Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-1

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Investment and Personal Investment and Personal Financial PlanningFinancial Planning

Chapter 15Chapter 15

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-2

ObjectivesObjectives

interest and dividends tax deferral: insurance and annuities capital gains and losses investment interest expense passive losses estate and gift rules

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-3

Business versus InvestmentBusiness versus Investment

Business activity Time and talent on regular basis Profit partially attributable to personal involvement

Investment activity Passive role as owner of income-producing property Managing a portfolio is investment activity.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-4

Investments in Financial AssetsInvestments in Financial Assets

Securities include: common and preferred stock savings accounts, CDs, notes, bonds

Return on investment includes interest dividends

Reinvested dividends are still taxable but increase basis. Jobs and Growth Tax Relief Reconciliation Act of 2003 created new 15% preferential tax rate for qualified dividend income.

gains (losses). Mutual funds may report ‘distributed’ capital gains/losses. These

are still taxable but increase basis even if no cash received.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-5

Interest IncomeInterest Income

Municipal bond interest income is tax-free at federal level for regular tax. If the bond is a private activity bond, the interest is an

AMT preference. See AP2 for an interesting problem with interaction of

federal and state rates.

U.S. debt (bills, notes, bonds) are taxable at federal level (often exempt at state level). Most pay interest every six months - taxable on receipt.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-6

Interest Income - Discount BondsInterest Income - Discount Bonds

Cash basis generally says recognized interest income when paid.

Interest income rules are exception - must recognize when earned, such as when original issue discount ACCRUES. Exception for Series EE U.S. savings bond - delay income

tax until bond is cashed. Exception allows ELECTION to be taxed currently on EE bonds.

OID is amortized using effective interest method. Market discount recognized when bond sold or matured. See AP3.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-7

Deferral with Life Insurance or AnnuitiesDeferral with Life Insurance or Annuities

Life insurance proceeds NOT taxable income at death.

Life insurance policies (but not TERM life policies) build up cash surrender value (CSV). If liquidate policy, excess of CSV over premiums paid is taxable.

Annuity contracts are not taxed until annuity payments are made. Taxation is like installment sales rules: portion of annuity excluded = payment x ratio of investment in annuity / expected return on annuity. See AP6 and 7.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-8

Gains/Losses on SecuritiesGains/Losses on Securities

Realization requires a sale or exchange Gain/loss = Proceeds - adjusted basis Character is capital - time period matters Basis issues

reinvested dividends increase basis. Sale of stock uses either specific ID or FIFO method of

matching basis with sales. Mutual fund shares sold typically use an average basis.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-9

Capital Losses on Worthless Securities Capital Losses on Worthless Securities and Bad Debtsand Bad Debts

Worthless securities are treated as if they are sold on the LAST day of the tax year for $0. Capital loss results - often long-term.

Nonbusiness bad debts are treated as a short-term capital loss. See AP9.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-10

Exchanging SecuritiesExchanging Securities

General rule is that exchanges are taxable. (e.g. Intel for Nike).

Nontaxable if the stocks are in the SAME corporation, or

part of the nontaxable reorganization. Keep your old basis - this creates

DEFERRAL of gain or loss. See AP 10, 11.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-11

What to do with Capital Gains and LossesWhat to do with Capital Gains and Losses

SHORT TERM asset held for <= 1 year LONG TERM asset held for > 1 year

Separate 28% rate category for collectibles and sale of qualified small business stock.

Net the gains and losses in each class (net ST, net LT, net 28%LT).

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-12

Netting and Tax Rates - Net LossNetting and Tax Rates - Net Loss

Net the net ST gain/loss with the net LT gain/loss

IF the total net capital gain/loss is a LOSS deduct $3000 against ordinary income carryforward remainder indefinitely

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-13

Netting and Tax Rates - Net GainNetting and Tax Rates - Net Gain

IF the total net capital gain/loss is a GAIN any NET ST gain is taxed at regular rates. any NET 28% is taxed at maximum 28% rate any other NET LT is taxed at 15% (or 5% if the

individual is in a 15% ordinary bracket). The section 1231 gain treated as capital which

is attributed to unrecaptured realty depreciation (section 1250) is taxed at maximum 25%.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-14

Investments in Small BusinessInvestments in Small Business

Qualified small business stock (<=$50 million assets after issue; issued after 8/10/93). Exclude 50% gain if held >5 years. Remaining gain is 28% rate gain.

