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Chapter 11 - Investments

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Chapter 11 Investments

SOLUTIONS MANUAL

Discussion Questions

1. [LO 1] 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.

2. [LO 1] 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.

3. [LO 1] Compare and contrast the tax treatment of interest from a Treasury bond and

qualified dividends from corporate stock.

Both the interest from Treasury bonds and dividends are taxed by cash method taxpayers

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.

4. [LO 1] 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.

Treasury bonds and Treasury notes are issued at maturity value, at a discount, or at a

premium, depending on prevailing interest rates. Treasury bonds and Treasury notes pay

a stated rate of interest semiannually. When Treasury bonds and Treasury notes are

either issued or subsequently purchased at either a premium or discount, special rules

apply. Specifically, taxpayers may elect to amortize the premium to reduce the amount of

interest currently reported. To the extent taxpayers amortize the premium, they reduce

the tax basis in the related bond or note. If a portion of the premium is unamortized




(either because the election to amortize the premium was not made or because the bond

is sold prior to maturity), the unamortized premium remains part of the tax basis of the

bond or note and affects the amount of capital gain or loss taxpayers recognize when the

bond or note is sold or when it matures.

Original issue discount must be amortized and included in gross income in addition to

any interest payments taxpayers actually receive. Also, the tax basis of a bond or note is

increased by the amount of original issue discount amortized into income. In contrast,

market discount is not amortized into income unless taxpayers elect to do so. Rather, the

market discount that would have been amortized into income (on an annual basis using a

straight line method) if the taxpayer had elected to amortize the market discount into

income is treated as ordinary income when the bond or note is sold or when it matures.

5. [LO 1] 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.

6. [LO 1] 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.

Also, interest from savings bonds used to pay for qualifying educational expenses may be

excluded entirely from income whereas interest from corporate bonds must eventually be

reported.

7. [LO 1] {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.

Generally, this election makes sense when the taxpayer’s current marginal tax rate is

expected to be significantly lower than the future marginal rate when the bond is sold or

matures.




8. [LO 1] Why might investors purchase interest-paying securities rather than dividend-

paying 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.

9. [LO 1] 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.

10. [LO 1] Do after-tax rates of return for investments in either interest or dividend paying

securities increase with the length of the investment? Why or why not?

After-tax rates of return do not increase for interest or dividend paying securities with the

length of the investment period because they are both taxed annually.

11. [LO 2] 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.

Also, any property that is used for personal rather than business purposes is a capital

asset. Examples of capital assets include investment assets such as corporate or

governmental bonds, corporate stock, stocks in mutual funds, and land held for

investment. Personal assets such as automobiles, personal residences, golf clubs, book

collections, and televisions are also capital assets.

12. [LO 2] 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.




13. [LO 2] 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.

14. [LO 2] Cameron purchases stock in Corporation X and in Corporation Y. Neither

corporation pays dividends. The stocks both earn an identical before-tax rate of return.

Cameron sells stock in Corporation X after three years and he sells the stock in

Corporation Y after five years. Which investment likely earned a greater after-tax return?

Why?

The gain from the sale of the Corporation Y stock should earn a greater after-tax return

because the tax was deferred for 5 years while the tax on the gain from the sale of

Corporation X stock was deferred for 3 years. The longer the tax is deferred, the less it

costs on an after-tax basis. The lower the tax cost, the higher the after-tax return, all else

equal.

15. [LO 2] What is the deciding factor in determining whether a capital gain is a short-term

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.

16. [LO 2] 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.

17. [LO 2] What tax rate applies to net short-term capital gains?

Net short-term capital gains are taxed at the taxpayer’s ordinary tax rates.

18. [LO 2] 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.

19. [LO 2] 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.

20. [LO 2] Are all long-term capital gains taxable at the same maximum rate? If not, what

rates may apply to long-term capital gains?

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%

21. [LO 2] {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.




22. [LO 2] 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.

23. [LO 2] 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 potential. If a taxpayer sells a 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.

Hence losses recognized on assets used for personal purposes are not deductible.

However, if Nick sold the car for more than he purchased it, he would be taxed on the

capital gain.

24. [LO 2] 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.

A third strategy is to sell investments with built-in losses. Selling loss assets reduces

taxes by providing up to a $3,000 deduction against ordinary income and by reducing the

amount of capital gains that would otherwise be subject to tax during the year. This is

particularly beneficial for a taxpayer with short-term capital gains that would be taxed at

high ordinary rates absent offsetting capital losses.




25. [LO 2] {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).

Clark should also assess his other capital gains and losses incurred during the year. The

gain he recognizes on the sale will enter the netting process. Thus, if he has a large short

term capital loss, he may want to sell the stock this year to absorb the loss.

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.

26. [LO 2] Under what circumstances would you expect the after-tax return from an

investment in a capital asset to approach that of tax-exempt assets assuming equal before-

tax rates of return?

The after-tax return from capital assets approaches the after-tax return of tax-exempt

assets (assuming equal pre-tax rates of return) the longer the taxpayer holds the capital

asset. The longer the taxpayer holds the capital asset before selling, the less the tax costs

in present value terms. In the extreme, a taxpayer who holds an appreciated capital asset

until death escapes income tax on the gain entirely. In this circumstance, the pretax and

after tax return on the capital assets would be the same just as it is with tax exempt

assets.

27. [LO 3] Why does the federal government exempt municipal bond interest from federal

income tax?

The federal government exempts municipal bond interest income from tax to subsidize

state and local governments. The tax benefits associated with municipal bonds allows

state and local governments to borrow at lower rates than they would otherwise have to

pay.




28. [LO 3] Why do taxpayers have an incentive to purchase municipal bonds from within

their own states?

The states typically exempt municipal bond interest from bonds issued within the state

from state income tax. As a result, taxpayers should prefer to purchase municipal bonds

issued by governmental entities within their own state holding other factors constant.

29. [LO 3] What is an “implicit tax” and how does it affect a taxpayer‟s decision to purchase

municipal bonds?

The price of tax-advantaged assets like municipal bonds is bid up in competitive markets

relative to the price of similar assets, like corporate bonds, without tax advantages. The

higher price paid for tax-advantaged assets reduces the rate of return on these assets

relative to other similar assets without tax advantages. This difference in rates of return

represents an “implicit tax” on tax-advantaged assets.

A taxpayer would have to calculate weather her implicit tax rate is greater than or less

than her individual marginal tax rate (explicit rate) before deciding to purchase

municipal bonds. If her explicit tax rate exceeds her implicit tax rate on municipal

bonds, she will prefer municipal bonds over taxable bonds all else being equal.

30. [LO 3] How do taxpayers‟ explicit marginal tax rates affect their decision to purchase

municipal bonds?

When deciding whether to purchase municipal bonds, taxpayers often must compare the

rate of return from municipal bonds with the after-tax rate of return from similar taxable

bonds. Taxpayers must factor in their own explicit marginal tax rates when computing

their after-tax rate of returns for taxable bonds. Taxpayers with low marginal tax rates

prefer explicitly taxed investments like corporate bonds because the explicit taxes they

actually pay are less than the implicit taxes they avoid on tax-favored assets like

municipal bonds.

31. [LO 3] Is there a natural clientele for municipal bonds? Why or why not?

Yes there is. Taxpayers with high marginal rates are the natural clientele for municipal

bonds. Although they pay “implicit taxes” due to lower returns on municipal bonds, the

explicit taxes they save by avoiding taxable bonds are greater than the implicit taxes they

pay.

32. [LO 3] In what sense can life insurance be viewed as an investment?

Some life insurance policies allow for a build-up in the cash surrender value of the policy

over time. Policy holders are frequently permitted to borrow against the cash surrender

value of the policy or may receive the cash surrender value if they choose to terminate

the policy.




33. [LO 3] How are life insurance proceeds taxed when paid after the insured individual‟s

death?

Life insurance proceeds distributed after the death of the insured individual are tax

exempt.

34. [LO 3] How are life insurance proceeds taxed if a policy is cashed out early?

In this instance, the policy holder is taxed at ordinary rates on the difference between

their investment in the policy and the amount they receive.

35. [LO 3] List the important nontax issues to consider when purchasing life insurance as an

investment.

Life insurance products, when compared to other investment alternatives, tend to be

weighed down by high fees and commissions. In addition, beneficiaries may find it

difficult to plan for cashing in their investments if they decide to wait until the insured

party dies.

36. [LO 3] How are state-sponsored 529 educational savings plans taxed if investment

returns are used for educational purposes? Are the returns taxed differently if they are

not ultimately used to pay for education costs?

Investment returns from state sponsored 529 plans are never taxed if used to pay for

“qualified higher education expenses”. If distributed investment returns are used for any

other purpose, the distributee will pay tax on the investment returns in the year received

at ordinary rates. In many instances, the distributee will also be required to pay an

additional 10% penalty tax in addition to the normal tax on the investment returns.

37. [LO 3] {Planning} Why would someone saving for college consider investing in

something other than a 529 plan?

529 plans offer a fixed menu of investments choices. An individual saving for education

costs with a desire for greater investment options may decide to invest elsewhere.

38. [LO 4] 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.




39. [LO 4] How is the amount of net investment income determined 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.

40. [LO 4] 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.

41. [LO 4] 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.

42. [LO 5] 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.”

43. [LO 5] 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.




44. [LO 5] 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.

45. [LO 5] {Planning} All else being equal, would a taxpayer with passive losses rather 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.

46. [LO 1,2,3] {Planning} Laurie is thinking about investing in one or several of the

following investment options:

Corporate bonds

529 plan

Dividend-paying stock

Life insurance

Savings account

Treasury bonds




Growth stock

a. Assuming all seven options earn similar returns before taxes, rank Laurie‟s investment

options from highest to lowest according to their after-tax returns.

b. Which of the investments employ the deferral and/or conversion tax planning

strategies?

c. How does the time period of the investment affect the returns from these alternatives?

d. How do these alternative investments differ in terms of their nontax characteristics?

Investment Part a

AT RoR

Rank

Part b

Tax planning

strategy

Part c

Time period Part d

Nontax

characteristics

Corporate

Bonds

6 None No effect Rate higher than

savings but may

be more risky.

