.8%

Courtney invested in RAD, Inc. stock nine months ago. She is considering tax planning strategies at the end of the year and is pondering whether or not to sell her investment in the stock. A friend has advised Courtney that she should hold the stock for at least three more months in order to have a long-term holding period. Which of the following considerations describes a valid reason for selling the stock now? Multiple choice question. A. Courtney wants to sell the stock, donate the proceeds to a qualified charity, and utilize the tax deduction on this year's tax return. B. Courtney currently has $2,000 in capital losses and she needs to generate at least $2,000 in capital gains to be able to deduct her capital losses. C. Courtney is currently in the 37% tax bracket. Consequently, she will not receive preferential treatment for long-term capital gains. D. Courtney is concerned that the value of the stock will decline in the near future.

D. Courtney is concerned that the value of the stock will decline in the near future.

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

D. Sales of investment assets

Which of the following answers pertain to net short-term capital gains and losses? (Check all that apply.) Multiple select question. A. The gains may be taxed at one of three preferential (15%, 25%, 28%) rates. B. The holding period is more than two years. C. The gains are taxed at lower, preferential tax rates. D. The gains are taxed at ordinary tax rates. E. The holding period is five years or less. F. The holding period is one year or less.

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

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. Multiple choice question. A. regular B. material C.full-time D. active

D. active

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.

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

True or false: Interest income is generally taxed at lower capital gains rates.

False Reason: Interest income is taxed at ordinary rates, while dividend income is generally taxed at capital gains rates.

Other investment expense

Not deductible

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.

True or false: Net passive income is included with net investment income and, therefore, may be subject to the 3.8% additional tax on net investment income.

True Reason: Net passive income is considered to be investment income. Consequently, it may be assessed the additional tax.

C corporations

a corporate taxpaying entity with income subject to taxation. Such a corporation is termed a "C" corporation because the corporation and its shareholders are subject to the provisions of Subchapter C of the Internal Revenue Code

Treasury bond

a debt instrument 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 note

a debt instrument 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 notes have terms of 2, 5, or 10 years

Bond

a debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing

Dividend

a distribution to shareholders of money or property from the corporation's earnings and profits

Mutual fund

a diversified portfolio of securities owned and managed by a regulated investment company

Accrued market discount

a ratable amount of the market discount at the time of purchase (based on the number of days the bond is held over the number of days until maturity when the bond is purchased) that is treated as interest income when a bond with market discount is sold before it matures

Face value

a specified final amount paid to the owner of a coupon bond on the date of maturity. The face value is also known as the maturity value

Basis

a taxpayer's unrecovered investment in an asset that provides a reference point for measuring gain or loss when an asset is sold

Zero-coupon bond

a type of bond issued at a discount that pays interest only at maturity

Original issue discount (OID)

a type of bond issued for less than the maturity or face value of the bond

Collectibles

a type of capital asset that includes a work of art, a rug or antique, a metal or gem, a stamp or coin, an alcoholic beverage, or other similar items held for investment for more than one year

Unrecaptured §1250 gain

a type of §1231 gain derived 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 percent capital gains rate

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 same order in which they are purchased (i.e., first purchased, first sold)

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

Active participant in a rental activity

an individual who owns at least 10 percent 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

Certificate of deposit (CD)

an interest-bearing debt instrument offered by banks and savings and loans. Money removed from the CD before maturity is subject to a penalty

Tax shelter

an investment or other arrangement designed to produce tax benefits without any expectation of economic profits

At-risk amount

an investor's risk of loss in a worst-case scenario. In a partnership, an amount generally equal to a partner's tax basis exclusive of the partner's share of nonrecourse debt.

