15-1

Individual Tax Consequences of Investment Activity

Timing issues in income recognition Expenses related to investment activity Tax basis of investment assets Gain/loss on disposition

Character of gain or loss Capital gains tax rates for individuals

Limits on deductibility of passive activity losses

Wealth transfer taxation

15-2

Income Recognition

General rule: interest/dividend income taxable when actually or constructively received Exceptions: municipal bond interest, return-of-

capital dividends, discounts on short-term bonds, market discount on long-term bonds

Original issue discount on long-term bonds taxed as effective interest income over life of the bonds

Proceeds of life insurance policies Liquidation prior to death is taxable, in excess of

premiums paid Death benefits not taxable

15-3

Investment Expenses

Expenses such as safety deposit box rental, investment management fees, subscriptions to investment newsletters are miscellaneous itemized deductions, deductible only to the extent that total exceeds 2% of AGI

Investment interest expense Not deductible if proceeds used to purchase tax-

exempt bonds If used to purchase other investment property,

itemized deduction cannot exceed taxpayers net investment income

15-4

Tax Basis of Investment Property

Initial tax basis generally equals cost plus acquisition fees

Basis adjustments: Basis in bonds increased for taxable OID Basis in securities increased (decreased) by

dividend reinvestments (return of capital distributions)

Basis in partnership and S corporation investments adjusted to reflect allocations of income and expense, contributions and distributions

Basis in rental property reduced by annual cost recovery deductions

15-5

Sales of Investment Property

If investor holds several blocks of identical securities, acquired at different prices, and sells a portion of shares owned, basis is assigned using FIFO unless shares sold can be specifically identified

Sales of mutual fund shares typically use an average basis method

15-6

Gain/Loss on Disposition of Investment Property

Each gain/loss categorized as: capital, ordinary, Sec. 1231 Capital gain/loss further categorized as short-term

(assets held 1 year or less), long-term (assets held more than one year), 28% gain (collectibles), or 25% gain (unrecaptured Sec. 1250 gain)

Gains and losses within each category are combined to obtain a net gain or loss

15-7

Netting Rules for Capital Gains/Losses

If any capital category has a net loss, such loss can be deducted first against net 28% gains, then against other gains

An individual taxpayer’s overall net capital loss is deductible only up to $3,000 annually, as a deduction ‘for’ AGI Any non-deductible net capital loss can be carried

forward Net capital gains taxed at special tax rates

15-8

Capital Gains Tax Rates

Excess of net short-term capital gains over net long-term capital losses taxed as ordinary income

Excess of net long-term capital gains over net short-term capital losses: 28% (25%) gains taxed at maximum of 28% (25%) or

taxpayer’s ordinary income tax rate Other long-term capital gains taxed at 15% (NEW

LAW – formerly 20%). However, if taxpayer’s ordinary income tax rate is 15% or less, long-term capital gains are taxed at 5% (NEW LAW – formerly 10%).

15-9

Special Rules Affecting Gain/Loss on Investments

Individuals may exclude 50% of gain on qualified small business stock held more than 5 years portion of gain recognized is 28% gain stock must be issued directly by a qualifying small

business (< $50 M gross assets) after 8/10/93 Loss on sale of Sec. 1244 stock deductible as

ordinary annual limit of $100,000 (MFJ) or $50,000 (single) First $1 M of stock issued directly by corporation

to investors for money or other property

15-10

PAL Limitations - Overview

Apply to individuals, fiduciaries, closely-held and personal service corporations

Income/loss separated into baskets active (including compensation), portfolio, passive

Losses from passive activities can offset income from other passive activities

Net passive activity losses cannot offset active or portfolio income, until the taxpayer completely disposes of the passive activity

15-11

Definitions

Passive activity loss - net loss for the taxable year from all passive activities

Passive activity - two types: Any trade or business in which the taxpayer does

not materially participate Any rental activity

Material participation: Taxpayer must be involved in the operations of the business on a regular, continuous, and substantial basis (based on facts and circumstances)

15-12

PAL Rules for Interests in Passthrough Entities

Classification of income and deductions as active/passive made at partner or shareholder level

Limited partners cannot, by law, materially participate

General partners and S corporation shareholders may treat their share of entity business income as active only if they materially participate in the business operations of the entity

15-13

Dispositions of Passive Activities

Any suspended losses from a passive activity are fully deductible in the year in which the entire interest is disposed of in a taxable transaction

Partial dispositions or dispositions in nontaxable transactions do not trigger suspended losses

15-14

Special Rules for Rental Real Estate

Individuals can deduct up to $25,000 annually of rental real estate losses if: AGI is less than $100,000 (allowance reduced by

50% for AGI in excess of $100,000) AND Taxpayer actively participates in the rental activity

Owns at least a 10% interest Is significantly involved in the management of the

property (approves tenants, sets lease terms, authorizes repairs, selects management service)

Wealth 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 55% Under new law, maximum rate drops to 45% by

2007. In 2010, maximum gift tax rate drops to 35%, and estate tax is eliminated (BUT it returns in 2011!)

Lifetime Transfer Tax Exclusion

Gift tax exclusion $1 million Estate tax exclusion

2002 and 2003 $1 million 2004 and 2005 $1.5 million 2006, 2007, and 2008 $2 million 2009 $3.5 million Estate tax eliminated in 2010 Estate tax reinstated in 2011 with exclusion of $1

million Estate tax exclusion reduced by any lifetime gift

tax exclusion used during decedent’s life

Gift Tax Remember, all receipts of gifts are excluded

from INCOME taxation We are now discussing GIFT taxation

Gift tax paid by the giver, not the recipient Can exclude $11,000 per year per donee from

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

spouse

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

Income Tax Effects of GiftsGift is not taxable income to recipientDonor’s adjusted basis in the property

carries over to become the recipient’s basis exception - use FMV if less than adjusted basis

After gift, any income derived from the property belongs to the recipient

Estate TaxTaxed at unified estate and gift rate

scheduleFMV of estate is taxed Unlimited marital deductionReduce estate by taxes, charity,

administrative expenses

Income Tax Effect of BequestsReceipt of a bequest is not taxable

income to heirBasis of inherited property = FMV at date

of death Free income tax step-up in basis

Trade-off: Gift now at low basis, avoid some transfer tax Keep and include in estate, but heirs get high basis