529 plan 2

(used for

education)

Conversion

Deferral if

proceeds not used

for education.

No effect if

proceeds used for

education.

Returns increase

with holding

period if proceeds

not used for

education.

Limited choices of

investments. Not

asset of student for

financial aid

purposes. 10%

penalty if not used

for education.

Dividend

Paying

Stock

4 Conversion No effect Consistent income

stream. Equity

investment subject

to market risk.

Life

Insurance

1

(if held until

death)

Conversion No effect if policy

held until death of

insured.

Otherwise returns

increase with

holding period.

High commissions

and fees.

Savings

Account

7(likely

wouldn’t earn

same return as

other

investments)

None No effect Safe investment;

likely low before-

tax return.

Treasury

Bonds

5

(but no state

None for

federal/conversion

No effect Safe investment.




taxes) for state.

Growth

Stock

3 Deferral and

conversion.

Returns increase

with holding

period.

Typically involves

risk; therefore,

should diversify.

Problems

47. [LO 1] Anne‟s marginal income tax rate is 30 percent. She purchases a corporate bond

for $10,000 and the maturity, or face value, of the bond is $10,000. If the bond pays 5

percent per year before taxes, what is Anne‟s annual after-tax rate of return from the bond

if the bond matures in one year? What is her annual after-tax rate of return if the bond

matures in 10 years?

Anne’s after-tax rate of return from the corporate bond is 3.5% or 5% x (1-.3). Because

interest from the bond is taxed annually and her rate is assumed to be constant, the after-

tax rate of return doesn’t depend on her investment horizon. Thus, her annual after-tax

rate of return remains at 3.5% if the bond matures in ten years.

48. [LO 1] Matt recently deposited $20,000 in a savings account paying a guaranteed interest

rate of 4 percent for the next 10 years. If Matt expects his marginal tax rate to be 20

percent for the next 10 years, how much interest will he earn after-tax for the first year of

his investment? How much interest will he earn after-tax for the second year of his

investment if he withdraws enough cash every year to pay the tax on the interest he

earns? How much will he have in the account after four years? How much will he have

in the account after seven years?

After one year, Matt will have earned $640 or $20,000 x .04(1-.2) after tax. In the

second year, Matt will earn $660 after tax or $20,640 x .04(1-.2) after tax. After four

years, Matt will have $22,686 or $20,000 x (1 + .04(1-.2))4 in the savings account. After

seven years, Matt will have $24,934 or $20,000 x (1 + .04(1-.2))7 in the savings account.

49. [LO 1] Dana intends to invest $30,000 in either a Treasury bond or a corporate bond.

The Treasury bond yields 5 percent before tax and the corporate bond yields 6 percent

before tax. Assuming Dana‟s federal marginal rate is 25 percent and her marginal state

rate is 5 percent which of the two options should she choose? If she were to move to

another state where her marginal state rate would be 10 percent, would her choice be any

different? Assume that Dana itemizes deductions.

When the state rate is 5 percent, Dana would achieve the following returns from the

Treasury bond or the corporate bond:

The Treasury bond yields $1,125 or $30,000 x [.05 × (1-.25)] after tax. The corporate

bond yields $1,282.50 or $30,000 x [.06 × (1 - .25 - .05(1-.25))] after tax. Note that the




actual state rate is reduced by 25% to allow for the deductibility of state income taxes on

the federal income tax return. Thus, she should choose the corporate bond.

When the state rate is 10%, Dana would achieve the following returns from the Treasury

bond or the corporate bond:

The Treasury bond would still yield $1,125 or $30,000 x [.05 × (1-.25)] after tax because

state rates don’t affect after- tax returns from Treasury bonds. The corporate bond yields

$1,215 or $30,000 x [.06 x (1 - .25 - .10(1-.25))] after tax. Again, note that the actual

state rate is reduced by 25% to allow for the deductibility of state income taxes on the

federal income tax return. If Dana’s state tax rate increases to 10%, corporate bonds

are still superior to Treasury bonds.

50. [LO 1] At the beginning of his current tax year David invests $12,000 in original issue

U.S. Treasury bonds with a $10,000 face value that mature in exactly 10 years. David

receives $700 in interest ($350 every six months) from the Treasury bonds during the

current year and the yield to maturity on the bonds is 5 percent.

a. How much interest income will he report this year if he elects to amortize the bond

premium?

b. How much interest will he report this year if he does not elect to amortize the bond

premium?

a. If David elects to amortize the $2,000 bond premium, he will use the constant

yield method (similar to the effective interest method used to amortize bond

premium under GAAP) to amortize the bond premium semiannually.

Ultimately, he will report $599 of interest income from the bond. The

amortization table below reflects the required calculations:

Column 1

Semiannual

Period

Column 2

Adjusted Basis

of Bond at

Beginning of

Semiannual

Period

Column 3

Interest

Received

Column 4

Premium

Amortization

(Column 3 –

Column 5)

Column 5

Reported

Interest

(Column 2 x .05

x .5)

1 $12,000 $350 $50 $300

2 $11,950 $350 $51 $299

Yearly

Total

$700 $101 $599

b. If David does not elect to amortize the bond, he will simply report the entire

$700 payment he receives as interest income for the year.

51. [LO 1] Seth invested $20,000 in Series EE savings bonds on April 1. By December 31,

the published redemption value of the bonds had increased to $20,700. How much




interest income will Seth report from the savings bonds in the current year absent any

special election?

Seth will not report any interest income from the EE savings bonds currently unless he

elects to have the increase in redemption value taxed currently.

52. [LO 1] At the beginning of her current tax year, Angela purchased a zero-coupon

corporate bond at original issue for $30,000 with a yield to maturity of 6 percent. Given

that she will not actually receive any interest payments until the bond matures in 10

years, how much interest income will she report this year assuming semiannual

compounding of interest?

Angela would recognize $1,827 of interest income from OID calculated as follows:

$30,000 x .06 × ½ = $900

$30,900 x .06 × ½ = 927

Total $1,827

53. [LO 1] At the beginning of his current tax year, Eric bought a corporate bond with a

maturity value of $50,000 from the secondary market for $45,000. The bond has a stated

annual interest rate of 5 percent payable on June 30 and December 31, and it matures in

five years on December 31. Absent any special tax elections, how much interest income

will Eric report from the bond this year and in the year the bond matures?

Accrued market discount on bonds is reported as interest income when the bonds are sold

or mature. Therefore, Eric will only report the interest he actually receives or $2,500

[($50,000 × .025) x 2]. In the year the bond matures, he will again report $2,500 of

interest income related to the semiannual interest payments received and an additional

$5,000 of interest income related to the market discount on the bonds.

54. [LO 1] Hayley recently invested $50,000 in a public utility stock paying a 3 percent

annual dividend. If Hayley reinvests the annual dividend she receives net of any taxes

owed on the dividend, how much will her investment be worth in four years if the

dividends paid are qualified dividends? (Hayley‟s marginal income tax rate is 28

percent.) What will her investment be worth in four years if the dividends are

nonqualified?

If Hayley receives qualified dividends, her annual after-tax rate of return will be 2.55%

or 3% × (1-.15). On the other hand, if the dividends are nonqualified her annual after-

tax rate of return will be 2.16% or 3% × (1-.28). As a result, her investment will be

worth $55,298 or 50,000 x (1+.0255)4 if the dividends are qualified. Otherwise, her

investment will be worth $54,462 or $50,000 × (1+.0216)4.

55. [LO1] {Planning} Five years ago, Kate purchased a dividend-paying stock for $10,000.

For all five years, the stock paid an annual dividend of 4 percent before tax and Kate‟s




marginal tax rate was 25 percent. Every year Kate reinvested her after-tax dividends in

the same stock. For the first two years of her investment, the dividends qualified for the

15 percent capital gains rate; however, for the last three years the 15 percent dividend rate

was repealed and dividends were taxed at ordinary rates.

a. What is the current value (at the beginning of year 6) of Kate‟s investment assuming

the stock has not appreciated in value?

b. What will Kate‟s investment be worth three years from now (at the beginning of year

9) assuming her marginal tax rate increases to 35 percent for the next three years?

a. The following formula takes into account the change in dividend tax rates in

the last three years of Kate’s investment:

$10,000 × (1+ (.04 × (1-.15))) 2

× (1+ (.04 × (1-.25))) 3

= $11,683

b. $11,683 × (1+ (.04 × (1-.35))) 3

= $12,618

56. [LO 2] John bought 1,000 shares of Intel stock on October 18, 2010 for $30 per share

plus a $750 commission he paid to his broker. On December 12, 2013, he sells the shares

for $42.50 per share. He also incurs a $1,000 fee for this transaction.

a. What is John‟s adjusted basis in the 1,000 shares of Intel stock?

b. What amount does John realize when he sells the 1,000 shares?

c. What is the gain/loss for John on the sale of his Intel stock? What is the character

of the gain/loss?

a. John’s basis in the 1,000 shares of Intel stock is $30,750. This is the purchase

price of $30,000 (i.e., 30 × $1,000) plus the $750 commission paid to the

broker.

b. On the sale, John realizes $41,500. This is the sales price of $42,500 (i.e.,

1,000 × $42.50) minus the transaction fee of $1,000.

c. John’s gain on the sale is $10,750 which is the amount realized minus his

adjusted basis (i.e., $41,500 – 30,750). The gain is a long-term capital gain

because John held the stock for more than a year before selling.