Loss on Section 1244 stock (1st $1million issued stock) is ordinary up to $100,000 for MFJ ($50,000 single, MFS) returns. Excess loss is capital loss. Gains still qualify as capital.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-15

Investment ExpensesInvestment Expenses

Other expenses (not interest) allowed to the extent they EXCEED 2% of AGI (jointly with unreimbursed employee expenses and some others). investment fees, investment publications, seminars

Investment interest expense is deductible UP TO net investment income: interest, dividend, annuities, STCG PLUS, if ELECT to be taxed at ordinary rates, may include LTCG C/F any excess interest expense indefinitely and deduct in future.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-16

Investment Interest Expense: ExampleInvestment Interest Expense: Example

AGI = $100,000 Investment advice fees = $3000. Investment interest expense = $15,000 Dividends = $13,000 LTCG = $5000 What is the MAXIMUM investment interest

expense you can deduct? If you do NOT elect to include LTCG, how much do you deduct? How would you decide?

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-17

Real Estate InvestmentsReal Estate Investments

Land is generally a capital asset - appreciation is taxed at favorable rates on sale.

RE taxes paid are deductible. Mortgage interest payments are investment

interest expense. Frequent sales of land may cause land to be

viewed as inventory. No depreciation - other expenses may be

deductible.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-18

Rental RERental RE

Report rent income and expenses on Schedule E. Rental property is depreciated using residential rates.

Allocate deductions to rental income in proportion of days rented / days used (by you or tenant). Exception: may allocate interest expense and tax expense

to rental income in proportion of days rented / 365.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-19

Rental RE and Personal UseRental RE and Personal Use

Losses are limited to rental income IF you use the house personally for more than the greater of 1) 14 days 2) 10% of the rental days.

Even if not violate above test, net losses may be limited due to basis rules (remember Chapter 9) or passive activity limits (see below).

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-20

Rental RE - ExampleRental RE - Example

Rental income = $10,000 Depreciation = $5,000 Interest expense = $8,000 Utilities = $2,000 What would we do if rental days = 190 and

personal days = 10? What would we do if rental days = 200 and

personal days = 50?

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-21

Passive ActivitiesPassive Activities

Definition: an interest in a business where the owner does not MATERIALLY PARTICIPATE - involved in day-to-day operations on a regular, continuous and substantial basis.

LOSS on passive activity is ONLY deductible to the extent of OTHER PASSIVE INCOME. (Excludes active income - e.g. wages, material activities; excludes portfolio income - e.g. interest, dividends). See AP19.

Excess losses are carried forward indefinitely - can deduct unused losses at disposition.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-22

Passive Activity Exception for Rental REPassive Activity Exception for Rental RE

Passive rental losses up to $25000 can be deducted if active management married AGI less than $100,000 (phases out fully at

$150,000).

The passive activities rules are far more complex than this text explores.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-23

Wealth Transfer PlanningWealth Transfer Planning

Gift, estate, and generation skipping transfer taxes

The unified gift and estate tax is based on cumulative transfers over time (life + death).

Graduated rates up to 48% In 2001, Congress repealed the estate and

generation-skipping taxes effective in 2010

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-24

Gift TaxGift Tax

Remember, all receipts of gifts are excluded from INCOME taxation. We are now discussing GIFT taxation.

Exclude $11,000 per year per donee from taxable gifts.

No gift tax on gifts to spouse, charity, paying tuition or medical costs.

Can treat gift by one spouse as made 1/2 by other spouse.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-25

Gift Tax ExclusionGift Tax Exclusion

Lifetime exclusion 2003 $1,000,000

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-26

Income Tax Effects of GiftsIncome Tax Effects of Gifts

Gift is not taxable income to donee. Donor’s adjusted basis in the property carries

over to become the donor’s basis. exception - use FMV if less than adjusted basis

After gift, any income derived from the property belongs to the donee.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-27

Kiddie TaxKiddie Tax

Unearned income of children < 14 years old In excess of $800 in 2004 Is taxed at the parent’s marginal tax rate Child < 14 standard deduction is limited to

GREATER of $800, or earned income + $250.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-28

Estate TaxEstate Tax

Taxed at unified estate and gift rate schedule FMV of estate is taxed Unlimited marital deduction Reduce estate by taxes, charity,

administrative expenses. See AP23.

Click to edit Master text styles Second level

Third level Fourth level

Fifth level

#15-29

Income Tax Effect of BequestsIncome Tax Effect of Bequests

Receipt of a bequest is not taxable income to heir.

Basis = FMV at date of death = free income tax step-up in basis. (In 2010, wealthy estates generate carryover basis).

Trade-off - gift now at low basis, perhaps avoid some transfer tax keep and include in estate, but heirs get high basis See AP24.