Assets that are held for investment or personal use assets are referred to as ______ assets. (Enter only one word per blank.)

capital

U.S. savings bonds

debt instruments issued by the U.S. Treasury at face value or at a discount, with a set maturity date. Interest earned from U.S. bonds is paid either at maturity or when the bonds are converted to cash before maturity

Passive investments

direct or indirect investments (other than through a C corporation) in a trade or business or rental activity in which the taxpayer does not materially participate

Exchange traded fund (ETF)

diversified portfolios of securities owned and managed by a regulated investment company similar to mutual funds except they are traded on exchanges and the shares trade throughout the day like ordinary stock listings

Long-term capital gains or losses

gains or losses from the sale of capital assets held for more than 12 months

Short-term capital gains or losses

gains or losses from the sale of capital assets held for one year or less

Capital asset

in general, an asset other than an asset used in a trade or business or an asset such as an account or note receivable acquired in a business from the sale of services or property

Investment income

income received from portfolio-type investments. Portfolio income includes capital gains and losses, interest, dividend, annuity, and royalty income not derived in the ordinary course of a trade or business. When computing the deductibility of investment interest expense, however, capital gains and dividends subject to the preferential tax rate are not treated as investment income unless the taxpayer elects to have this income taxed at ordinary tax rates

Investment interest expense

interest paid on borrowings or loans that are used to fund portfolio investments. Individuals are allowed an itemized deduction for qualified investment interest paid during the year

Portfolio investments

investments producing dividends, interest, royalties, annuities, or capital gains

Flow-through entities

legal entities, like partnerships, limited liability companies, and S corporations, that do not pay income tax. Income and losses from flow-through entities are allocated to their owners

Qualified dividends

paid by domestic or certain qualified foreign corporations that are eligible for lower capital gains rates

Qualified small business stock

stock received at original issue from a corporation with a gross tax basis in its assets both before and after the issuance of no more than $50,000,000 and with 80 percent of the value of its assets used in the active conduct of certain qualified trades or businesses

Passive activity loss (PAL) rules

tax rules designed to limit taxpayers' ability to deduct losses from activities in which they don't materially participate against income from other sources

Tax basis

the amount of a taxpayer's unrecovered cost of or investment in an asset; see also adjusted tax basis

Maturity

the amount of time to the expiration date, or maturity date, of a debt instrument. The maturity of a debt instrument is generally the life of the instrument, at which point a payment of the face value is due or the instrument terminates.

Maturity value

the amount paid to a bondholder when the bond matures and the bondholder redeems the bond for cash

Operating income

the annual income from a trade or business or rental activity

Operating loss

the annual loss from a trade or business or rental activity

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

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

Net long-term capital gain

the excess of long-term capital gains for the taxable year over the long-term capital losses for such year

Net long-term capital loss

the excess of long-term capital losses for the taxable year over the long-term capital gains for such year

Net capital gain

the excess of net long-term capital gain for the taxable year over net short-term capital loss for such year

Net short-term capital gain

the excess of short-term capital gains for the taxable year over the short-term capital losses for such year

Net short-term capital loss

the excess of short-term capital losses for the taxable year over the short-term capital gains for such year

Amortization

the method of recovering the cost of intangible assets over a specific time period.

Ex-dividend date

the relevant date for determining who receives a dividend from a stock. Anyone purchasing stock before this date will receive current dividends. Otherwise, the purchaser must wait until subsequent dividends are declared before receiving them

Bond discount

the result of issuing bonds for less than their maturity value

Bond premium

the result of issuing bonds for more than their maturity value

Wash sale

the sale of an investment if that same investment (or substantially identical investment) is purchased within 30 days before or after the sale date. Losses on wash sales are deferred

Maximum 15 percent rate amount

threshold for the 15 percent rate to apply to long-term capital gains. Any 0/15/20 percent capital gains included that result in taxable income above the maximum zero rate amount and up to the maximum 15 percent rate amount are taxed at 15 percent. The threshold is based on a taxpayer's filing status and income

Maximum zero percent rate amount

threshold for the zero percent rate to apply to long-term capital gains. Any 0/15/20 percent capital gains included in taxable income up to the maximum zero percent amount are taxed at 0 percent. It is based on a taxpayer's filing status and income level