57. [LO 2] Dahlia is in the 28 percent tax rate bracket and has purchased the following shares

of Microsoft common stock over the years:

Microsoft common stock

Date Purchased Shares Basis

7/10/2003 400 $12,000

4/20/2004 300 $10,750

1/29/2005 500 $12,230

11/02/2007 250 $7,300

If Dahlia sells 800 shares of Microsoft for $40,000 on December 20, 2013, what is her

capital gain or loss in each of the following assumptions?

a. She uses the FIFO method.

b. She uses the specific identification method and she wants to minimize her current

year capital gain.

a. Under the FIFO method, the first 400 shares sold have a $12,000 basis, the

next 300 have a $10,750 basis, and the last 100 shares have a basis of $2,446

(100/500 × $12,230) for a total basis of $25,196. The resulting capital gain

would be $40,000 less the $25,196 tax basis of the shares sold or $14,804.

b. The shares purchased in 2003 cost $30 per share, the shares purchased in

2004 cost $35.83 per share, the shares purchased in 2005 cost $24.46 per

share, and the shares purchased in 2007 cost $29.20 per share. To minimize

her capital gain, Dahlia should specifically identify the 300 shares purchased

in 2004, then the 400 shares purchased in 2003 and then 100 of the shares

purchased in 2007. Under the specific identification method, the 300 shares

purchased in 2004 have a $10,750 basis, the 400 shares purchased in 2003

have a $12,000 basis, and the 100 shares purchased in 2007 have a basis of

$2,920 (100/250 X $7,300) for a total basis of $25,670. The resulting capital

gain would be the $40,000 sales proceeds less the $25,670 tax basis of the

shares sold or $14,330.

58. [LO 2] {Research} Karyn loaned $20,000 to her co-worker to begin a new business

several years ago. If her co-worker declares bankruptcy on June 22nd

of the current year,

is Karyn allowed to deduct the bad debt loss this year? If she can deduct the loss, what is

the character of the loss?

According to IRC Section 166 and Publication 550, taxpayers may deduct non-business

bad debts in the year the amount of the loss can be determined. Because Karyn will not

be able to measure her actual loss until the bankruptcy process is complete, she must

wait to deduct her loss until she knows with certainty the amount of her loss.




59. [LO 2] Sue has 5,000 shares of Sony stock that has an adjusted basis of $27,500. She

sold the 5,000 shares of stock for cash of $10,000, and she also received a piece of land

as part of the proceeds. The land was valued at $20,000 and had an adjusted basis to the

buyer of $12,000. What is Sue‟s gain or loss on the sale of 5,000 shares of Sony stock?

Sue’s gain on the sale is $2,500, which is the amount realized of $30,000

($10,000+$20,000) less her adjusted basis of $27,500. Note that the value of the land is

included in her amount realized along with the cash she received.

60. [LO 2] Matt and Meg Comer are married. They do not have any children. Matt works as

a history professor at a local university and earns a salary of $54,000. Meg works part-

time at the same university. She earns $21,000 a year. The couple does not itemize

deductions. Other than salary, the Comers‟ only other source of income is from the

disposition of various capital assets (mostly stocks).

a. What is the Comers‟ tax liability for 2013 if they report the following capital gains

and losses for the year?

Short-term capital gains $9,000

Short-term capital losses ($2,000)

Long-term capital gains $15,000

Long-term capital losses ($6,000)

b. What is the Comers‟ tax liability for 2013 if they report the following capital gains

and losses for the year?

Short-term capital gains $1,500

Short-term capital losses $0



a. Salary $75,000

Net short-term capital gain 7,000

Net long-term capital gain 9,000

AGI $91,000

Standard deduction (12,200)

Personal exemption (7,800)

Taxable income $71,000

Less preferentially taxed income (9,000)

Income taxed at ordinary rates $62,000 tax $1,785 + $6,623 =

$8,408

Income subject to capital gains rates $9,000 tax ($9,000 × 0%) = $0

Total tax liability = $8,408+ $0 = $8,408




b. Short-term capital gains $1,500

Short-term capital losses $0

Net short-term capital gain $1,500



Net long-term capital gains $5,000

Salary $75,000

Long-term capital gains 5,000

Short-term capital gains 1,500

AGI $81,500

Standard deduction (12,200)

Personal exemption (7,800)


Less preferentially taxed income (5,000)

Income taxed at ordinary rates $56,500 tax $1,785 + $5,798 =

$7,583

Income subject to capital gains rates $5,000 tax ($5,000 ×0%) = $0

Total tax liability = $7, 583 + $0 = $7,583

61. [LO 2] Grayson is in the 25 percent tax rate bracket and has the sold the following stocks

in 2013:

Date Purchased Basis Date Sold Amount Realized

Stock A 1/23/1989 $7,250 7/22/2013 $4,500

Stock B 4/10/2013 14,000 9/13/2013 17,500

Stock C 8/23/2011 10,750 10/12/2013 15,300

Stock D 5/19/2003 5,230 10/12/2013 12,400

Stock E 8/20/2013 7,300 11/14/2013 3,500

a. What is Grayson‟s net short-term capital gain or loss from these transactions?

b. What is Grayson‟s net long-term gain or loss from these transactions?

c. What is Grayson‟s overall net gain or loss from these transactions?

d. What amount of the gain, if any, is subject to the preferential rate for certain

capital gains?

a. Grayson’s net short-term capital loss is $300, which is the net of the short-term

gains and losses for the year. This $300 loss is the short-term capital gain of

$3,500 from Stock B (i.e. $17,500 – 14,000) less the short-term capital loss of

$3,800 from Stock E (i.e. $3,500 – 7,300).




b. Grayson’s net long-term capital gain is $8,970, which is the net long-term gain

less the long-term loss for the year. This is the net of the long-term capital gain of

$11,720 (i.e. $4,550 from Stock C ($15,300 – 10,750) and $7,170 from Stock D

($12,400 – 5,230)) less the long-term capital loss of $2,750 from Stock A ($4,500

– 7,250).

c. Grayson’s net capital gain is $8,670, which is the net short-term loss offset

against the net long-term capital gain for the year because the signs are opposite.

This $300 short-term capital loss (from part a) is netted against the $8,970 net

long-term capital loss (from part b).

d. Grayson’s entire net capital gain of $8,670 will be taxed at a preferential 15

percent tax rate.

62. [LO 2] George bought the following amounts of Stock A over the years:

Date Purchased Number of Shares Adjusted Basis

Stock A 11/21/1987 1,000 $24,000

Stock A 3/18/1993 500 9,000

Stock A 5/22/2002 750 27,000

On October 12, 2013, he sold 1,200 of his shares of Stock A for $38 per share.

a. How much gain/loss will George have to recognize if he uses the FIFO method of

accounting for the shares sold?

b. How much gain/loss will George have to recognize if he specifically identifies the

shares to be sold by telling his broker to sell all 750 shares from the 5/22/2002

purchase and 450 shares from the 11/21/1987 purchase?

a. George will recognize $18,000 of long-term capital gain. This is the amount

realized of $45,600 (i.e. $38 per shares multiplied by 1,200 shares) less the

adjusted basis of $27,600. The adjusted basis is calculated under the FIFO

method. This means the 1,200 shares sold were the first 1,200 purchased.

Therefore the 1,200 sold were the 1,000 shares purchased on 11/21/1987 (basis of

$24,000) and 200 of the shares purchased on 3/18/1993 (basis of $3,600 which is

calculated by taking the $9,000 total basis divided by 500 shares purchased

multiplied by the 200 shares sold).

b. George’s long-term capital gain is $7,800. This is the amount realized of $45,600

(i.e. $38 per shares multiplied by 1,200 shares) less the adjusted basis of $37,800.

The adjusted basis is calculated under the specific identification method. George

identified that the shares sold were the 750 purchased on 5/22/2002 (basis of

$27,000) and 450 of the shares purchased on 11/21/1987 (basis of $10,800 or




$24,000 total basis divided by 1,000 shares purchased multiplied by the 450 shares

sold).

63. [LO 2] During the current year, Ron and Anne sold the following assets:

Capital

Asset

Market

Value

Tax

Basis

Holding Period

L stock $50,000 $41,000 > 1 year

M stock 28,000 39,000 > 1 year

N stock 30,000 22,000 < 1 year

O stock 26,000 33,000 < 1 year

Antiques 7,000 4,000 > 1 year

Rental home 300,000* 90,000 > 1 year

*$30,000 of the gain is 25 percent gain (from accumulated

depreciation on the property).

a. Given that Ron and Anne have taxable income of only $20,000 (all ordinary) before

considering the tax effect of their asset sales, what is their gross tax liability for 2013

assuming they file a joint return?

b. Given that Ron and Anne have taxable income of $400,000 (all ordinary) before

considering the tax effect of their asset sales, what is their gross tax liability for 2013

assuming they file a joint return?

a. Ron and Anne’s netting process is reflected in the following table:

Description Short-

Term

Long-term

Overall

Long-

Term

28%

Long-

Term

25%

Long-

Term

0/15/20%

Stock N $8,000

Stock O $(7,000)

Step 1:

$1,000

Antiques $3,000 $3,000

Unrecaptured

§1250 Gain

$30,000 $30,000

Remaining

Gain from

Rental

Property

$180,000 $180,000

Stock L $9,000 $9,000

Stock B $(11,000) $(11,000)

Step 2: $211,000

Steps 4 and 5: $178,000

Step 6: N/A

Step 7 $3,000




Step 8 $30,000

Summary $1,000 $3,000 $30,000 $178,000

Ron and Anne’s ordinary income will increase from $20,000 to $21,000 due to their

$1,000 net short-term capital gain. Ron and Anne’s gross tax liability of $31,133 is

computed as follows:

Amount and

Type of

Income

Applicable

Rate

Tax

Explanation

$17,850;

ordinary

10% $1,785 $17,850 × 10%

The first $17,850 of Ron and Anne’s $21,000 of

ordinary income is taxed at 10% (see MFJ tax rate

schedule for this and other computations).

$3,150;

ordinary

15% $473 $3,150 × 15%.

Ron and Anne’s remaining $3,150 of ordinary

income (21,000 – 17,850) is taxed at 15%.

$30,000; 25%

rate capital

gain

15% $4,500 $30,000 × 15%

$3,000 28%

rate capital

gains

15% $450 $3,000 × 15%

$18,500;

0/15/20% rate

capital gains

0%

$0

$18,500 × 0%

$18,500 ($72,500 - $21,000 ordinary income -

$30,000 25% capital gain - $3,000 28% capital

gain) of 0/15/20% rate capital gain fits into the

remaining 15% bracket so it is taxed at 0%.

$159,500 15% $23,925 $159,500 × 15%

All of the remaining $159,500 ($178,000 - $18,500)

of 0/15/20% capital gain is in an ordinary income

bracket greater than 15% and less than 39.6% so it

is all taxed at 15%.

Gross tax

liability

$31,133

b. The netting process used to determine Ron and Anne’s gross tax liability for the year

is unchanged from the process used in part a.

Ron and Anne’s ordinary income will increase from $400,000 to $401,000 due to

their $1,000 net short-term capital gain. Ron and Anne’s gross tax liability of

$151,836 is computed as follows:




Amount and

Type of

Income

Applicable

Rate

Tax

Explanation

$17,850;

ordinary

10% $1,785 $17,8500 × 10%

The first $17,850 of Ron and Anne’s $401,000 of

ordinary income is taxed at 10% (see MFJ tax rate

schedule for this and other computations).

$54,650;

ordinary

15% $8,197.5 $54,650 × 15%.

The next $54,650($72,500- $17,850) of Ron and

Anne’s $401,000 of ordinary income is taxed at

15%.

$73,900;

ordinary

25% $18,475 $73,900 × 25%

The next $73,900 ($146,400-$72,500) of Ron and


25%.

$76,650;

ordinary

28% $21,462 The next $76,650 ($223,050-$146,400) of Ron and


28%

$175,300 33% $57,849 The next $175,300 ($398,350-$223,050) of Ron

and Anne’s $401,000 or ordinary income is taxed

at 33%.

$2,650;

ordinary

35% $927.5 $2,650 × 35%

$2,650 ($401,000 - $398,350) taxed in 35%

ordinary income bracket.

$3,000; 28%

rate capital

gains

28% $840 $3,000 × 28%

$30,000; 25%

rate capital

gains

25% $7,500 $30,000 × 25%

$16,000;

0/15/20% rate

capital gains

15% $2,400 $16,000 × 15%

$16,000 ($450,000 - $401,000 ordinary income -

$30,000 25% capital gain - $3,000 28% capital

gain) of 0/15/20% rate capital gain fits into the

remaining 35% bracket so it is taxed at 15%.

$162,000;

0/15/20% rate

capital gains

20% $32,400 $162,000 × 20%

All of the remaining $162,000 ($178,000 -

$16,000) of 0/15/20% capital gain is in the 39.6%

ordinary income bracket so it is taxed at 20%.

Gross tax

liability

$151,836




64. [LO 2] In 2013, Tom and Amanda Jackson (married filing jointly) have $200,000 of

taxable income before considering the following events:

a) On May 12, 2013, they sold a painting (art) for $110,000 that was inherited from

Grandma on July 23, 2011. The fair market value on the date of Grandma's death

was $90,000 and Grandma's adjusted basis of the painting was $25,000.

b) Applied a long-term capital loss carryover from 2012 of $10,000.

c) Recognized a $12,000 loss on 11/1/13 sale of bonds (acquired on 5/12/03).

d) Recognized a $4,000 gain on 12/12/13 sale of IBM stock (acquired on 2/5/13).

e) Recognized a $17,000 gain on the 10/17/13 sale of rental property (the only

§1231 transaction) of which $8,000 is reportable as gain subject to the 25 percent

maximum rate and the remaining $9,000 is subject to the 15 percent maximum

rate (the property was acquired on 8/2/07).

f) Recognized a $12,000 loss on 12/20/13 sale of bonds (acquired on 1/18/13).

g) Recognized a $7,000 gain on 6/27/13 sale of BH stock (acquired on 7/30/04).

h) Recognized an $11,000 loss on 6/13/13 sale of QuikCo stock (acquired on

3/20/06).

i) Received $500 of qualified dividends on 7/15/13.

Complete the required capital gains netting procedures and calculate the Jacksons‟

2013 tax liability.

ST LT

28% 25% 0/15/20%

(d) 4,000 (a) 20,000 (e) 8,000 (c) (12,000)

(f) (12,000) (b) (10,000) (e) 9,000

(g) 7,000

(h) (11,000)

(8,000) $10,000 $8,000 ($7,000)

(7,000) 7,000

(8,000) $3,000 $8,000 $ 0

8,000 (3,000) (5,000)

$ 0 $ 0 $3,000 $ 0

2013 Taxable Income:

TI b/4 $200,000

Qual. Dividend 500

LTCG 25% 3,000

Taxable Inc $203,500




2013 Tax Liability:

Ordinary Income: $28,457.50 + 28% × ($200,000-146,400) = $43,465.50

Capital Gains: + 25% × $3,000 = 750.00

Dividends: + 15% × $500 = 75.00

Total tax liability $44,290.50

65. [LO 2] For 2013, Sherri has a short-term loss of $2,500 and a long-term loss of $4,750.

a. How much loss can Sherri deduct in 2013?

b. How much loss will Sherri carryover to 2014 and what is the character of the loss

carryover?

a. Sherri has a $2,500 short-term capital loss and a $4,750 long-term capital loss.

Because both are losses they cannot be netted. Individual taxpayers can offset

$3,000 of capital loss against ordinary income, with short-term losses being offset

first.

b. Individual taxpayers can offset $3,000 of capital loss against ordinary income,

with short-term losses being offset first. Therefore, Sherri can deduct the $2,500

short-term capital loss and $500 of the long-term capital loss in 2013. The

remaining $4,250 of the long-term capital loss (i.e. $4,750 less the $500 deducted

currently) is carried forward indefinitely.

66. [LO 2] Three years ago, Adrian purchased 100 shares of stock in X Corp. for $10,000.

On December 30 of year 4, Adrian sells the 100 shares for $6,000.

a. Assuming Adrian has no other capital gains or losses, how much of the loss is

Adrian able to deduct on her year 4 tax return?

b. Assume the same facts as in part a, except that on January 20 of year 5, Adrian

purchases 100 shares of X Corp. stock for $6,000. How much loss from the sale

on December 30 of year 4 is deductible on Adrian‟s year 4 tax return? What basis

does Adrian take in the stock purchased on January 20 of year 5?

a. Adrian has a $4,000 long-term capital loss. She can offset $3,000 of the capital

loss against ordinary income. The remaining $1,000 of the capital loss (i.e.

$4,000 less the $3,000 deducted currently) is carried forward indefinitely.

b. Adrian has a realized $4,000 long-term capital loss on the sale of the 100 shares.

However, she has purchased substantially identical stock within the 61 day period

(30 days before the sale until 30 days after the sale); therefore, her loss is limited

by the wash sale rules. Since Adrian purchased 100 shares the loss is not

currently recognized. The loss is added to the basis of the new shares purchased.

Thus, the basis of the 100 new shares of stock is $10,000 (i.e. the $6,000 purchase

price plus the unrecognized loss of $4,000).




67. [LO 2] Christopher sold 100 shares of Cisco stock for $5,500 in the current year. He

purchased the shares several years ago for $2,200. Assuming his marginal ordinary

income tax rate is 28 percent, and he has no other capital gains or losses, how much tax

will he pay on this gain?

Christopher’s long-term capital gain is $3,300 ($5,500 amount realized less his

$2,200 tax basis). Since Christopher’s marginal rate on ordinary income is

above 15% and below 39.6% his long-term capital gains rate is 15%. Therefore,

he will pay 15% of $3,300 or $495 in capital gains tax.

68. [LO 2] Christina, who is single, purchased 100 shares of Apple Inc. stock several years

ago for $3,500. During her year-end tax planning, she decided to sell 50 shares of Apple

for $1,500 on December 30. However, two weeks later, Apple introduced the iPhone 5,

and she decided that she should buy the 50 shares (cost of $1,600) of Apple back before

prices skyrocket.

a. What is Christina‟s deductible loss on the sale of 50 shares? What is her basis in

the 50 new shares?

b. Assume the same facts, except that Christina repurchased only 25 shares for $800.

What is Christina‟s deductible loss on the sale of 50 shares? What is her basis in

the 25 new shares?

a. Christina has engaged in a wash sale because she bought identical stock within

30 days of selling Apple stock. Therefore, her $250 ($1,500 less $1,750) loss is

disallowed. The basis of Christina’s 50 shares of new Apple stock is $1,850

($1,600 purchase price plus $250 of disallowed loss).

b. Christina has engaged in a partial wash sale because she bought 25 shares of

identical stock within 30 days of selling Apple stock. Therefore, she may deduct

$125 or 50% of her $250 ($1,750 less $1,500) loss; the remaining $125 is

disallowed. The basis of Christina’s 25 shares of new stock is $925 ($800

purchase price plus $125 of disallowed loss).

69. [LO 2] {Research}Arden purchased 300 shares of AMC common stock several years ago

for $1,500. On April 30, Arden sold the shares of AMC common for $500 and then

purchased 250 shares of AMC preferred stock two days later for $700. The AMC

preferred stock is not convertible into AMC common stock. What is Arden‟s deductible

loss from the sale of the 300 shares of AMC common stock?

Section 1.1233-1(d) of the Income Tax Regulations indicates that common and preferred

stock of the same company are not considered "substantially identical property" for

purposes of applying the wash sale rules as long as the preferred stock is not convertible

into common stock. Thus, Arden may deduct $1,000 dollars of loss from the sale of the

AMC stock in the current year.




70. [LO 2] {Planning} Shaun bought 300 shares of Dental Equipment, Inc. several years ago

for $10,000. Currently the stock is worth $8,000. Shaun‟s marginal tax rate this year is

25 percent, and he has no other capital gains or losses. Shaun expects to have a marginal

rate of 30 percent next year, but also expects to have a long-term capital gain of $10,000.

To minimize taxes, should Shaun sell the stock on December 31 of this year or January 1

of next year (ignore the time value of money)?

If Shaun sells the stock in the current year, he may deduct his $2,000 capital loss against

his ordinary income. Given that his tax rate in the current year is 25 percent, this will

produce a tax benefit of 25 percent of $2,000 or $500. On the other hand, if he waits

until the following year to recognize the $2,000 capital loss, he must apply the loss

against his $10,000 long-term capital gains taxed at a 15 percent rate. If he waits, his

loss would produce a tax benefit of only 15 percent of $2,000 or $300. Therefore, Shaun

should sell his stock in the current year.

71. [LO 2] {Planning} Irene is saving for a new car she hopes to purchase either four or six

years from now. Irene invests $10,000 in a growth stock that does not pay dividends and

expects a 6 percent annual before-tax return (the investment is tax deferred). When she

cashes in the investment after either four or six years, she expects the applicable marginal

tax rate on long-term capital gains to be 25 percent.

a. What will be the value of this investment four and six years from now?

b. When Irene sells the investment, how much cash will she have after taxes to

purchase the new car (four and six years from now)?

a. Her investment will be worth $12,625 or $10,000 X (1+.06)4 after 4 years; and

$14,185 or $10,000 X (1+.06)6 after 6 years.

b. After 4 years, Irene will pay taxes of 25 percent on her investment returns of

$2,625 leaving her with investment returns after taxes of $1,969 or [(1-.25) X

$2,625]. This, combined with her original $10,000 investment, will leave her with

$11,969 to purchase the car.

After 6 years, Irene will pay taxes of 25 percent on her investment returns of

$4,185 leaving her with investment returns after taxes of $3,139 or [(1-.25) X

$4,185]. This, combined with her original $10,000 investment, will leave her with

$13,139 to purchase the car.

72. [LO2] {Planning} Komiko Tanaka invests $12,000 in LymaBean, Inc. LymaBean does

not pay any dividends. Komiko projects that her investment will generate a 10 percent

before-tax rate of return. She plans to invest for the long term.

a. How much cash will Komiko retain, after-taxes, if she holds the investment for 5

years and then she sells it when the long-term capital gains rate is 15 percent?

b. What is Komiko‟s after-tax rate of return on her investment in part (a)?




c. How much cash will Komiko retain, after-taxes, if she holds the investment for 5

years and then sells when the long-term capital gains rate is 25 percent?

d. What is Komiko‟s after-tax rate of return on her investment in part (c)?

e. How much cash will Komiko retain, after taxes, if she holds the investment for 15

years and then she sells when the long-term capital gains rate is 15 percent?

f. What is Komiko‟s after-tax rate of return on her investment in part (e)?

a. $12,000 × (1.10)5 = $19,326 amount received

(12,000) basis in stock

$7,326 long-term capital gain

× 15 percent

= 1,099 tax on gain

Cash retained = $19,326 – 1,099 taxes = $18,227

b. ($18,227/12,000)1/5

– 1 = 8.7 percent

c. $12,000 × (1.10)5 = $19,326 amount received



× 25%

= $1,832 tax on gain


d. ($17,494/12,000)1/5

– 1 = 7.83 percent

e. $12,000 × (1.10)15

= $50,127 amount received



× 15%

= $5,719 tax on gain


f. ($44,408/12,000)1/15

– 1 = 9.11 percent

73. [LO 2] {Research} Becky recently discovered some high-tech cooking technology that

has advantages over microwave and traditional ovens. She received a patent on the

technology that gives her exclusive rights to the technology for 20 years. Becky would

prefer to retain the patent, but she doesn‟t want to deal with the manufacturing and

marketing of the technology. She was able to reach a compromise. A little over a year

after she secured the patent, Becky signed a contract with DEF Company giving DEF

control to manufacture and market the technology. In exchange, Becky is to receive a

royalty based on the sales of the technology. For tax purposes, Becky is not sure how to




treat her arrangement with DEF. If the exchange with DEF is treated as a sale, she will

recognize long-term capital gain because the patent is a capital asset held for more than a

year. If the exchange is not treated as a sale, Becky will recognize ordinary income as

she receives the royalties. (Hint: IRC §1235)

a. Is it possible for Becky to treat the exchange with DEF as a sale even though she

never relinquishes actual title of the patent? If so, what requirements must she

meet to treat the contract as a sale for tax purposes?

b. Does your answer to the question above change if Becky‟s contract with DEF

gave DEF Company control over the income from the patent for the next 10 years

of the patent‟s remaining 19-year life?

a. Section 1235 allows certain contracts outlining an exchange to be treated as sales

if the exchange meets the following two criteria:

(1) The exchange results in a transfer of property consisting of “all substantial

rights to a patent”, and (2) the transferor is a “holder” of the patent.

The first criteria (all substantial rights to a patent) require the transferor (i.e.,

Becky) to permanently give up all rights to control creation of income from the

patent. The transferee’s (DEF) control cannot be limited geographically or by

industry. Also the rights cannot be for a shorter period than the life of the patent.

The second criterion requires the taxpayer to be an individual or a partner in a

partnership. This restricts corporations from getting the beneficial sales

treatment of the patent.

In this case, Becky would qualify for capital gain treatment on the exchange with

DEF. Thus, she would be taxed on the gain from the exchange at the preferential

capital gains rates instead of the ordinary income rates applicable to royalty

income.

b. In this case, Becky would not meet the first criteria to qualify for sale treatment

because she no longer transferred “all substantial rights to the patent” to DEF.

Consequently, she would be required to treat the royalties as ordinary income

rather than long-term capital gain.

74. [LO 3] {Planning} The Johnsons recently decided to invest in municipal bonds because

their marginal tax rate is 40 percent. The return on municipal bonds is currently 3.5

percent and the return on similar taxable bonds is 5 percent. Compare the after-tax

returns of the municipal and taxable bonds.

a. Which type of bond should the Johnsons select?

b. What type of bond should the Johnsons select if their marginal tax rate was 20

percent?

c. At what marginal tax rate would the Johnsons be indifferent between investing in

either taxable or municipal bonds?




a. Assuming the Johnson’s marginal rate is 40 percent, their after-tax rate of return

from taxable bonds would be 3 percent or 5 percent x (1-.40). Because this is less

than the 3.5 percent rate of return from municipal bonds, they should purchase

municipal bonds.

b. If the Johnson’s marginal rate is 20 percent the after-tax rate of return from

taxable bonds would be 4 percent or 5 percent x (1-.20). Under this assumption,

the Johnsons should buy taxable bonds.

c. To discover the marginal tax rate at which the neighbors would be indifferent

between investing in either type of bond, solve the following equation for t: 5

percent x (1-t) = 3.5 percent. It turns out that t equals 30 percent. In other

words, the after-tax rates of return for both bonds are equal if the Johnsons have

a marginal tax rate of 30 percent.

75. [LO 3] Lynette VanWagoner purchased a life insurance policy to insure her mother Idon.

Idon is currently 64. Insurance companies predict that women in her condition will live,

on average, to be 81 years old. Lynette makes a one-time payment of $100,000 to

purchase a life insurance policy on Idon‟s life. The policy provides for a $1,000,000

death benefit and a cash surrender value equal to the original $100,000 premium plus a 7

percent annual rate of return on the premium.

a. How much will Lynette receive after taxes if Idon dies in 14 years?

b. How much will Lynette receive after taxes if Idon dies in seven years?

c. How much will Lynette receive after taxes if Lynette decides to cash in the policy

after four years when Idon is still living and Lynette‟s marginal tax rate is 28

percent?

a. If Lynette receives the life insurance proceeds after Idon’s death, she will receive

$1,000,000 after taxes without regard to the number of years Idon lives after the

policy is purchased because death benefits from life insurance policies are tax

free.

b. Again, if Lynette receives the life insurance proceeds after Idon’s death, she will

receive $1,000,000 after taxes without regard to the number of years Idon lives

after the policy is purchased because death benefits from life insurance policies

are tax free.

c. If Lynette decides to cash in the policy four years after purchasing it, she will

receive $131,080 or 100,000 × (1.07)4 before taxes. Comparing the $131,080

proceeds to her original $100,000 investment, Lynette’s taxable earnings will be

$31,080. Given her assumed tax rate of 28 percent, she will pay $8,702 or (.28 ×

$31,080) in tax leaving her with $122,378 or ($131,080 - $8,702) after taxes.




76. [LO 3] Ben recently made a one-time investment of $20,000 in the Florida 529

educational savings plan for his three-year-old son, Mitch. Assume the plan yields a

constant 6 percent return for the next 15 years.

a. How much money will be available for Mitch after taxes when he begins college

at age 18?

b. Assume, instead, that when Mitch turns 18, he decides to forego college and

spend his time as a traveling artist. If Mitch‟s parents give him the amount in the

529 plan to pursue his dreams, how much will he keep after taxes if his marginal

tax rate is 10 percent?

a. Because earnings inside a 529 plan compound tax free, the 529 plan Ben set up

for Mitch will be worth $47,931 or $20,000 × (1+.06)15

after fifteen years. If this

amount is distributed to Mitch and he uses it to pay for qualified higher education

expenses, neither he nor Ben will owe any tax on the distribution.

b. If Mitch becomes a traveling artist, he will pay taxes and penalties on the

earnings portion of the $47,931 distribution. Because the original investment in

the account was $20,000, the earnings portion of the $47,931 distribution would

be $27,931. This amount will be subject to Mitch’s ordinary 10 percent tax rate

plus a 10 percent penalty rate. Thus, Mitch will pay $5,586 or $27,931 x 20

percent in taxes and penalties leaving him with $42,345 to pursue his dreams as a

traveling artist.

77. [LO 4] Rich and Shauna Nielson file a joint tax return, and they itemize deductions.

Assume their marginal tax rate on ordinary income is 25 percent. The Nielsons incur

$2,000 in miscellaneous itemized deductions, excluding investment expenses. They also

incur $1,000 in noninterest investment expenses during the year. What tax savings do

they receive from the investment expenses under the following assumptions:

a. Their AGI is $90,000.

b. Their AGI is $130,000.

a. The Nielsons have $3,000 of miscellaneous itemized deductions including

investment expenses. These deduction are only deductible to the extent they

exceed 2 percent of AGI. If AGI is $90,000, 2 percent of AGI is $1,800 and

$1,200 of the $3,000 is deductible. The deductible portion is first treated as

investment expense and then noninvestment miscellaneous itemized deductions.

In this situation, all $1,000 of the investment expenses are deductible ($200 of the

other miscellaneous itemized deductions are deductible). The tax benefit of the

investment expenses is $250 (i.e., $1,000 deduction × 25 percent marginal tax

rate).

b. If AGI is $130,000, 2 percent of AGI is $2,600. In this case only $400 of the

miscellaneous itemized deductions are deductible. Because the deductible portion




is first considered to be the investment expenses, all $400 of the deductible

miscellaneous itemized deductions are considered to be investment expenses. The

tax benefit from the $400 deductible investment expense is $100 (i.e., $400 × 25

percent).

78. [LO 4] Mickey and Jenny Porter file a joint tax return, and they itemize deductions. The

Porters incur $2,000 in employment-related miscellaneous itemized deductions. They

also incur $3,000 of investment interest expense during the year. The Porters‟ income for

the year consists of $150,000 in salary, and $2,500 of interest income.

a. What is the amount of the Porters‟ investment interest expense deduction for the

year?

b. What would their investment interest expense deduction be if they also had a

($2,000) long-term capital loss?

a. The $3,000 of investment interest expense is deductible to the extent of net

investment income. In this problem, investment income and net investment income

are $2,500 because there are no investment expenses. Consequently, $2,500 of

the investment interest expense is deductible and $500 is carried forward to next

year.

b. If the Porters also have a $2,000 long-term capital loss, their net investment

income remains $3,000 for purposes of determining the investment interest

expense deduction. Capital losses are not included in the calculation of net

investment income. Consequently, $2,500 of the investment interest expense is

deductible and $500 is carried over to next year.

79. [LO 4] {Planning} On January 1 of year 1, Nick and Rachel Sutton purchased a parcel of

undeveloped land as an investment. The purchase price of the land was $150,000. They

paid for the property by making a down payment of $50,000 and borrowing $100,000

from the bank at an interest rate of 6 percent per year. At the end of the first year, the

Suttons paid $6,000 of interest to the bank. During year 1, the Suttons only source of

income was salary. On December 31 of year 2, the Suttons paid $6,000 of interest to the

bank and sold the land for $210,000. They used $100,000 of the sale proceeds to pay off

the $100,000 loan. The Suttons itemize deductions and are subject to a marginal ordinary

income tax rate of 35 percent.

a. Should the Suttons treat the capital gain from the land sale as investment income

in year 2 in order to minimize their year 2 tax bill? If so, how much?

b. How much does this cost or save them in year 2?

a. In year one, the Suttons incurred $6,000 of investment interest expense but did not

have any investment income so the investment interest expense is not deducted

and is carried over to year 2. In year 2, the Suttons incurred another $6,000 of

investment interest expense. Combined with the carryover from year 1, the

Suttons had $12,000 of investment interest expense they could potentially deduct




in year 2. In year 2, the Suttons have $60,000 of long-term capital gain. None of

this long-term capital gain is investment income unless the Suttons elect to have

some of it taxed at ordinary rates.

If the Suttons don’t elect to tax any of the capital gain as ordinary income, they

would not be able to deduct any of the investment interest expense and they would

owe taxes of $9,000 (i.e., $60,000 x 15 percent). The Suttons would have a

$12,000 investment expense carry forward to next year.

If the Suttons elect to include $12,000 of the long-term capital gain in investment

income and have it taxed at ordinary rates, the Suttons would owe tax of $4,200

($12,000 x 35 percent) on this portion of the capital gain and they would owe

$7,200 of taxes on the rest of the capital gain (i.e., $48,000 x 15 percent). The

$12,000 investment interest expense deduction would save the Suttons $4,200 in

taxes (i.e., $12,000 x 35 percent). The end result is that if the Suttons make the

election, they will owe $7,200 in taxes (i.e., $4,200 + $7,200 - $4,200). They will

not however have an investment interest expense carry forward. Making the

election would make sense for the Suttons if they did not expect to have any

investment income for the foreseeable future.

b. In terms of the year 2 tax bill only, making the election to tax some of the long-

term capital gain at ordinary rates saves the Suttons $1,800 in taxes (i.e., $9,000 -

$7,200).

80. [LO 4] {Research} George recently received a great stock tip from his friend, Mason.

George didn‟t have any cash on hand to invest, so he decided to take out a $20,000 loan

to facilitate the stock acquisition. The loan terms are 8 percent interest with interest-only

payments due each year for five years. At the end of the five-year period the entire loan

principal is due. When George closed on the loan on April 1, 2012, he decided to invest

$16,000 in stock and to use the remaining $4,000 to purchase a four-wheel recreation

vehicle. George is unsure how he will treat the interest paid on the $20,000 loan. In

2013, George paid $1,200 interest expense on the loan. For tax purposes, how should he

treat the 2013 interest expense? (Hint: visit www.irs.gov and consider IRS Publication

550)

IRS Publication 550 indicates that “if you borrow money for personal purposes as well

as for investment, you must allocate the debt among those purposes.” This means that

only interest expense paid on the portion of debt that was used for the investment in the

stocks can be deducted as investment interest. The interest paid on the loan allocated to

the personal portion isn’t deductible to the taxpayer.

Therefore, in determining the deductibility of the $1,200 interest expense paid by George

during 2013, George would allocate 80 percent (i.e., $16,000 / 20,000) of the interest

expense to the purchase of the stock and 20 percent (i.e., $4,000 / 20,000) of the interest

expense to the purchase of the 4-wheeler. Consequently, George would have $960 of

http://www.irs.gov/




investment interest expense (80 percent x $1,200) and he would have $240 (i.e., 20

percent x $1,200) of nondeductible personal interest.

81. [LO5] Larry recently invested $20,000 (tax basis) in purchasing a limited partnership

interest. His at-risk amount is also $20,000. In addition, Larry‟s share of the limited

partnership loss for the year is $2,000, his share of income from a different limited

partnership was $1,000, and he had $3,000 of dividend income from the stock he owns.

How much of Larry‟s $2,000 loss from the limited partnership can he deduct in the

current year?

Before considering his $2,000 loss, Larry’s tax basis is $20,000 and his at-risk amount is

$20,000. Therefore the basis and at-risk hurdles do not apply. However, Larry still may

not deduct $1,000 of the $2,000 loss because he only has $1,000 of passive income for

the year. Therefore, Larry has a $1,000 passive activity loss carryover.

82. [LO5] Rubio recently invested $20,000 (tax basis) in purchasing a limited partnership

interest. His at-risk amount is $15,000. In addition, Rubio‟s share of the limited

partnership loss for the year is $22,000, his share of income from a different limited

partnership was $5,000, and he had $40,000 in wage income and $10,000 in long-term

capital gains.

a. How much of Rubio‟s $22,000 loss can he deduct considering only the tax

basis limitation?

b. How much of the loss from part a. can Rubio deduct under the at-risk

limitations?

c. How much of Rubio‟s $22,000 loss from the limited partnership can he deduct

in the current year considering all limitations?

a. Rubio’s initial tax basis in the limited partnership is $20,000. Rubio’s

$22,000 loss reduces his tax basis to zero leaving him with a $2,000 loss

carryover because of the tax basis loss limitation.

b. Rubio’s initial at-risk amount in the limited partnership is $15,000. Rubio’s

$22,000 loss reduces his at-risk amount to zero leaving him with a $5,000 at-

risk carryover ($20,000 loss allowed under the tax basis limitation less the

$15,000 amount Rubio has at risk).

c. After applying the tax basis and at-risk limitations, Rubio can potentially

deduct $15,000 of loss. However, because Rubio is a limited partner this loss

is considered a passive loss. Therefore, Rubio may only deduct this loss in the

current year to the extent he has passive income. Because Rubio has only

passive income of $5,000 (from another limited partnership), he may only

deduct $5,000 of the $15,000 loss leaving him with a $10,000 passive activity

loss that can be carried forward indefinitely.




83. Molly Grey (single) acquired a 30 percent limited partnership interest in Beau Geste LLP

several years ago for $48,000. At the beginning of year 1, Molly has tax basis and an at-

risk amount of $20,000. In year 1, Beau Geste incurs a loss of $180,000 and does not

make any distributions to the partners.

In year 1, Molly„s AGI (excluding any income or loss from Beau Geste) is

$60,000. This includes $10,000 of passive income from other passive activities.

In year 2, Beau Geste earns income of $30,000. In addition, Molly contributes an

additional $30,000 to Beau Geste during year 2. Molly‟s AGI in year 2 is $63,000

(excluding any income or loss from Beau Geste). This amount includes $8,000 in

income from her other passive investments.

a. Based on the above information, determine the following amounts:

At-risk amount at the end of year 1

At-risk amount at the end of year 2

Losses allowed under the at-risk rules in year 2

Total suspended passive losses at the end of year 1

Total suspended at-risk losses at the end of year 2

Deductible losses in year 1

Year 2 AGI after considering Beau Geste events

b. Briefly describe actions Molly Grey could undertake in year 2 to utilize any

suspended passive losses from year 1.

To determine the required amounts, Molly must determine her at-risk basis for each

year.

At-Risk Amount:

Initial year 1 amount: $ 20,000 Given in problem

Allowed loss: (20,000) See below

End of year 1 at-risk amount $ -0-

Contribution for year 2 $ 30,000 Given in problem

BG Income (30% x $30,000) 9,000 Given in problem

Allowed loss: (34,000) See below

End of year 2 at-risk amount $ 5,000




At-risk allowed loss calculation:

Year Total Loss At-Risk Allowed At-Risk Disallowed

1 $ 54,000 $ 20,000 $ 34,000

2 34,000 34,000 -0-

Passive activity loss allowed calculation:

Year At-Risk Allowed PAL Allowed PAL Disallowed

1 $20,000 $10,000 $10,000

2 34,000

10,000 17,000 27,000

In year 1, Molly has at-risk amount of $20,000 before losses from Beau Geste and therefore

is only allowed $20,000 of losses under the at-risk rules. This loss then must pass the passive

activity loss rules. Since Molly has $10,000 of passive activity income from other sources in

year 1, she may deduct $10,000 of the $20,000 loss allowed under the at-risk rules under the

passive activity loss rules. This leaves $10,000 suspended under the passive activity loss

rules for year 1.

In year 2, Molly’s at-risk amount increases by the amount of her contribution ($30,000) and

by the income generated by Beau Geste to $39,000 before considering any losses from Beau

Geste. This additional at-risk amount will allow Molly to use up to $39,000 of losses

suspended by the at-risk rules in previous years. As a result, the $34,000 of losses suspended

in year 1 now flow to the passive activity loss rules. In addition to the $34,000 loss freed

from the at-risk rules, Molly must also consider whether she can use the $10,000 loss that

was suspended under the passive activity loss rules in year 1. Since she has $17,000 ($9,000

from Beau Geste and $8,000 from other sources) of passive income she may deduct $17,000

of the total $44,000 losses in year 2. This leaves $27,000 of losses that remain suspended

under the passive activity loss rules at the end of year 2.

Molly’s AGI for year 2 is determined as follows:

Year 2 AGI: AGI before Beau Geste: $63,000

+ Year 2 passive income from Beau Geste 9,000

- Year 2 allowed passive losses 17,000

= Year 2 AGI $55,000

a. Based on the above calculations the following amounts:

At-risk amount at the end of year 1: $-0-

At-risk amount at the end of year 2 $5,000

Losses allowed under the at-risk rules in year 2 $34,000




Total suspended passive losses at the end of year 1 $10,000

Total suspended at-risk losses at the end of year 2 $-0-

Deductible losses in year 1 $10,000

Year 2 AGI after considering Beau Geste events $55,000

b. Meredith could a) sell her entire interest in Beau Geste; or b) acquire an additional

passive income generator (e.g., rental property).

84. [LO 5] Anwar owns a rental home and is involved in maintaining it and approving

renters. During the year he has a net loss of $8,000 from renting the home. His other

sources of income during the year were a salary of $111,000 and $34,000 of long-term

capital gains. How much of Anwar‟s $8,000 rental loss can he deduct currently if he has

no sources of passive income?

Because Anwar meets the definition of an “active participant” and has adjusted gross

income of less than $150,000, before considering his rental loss, he may deduct $2,500 of

the loss against his other income. His $2,500 deduction is computed as follows:

Description Amount Explanation

(1) Maximum deduction available

before phase-out

$25,000

(2) Phase-out of maximum deduction $22,500 [($145,000 AGI –

100,000) x .5]

(3) Maximum deduction in current year $2,500 (1) – (2)

(4) Rental loss in current year $8,000

(5) Rental loss deductible in current

year

$2,500 Lesser of (3) or (4)

Passive loss carry forward $5,500 (3) – (4)

Comprehensive Problems

85. [LO 1, 2, 3] {Planning} As noted in the chapter, Nick inherited $100,000 with the

stipulation that he “invest it to financially benefit his family.” Nick and Rachel decided

they would invest the inheritance to help them accomplish two financial goals:

purchasing a Park City vacation home and saving for Lea‟s education.




Vacation Home Lea‟s Education

Initial Investment $50,000 $50,000

Investment Horizon 5 years 18 years

The Suttons have a marginal income tax rate of 30 percent (capital gains rate of 15

percent), and have decided to investigate the following investment opportunities.

5 Years Annual

After-Tax

Rate of

Return

18 Years Annual

After-Tax

Rate of

Return

Corporate bonds 5.75% 4.75%

Dividend-paying stock

(no appreciation)

3.50%

3.50%

Growth stock Future

Value is

$65,000

Future Value is

$140,000

Municipal bond 3.20% 3.10%

Qualified tuition

program

5.75%

5.50%

Complete the two annual after-tax rates of return columns for each investment and

provide investment recommendations for the Suttons.

Considering after-tax rates of return alone, the computations below suggest that the

Suttons should invest in growth stocks to save for the vacation home and invest in a

qualified tuition program for their daughter’s education. Before making a final decision,

the Suttons should also consider relevant nontax factors including differences in risk

across the investments.

5 Years

(home)

Annual

After Tax

Rate of

Return

18 Years

(education)

Annual After

Tax Rate of

Return

Corporate Bonds 5.75% 4.025% 4.75% 3.325%

Dividend-Paying

Stock, pref. rate

15%

(no appreciation)

3.50%

2.975%

3.50%

2.975%

Growth Stock FV is

$65,000

4.65%

FV is

$140,000

5.30%

Municipal Bond 3.20% 3.20% 3.10% 3.10%

Qualified Tuition

Program

5.75%

3.60%*

5.50%

5.5 %




or 3.84% **

Growth Stock Calculations:

FV of Growth Stock After-Tax in 5 Years: 65,000 – [.15 × (65,000 -50,000)] = $62,750

Annual After-tax rate of return= [($62,750/50,000)1/5

– 1] = 4.65%

FV of Growth Stock After-Tax in 18 Years: 140,000 – [.15 × (140,000 -50,000)] =

$126,500

Annual After tax rate of return= [($126,500/50,000)1/18

– 1] =5.3%

Qualified Tuition Program Calculations:

FV of QTP in 5 Years: 50,000 × (1+.0575)5 = $66,126

FV of QTP After-Tax in 5 Years: 66,123 – [.4 × (66,126 -50,000)] = $59,676

* The appreciation is subject to tax at 40 percent (30 percent + penalty of 10 percent)

Annual After Tax Rate of Return= [($59,676/50,000)1/5

– 1] = 3.6%

FV of QTP in 18 Years: 50,000 × (1+.055)18

= $131,073

FV of QTP After-Tax in 18 Years if Funds Not Used for Education: 131,073 – [.4 ×

(131,073 - 50,000)] = $98,644

** If not used for educational purposes the appreciation is subject to tax at 40 percent

(30 percent + penalty of 10 percent)

Annual After Tax Rate of Return= [($98,644/50,000)1/18

– 1] = 3.84%

86. [Tax Forms] [LO 1, 2, 3, 4] During 2013, your clients, Mr. and Mrs. Howell, owned the

following investment assets:

Investment Assets Date

Acquired

Purchase

Price

Broker’s

Commission

Paid at Time

of Purchase

300 shares of IBM common 11/22/10 $10,350 $100


3,000 shares of Apple

preferred

12/12/11

$147,000

$1,300

2,100 shares of Cisco

common

8/14/12

$52,500

$550

420 Shares of Vanguard

mutual fund

3/2/13

$14,700

No load fund*

*No commissions are charged when no load mutual funds are bought and sold.

Because of the downturn in the stock market, Mr. and Mrs. Howell decided to sell most

of their stocks and mutual fund in 2013 and to reinvest in municipal bonds. The following

investment assets were sold in 2013:




Investment Assets Date Sold Sale

Price

Broker’s

Commission

Paid at Time of

Sale@


3,000 shares of Apple

preferred

10/5/13

$221,400

$2,000

2,100 shares of Cisco

common

8/15/13

$63,250

$650

451 Shares of Vanguard

mutual fund

12/21/13

$15,700

No load fund*

*No commissions are charged when no load mutual funds are bought and sold.

The Howells‟ broker issued them a Form 1099 showing the sales proceeds net of the

commissions paid. For example, the IBM sales proceeds were reported as $13,600 on the

Form 1099 they received.

In addition to the sales reflected in the table above, the Howell‟s provided you with the

following additional information concerning 2013:

The Howells received a Form 1099 from the Vanguard mutual fund reporting a $900

long-term capital gain distribution. This distribution was reinvested in 31 additional

Vanguard mutual fund shares on 6/30/13.

In 2008, Mrs. Howell loaned $6,000 to a friend who was starting a new multilevel

marketing company called LD3. The friend declared bankruptcy in 2013, and Mrs.

Howell has been notified that she will not be receiving any repayment of the loan.

The Howells have a $2,300 short-term capital loss carryover and a $4,800 long-term

capital loss carryover from prior years.

The Howells did not instruct their broker to sell any particular lot of IBM stock.

The Howells earned $3,000 in municipal bond interest, $3,000 in interest from

corporate bonds, and $4,000 in qualified dividends.

Assume the Howells have $130,000 of wage income during the year.

a. Go to the IRS web site (www.IRS.gov) and download the most current version of

Form 8949 and Schedule D. Use Form 8949 and page 1 of Schedule D to compute

net long-term and short-term capital gains. Then, compute the Howells‟ tax liability

for the year (ignoring the alternative minimum tax and any phase-out provisions)

assuming they file a joint return, they have no dependents, they don‟t make any

http://www.irs.gov/




special tax elections, and their itemized deductions total $25,000. Assume that asset

bases are not reported to the IRS.

b. Are there any tax planning recommendations related to the stock sales that you should

have shared with the Howells before their decision to sell?

c. Assume the Howells‟ short-term capital loss carryover from prior years is $82,300

rather than $2,300 as indicated above. If this is the case, how much short-term and

long-term capital loss carryover remains to be carried beyond 2013 to future tax

years?

a. The Howell’s Form 8949 and Schedule D for the year would be completed as follows:




The Howell’s net capital gain is then included with their other income for the year in

calculating their final tax liability for the year.

Description Amount Explanation

Wage Income 130,000 Given

Interest Income 3,000 Given

Qualified Dividends 4,000 Given

Net Capital Gains from

Schedule D

71,700 See Schedule D above

Adjusted Gross Income 208,700

Total Itemized

Deductions

(25,000) The effect of investment

advice fees and investment

interest expense already

included in this number

Personal Exemptions (7,800)

Taxable Income 175,900

The Howell’s 2013 tax liability would be $28,515. This is calculated by determining

ordinary income of $100,200 which is $175,900 of taxable income minus $71,700 net

long-term capital gain that will be taxed at 15% and minus $4,000 qualified dividends

that will be taxed at 15%. The tax on $100,200 is $16,908 and the 15% tax on long-term

capital gains and qualified dividends of $75,700 is $11,355. This results in a total 2013

tax liability of $28,263.

b. Mr. and Mrs. Howell should have told their broker to sell the 200 shares of IBM

acquired on 4/3/11 first, using the specific identification method. Because these

shares have a much higher tax basis than the shares acquired on 11/22/10, the

Howells could have reported a capital loss on the sale of the IBM stock, which could

have been used to offset the gains from the sale of the Apple and Cisco stock.

However, at this point in time, it’s too late to implement this strategy. Mr. and Mrs.

Howell should have consulted with their tax advisor prior to the sale.

c. If we assume the Howell’s short-term capital loss carryover into 2013 was $82,300

rather than $2,300 as originally assumed, a number of things change. First, the net

short-term capital loss for the year increases to $88,200. When netted against the net

long-term capital gain for the year of $79,900, a net short-term capital loss for the

year of $8,300 remains. $3,000 of this loss can be used to reduce ordinary income,

and the remaining $5,300 constitutes a short-term capital loss carryover to future tax

years.

87. [Tax Forms] WAR (We Are Rich) has been in business since 1980. WAR is an accrual

method sole proprietorship that deals in the manufacturing and wholesaling of various

types of golf equipment. Hack & Hack CPAs have filed accurate tax returns for WAR‟s

owner since WAR opened its doors. The managing partner of Hack & Hack (Jack) has




gotten along very well with the owner of WAR – Mr. Someday Woods (single).

However, in early 2013, Jack Hack and Someday Woods played a round of golf and Jack,

for the first time ever, actually beat Mr. Woods. Mr. Woods was so upset that he fired

Hack & Hack and has hired you to compute his 2013 taxable income. Mr. Woods was

able to provide you with the following information from prior tax returns. The taxable

income numbers reflect the results from all of Mr. Wood‟s activities except for the items

separately stated. You will need to consider how to handle the separately stated items for

tax purposes. Also, note that the 2008–2012 numbers do not reflect capital loss

carryovers.

2008 2009 2010 2011 2012

Ordinary taxable

income

$4,000 $2,000 $94,000 $170,000 $250,000

Other items not

included in

ordinary taxable

income

Net gain (loss) on

disposition of

§1231 assets

$3,000 10,000 ($6,000)

Net long-term

capital gain (loss)

on disposition of

capital assets

($15,000) $1,000 ($7,000) ($7,000)

In 2013, Mr. Woods had taxable income in the amount of $460,000 before considering

the following events and transactions that transpired in 2013:

a. On January 1, 2013, WAR purchased a plot of land for $100,000 with the intention of

creating a driving range where patrons could test their new golf equipment. WAR

never got around to building the driving range; instead, WAR sold the land on

October 1, 2013, for $40,000.

b. On August 17, 2013, WAR sold its golf testing machine, “Iron Byron” and replaced it

with a new machine “Iron Tiger.” “Iron Byron” was purchased and installed for a

total cost of $22,000 on February 5, 2009. At the time of sale, “Iron Byron” had an

adjusted tax basis of $4,000. WAR sold “Iron Byron” for $25,000.

c. In the months October through December 2013, WAR sold various assets to come up

with the funds necessary to invest in WAR‟s latest and greatest invention–the three

dimple golf ball. Data on these assets are provided below:

Asset

Placed in

Service (or

purchased)

Sold Initial

Basis

Accumulated

Depreciation

Selling

Price

Someday‟s black

leather sofa

(used in office)

4/4/12

10/16/13

$3,000

$540

$2,900

Someday‟s 3/1/11 11/8/13 $8,000 $3,000 $4,000




office chair

Marketable

securities

2/1/10 12/1/13 $12,000 $0 $20,000

Land held for

investment

7/1/12 11/29/13 $45,000 $0 $48,000

Other investment

property

11/30/11 10/15/13 $10,000 $0 $8,000

d. Finally, on May 7, 2013, WAR decided to sell the building where they tested their

plutonium shaft, lignite head drivers. WAR purchased the building on January 5,

2001, for $190,000 ($170,000 for the building, $20,000 for the land). At the time of

the sale, the accumulated depreciation on the building was $50,000. WAR sold the

building (with the land) for $300,000. The fair market value of the land at the time of

sale was $45,000.

Part 1: Compute Mr. Woods‟s taxable income after taking into account the transactions

described above.

Part 2: Compute Mr. Woods‟s tax liability for the year.

Part 3: Complete Mr. Woods‟s Form 8949, Schedule D, and Form 4797 (use the most

current version of these schedules) to be attached to his Form 1040. Assume that asset

bases are not reported to the IRS.

Part 1: Mr. Woods’s taxable income is determined as follows:

This table determines the gains, losses and character for each of the dispositions.

Sales

Price

Adjusted

Basis Gain/Loss Character

Land $40,000 $100,000 $(60,000) Ordinary Loss

Iron Byron 25,000 4,000 21,000

$18,000 = §1245 Ordinary

Income; $3,000 = §1231

Sofa 2,900 2,460 440 §1245 Ordinary income

Chair 4,000 5,000 (1,000) §1231 loss

Marketable

Securities 20,000 12,000 8,000 LTCG

Land - Investment 48,000 45,000 3,000 LTCG

Investment Property 8,000 10,000 (2,000) LTCL

Building 255,000 120,000 135,000

$50,000 Unrecaptured §1250

gain; $85,000 §1231 gain

Land -Bldg 45,000 20,000 25,000 §1231 gain

Once the gains and losses have been characterized, they are netted in the §1231 netting

process as follows:




§1231 Netting

Notes on netting:

Step 1 - depreciation recapture

§1245 Iron Byron $18,000

§1245 Sofa 440

$18,440

Ordinary Income

Step 2 - §1231 G/L netting

Gains – Iron

Byron $3,000

Building 85,000

Land 25,000

Losses - Chair (1,000)

$112,000

Unrecaptured

§1250 Gain – Bldg 50,000

Step 3 - Lookback rule

(Reclassify unrecaptured §1250 gains before regular

§1231 gains)

$50,000

$6,000 will be Ordinary Income

$44,000 Unrecaptured §1250 LTCG at 25%

$112,000

0/15/20% LTCG

The capital gains and loss netting process follows the §1231 netting process as follows:

Capital G/L netting

Long term

Short term 28% 25% 0/15/20%

$ 44,000 $ 112,000

(5,000) LTCL carryforward

8,000

3,000

(2,000)

(5,000) $ 44,000 $ 121,000

5,000 (5,000)

$ 39,000 $ 121,000 Net LTCG




Mr Woods’s taxable income is calculated as follows:

Taxable Income:

Taxable income before transactions $460,000

Ordinary loss - land (60,000)

Recapture 18,440

Ordinary income from lookback 6,000

LTCG @ 25% 39,000

LTCG @ 0/15/20% 121,000


Part 2: Mr. Woods’s tax liability is calculated as follows:

Tax Liability:

Calculate Ordinary income $424,440

Tax on ordinary income $124,718

Tax on 25% Gain 9,750

Tax on 0/15/20% Gain (taxed at

20%) 24,200

Tax liability $158,668

Part 3: Mr. Woods’s Form 8949, Schedule D, and Form 4797 would be completed as

follows:




88. Fizbo Corporation is in the business of breeding and racing horses. Fizbo has taxable

income of $5,000,000 other than from these transactions. It has nonrecaptured §1231

losses of $10,000 from 2009 and $13,000 from 2007.




Consider the following transactions that occur during 2013:

a. A building with an adjusted basis of $300,000 is totally destroyed by fire. Fizbo

receives insurance proceeds of $400,000, but does not plan to replace the building.

The building was built 12 years ago at a cost of $420,000 and was used to provide

lodging for employees.

b. Fizbo sells four acres of undeveloped farmland (used for grazing) for $50,000. Fizbo

purchased the land 15 years ago for $15,000.

c. Fizbo sells a racehorse for $250,000. The racehorse was purchased four years ago for

$200,000. Total depreciation taken on the racehorse was $160,000.

d. Fizbo exchanges equipment that was purchased three years ago for $300,000 for

$100,000 of IBM common stock. The adjusted basis of the equipment is $220,000. If

straight-line depreciation had been used, the adjusted basis would be $252,000.

e. On November 1, Fizbo sold XCON stock for $50,000. Fizbo had purchased the stock

on December 12, 2012 for $112,000.

Part 1: After ALL netting is complete, what is Fizbo‟s total amount of income from

these transactions to be treated as ordinary income or loss? What is its capital

gain or loss?

Part 2: What is Fizbo‟s taxable income for the year after including the effects of these

transactions?

Part 1: Fizbo’s ordinary income/loss and capital gains/losses are as follows:

This table determines the gains, losses and character for each of the dispositions.

Asset Amount

Realized

Adjusted

Basis

Gain/(Loss) Character

Building $400,000 $300,000 $100,000 $20,000 is §291 gain

$80,000 is §1231 gain

Farm land 50,000 15,000 35,000 $35,000 §1231 gain

Racehorse1 250,000 40,000 210,000 160,000 §1245 recapture

50,000 §1231 gain

Equipment 100,000 220,000 (120,000) §1231 loss

XCON Stock 50,000 112,000 (62,000) STCL

Once the gains and losses have been characterized, they are netted in the §1231 netting

process as follows:

§1231 Netting:

Step 1: recapture:

§291 from building $20,000

§1245 from racehorse 160,000

$180,000 Ordinary income

Step 2: net §1231 gains and losses:

1In the racing business, racehorses are considered to be analogous to equipment for a manufacturing business.




G: Building $80,000

Farm land 35,000

Racehorse 50,000

Equipment (120,000)

Net §1231 Gain $45,000

Step 3: Lookback losses: Ordinary income = $10,000 §1231 = $35,000

The §1231 gains are combined with the other capital gains and losses:

Capital Gain/Loss Netting:

§1231 $35,000

Capital loss from stock (62,000)

Net capital loss $(27,000)

Ordinary income: Depreciation recapture $180,000

Lookback 10,000

Total $ 190,000

Capital gain/loss: $ (27,000)

Part 2: Fizbo’s taxable income is determined as follows:

Taxable income before transactions $5,000,000

Ordinary income 190,000

Taxable income $5,190,000

Note that Fizbo may not reduce its taxable income by the net capital loss. Corporations’

capital losses are limited to their capital gains.

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