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#15-1
McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
Investment and Personal Investment and Personal Financial PlanningFinancial Planning
Chapter 15Chapter 15
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ObjectivesObjectives
interest and dividends tax deferral: insurance and annuities capital gains and losses investment interest expense passive losses estate and gift rules
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Business versus InvestmentBusiness versus Investment
Business activity Time and talent on regular basis Profit partially attributable to personal involvement
Investment activity Passive role as owner of income-producing property Managing a portfolio is investment activity.
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Investments in Financial AssetsInvestments in Financial Assets
Securities include: common and preferred stock savings accounts, CDs, notes, bonds
Return on investment includes interest dividends
Reinvested dividends are still taxable but increase basis. Jobs and Growth Tax Relief Reconciliation Act of 2003 created new 15% preferential tax rate for qualified dividend income.
gains (losses). Mutual funds may report ‘distributed’ capital gains/losses. These
are still taxable but increase basis even if no cash received.
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Interest IncomeInterest Income
Municipal bond interest income is tax-free at federal level for regular tax. If the bond is a private activity bond, the interest is an
AMT preference. See AP2 for an interesting problem with interaction of
federal and state rates.
U.S. debt (bills, notes, bonds) are taxable at federal level (often exempt at state level). Most pay interest every six months - taxable on receipt.
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Interest Income - Discount BondsInterest Income - Discount Bonds
Cash basis generally says recognized interest income when paid.
Interest income rules are exception - must recognize when earned, such as when original issue discount ACCRUES. Exception for Series EE U.S. savings bond - delay income
tax until bond is cashed. Exception allows ELECTION to be taxed currently on EE bonds.
OID is amortized using effective interest method. Market discount recognized when bond sold or matured. See AP3.
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Deferral with Life Insurance or AnnuitiesDeferral with Life Insurance or Annuities
Life insurance proceeds NOT taxable income at death.
Life insurance policies (but not TERM life policies) build up cash surrender value (CSV). If liquidate policy, excess of CSV over premiums paid is taxable.
Annuity contracts are not taxed until annuity payments are made. Taxation is like installment sales rules: portion of annuity excluded = payment x ratio of investment in annuity / expected return on annuity. See AP6 and 7.
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Gains/Losses on SecuritiesGains/Losses on Securities
Realization requires a sale or exchange Gain/loss = Proceeds - adjusted basis Character is capital - time period matters Basis issues
reinvested dividends increase basis. Sale of stock uses either specific ID or FIFO method of
matching basis with sales. Mutual fund shares sold typically use an average basis.
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Capital Losses on Worthless Securities Capital Losses on Worthless Securities and Bad Debtsand Bad Debts
Worthless securities are treated as if they are sold on the LAST day of the tax year for $0. Capital loss results - often long-term.
Nonbusiness bad debts are treated as a short-term capital loss. See AP9.
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Exchanging SecuritiesExchanging Securities
General rule is that exchanges are taxable. (e.g. Intel for Nike).
Nontaxable if the stocks are in the SAME corporation, or
part of the nontaxable reorganization. Keep your old basis - this creates
DEFERRAL of gain or loss. See AP 10, 11.
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What to do with Capital Gains and LossesWhat to do with Capital Gains and Losses
SHORT TERM asset held for <= 1 year LONG TERM asset held for > 1 year
Separate 28% rate category for collectibles and sale of qualified small business stock.
Net the gains and losses in each class (net ST, net LT, net 28%LT).
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Netting and Tax Rates - Net LossNetting and Tax Rates - Net Loss
Net the net ST gain/loss with the net LT gain/loss
IF the total net capital gain/loss is a LOSS deduct $3000 against ordinary income carryforward remainder indefinitely
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Netting and Tax Rates - Net GainNetting and Tax Rates - Net Gain
IF the total net capital gain/loss is a GAIN any NET ST gain is taxed at regular rates. any NET 28% is taxed at maximum 28% rate any other NET LT is taxed at 15% (or 5% if the
individual is in a 15% ordinary bracket). The section 1231 gain treated as capital which
is attributed to unrecaptured realty depreciation (section 1250) is taxed at maximum 25%.
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Investments in Small BusinessInvestments in Small Business
Qualified small business stock (<=$50 million assets after issue; issued after 8/10/93). Exclude 50% gain if held >5 years. Remaining gain is 28% rate gain.
Loss on Section 1244 stock (1st $1million issued stock) is ordinary up to $100,000 for MFJ ($50,000 single, MFS) returns. Excess loss is capital loss. Gains still qualify as capital.
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Investment ExpensesInvestment Expenses
Other expenses (not interest) allowed to the extent they EXCEED 2% of AGI (jointly with unreimbursed employee expenses and some others). investment fees, investment publications, seminars
Investment interest expense is deductible UP TO net investment income: interest, dividend, annuities, STCG PLUS, if ELECT to be taxed at ordinary rates, may include LTCG C/F any excess interest expense indefinitely and deduct in future.
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Investment Interest Expense: ExampleInvestment Interest Expense: Example
AGI = $100,000 Investment advice fees = $3000. Investment interest expense = $15,000 Dividends = $13,000 LTCG = $5000 What is the MAXIMUM investment interest
expense you can deduct? If you do NOT elect to include LTCG, how much do you deduct? How would you decide?
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Real Estate InvestmentsReal Estate Investments
Land is generally a capital asset - appreciation is taxed at favorable rates on sale.
RE taxes paid are deductible. Mortgage interest payments are investment
interest expense. Frequent sales of land may cause land to be
viewed as inventory. No depreciation - other expenses may be
deductible.
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Rental RERental RE
Report rent income and expenses on Schedule E. Rental property is depreciated using residential rates.
Allocate deductions to rental income in proportion of days rented / days used (by you or tenant). Exception: may allocate interest expense and tax expense
to rental income in proportion of days rented / 365.
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Rental RE and Personal UseRental RE and Personal Use
Losses are limited to rental income IF you use the house personally for more than the greater of 1) 14 days 2) 10% of the rental days.
Even if not violate above test, net losses may be limited due to basis rules (remember Chapter 9) or passive activity limits (see below).
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Rental RE - ExampleRental RE - Example
Rental income = $10,000 Depreciation = $5,000 Interest expense = $8,000 Utilities = $2,000 What would we do if rental days = 190 and
personal days = 10? What would we do if rental days = 200 and
personal days = 50?
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Passive ActivitiesPassive Activities
Definition: an interest in a business where the owner does not MATERIALLY PARTICIPATE - involved in day-to-day operations on a regular, continuous and substantial basis.
LOSS on passive activity is ONLY deductible to the extent of OTHER PASSIVE INCOME. (Excludes active income - e.g. wages, material activities; excludes portfolio income - e.g. interest, dividends). See AP19.
Excess losses are carried forward indefinitely - can deduct unused losses at disposition.
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Passive Activity Exception for Rental REPassive Activity Exception for Rental RE
Passive rental losses up to $25000 can be deducted if active management married AGI less than $100,000 (phases out fully at
$150,000).
The passive activities rules are far more complex than this text explores.
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Wealth Transfer PlanningWealth Transfer Planning
Gift, estate, and generation skipping transfer taxes
The unified gift and estate tax is based on cumulative transfers over time (life + death).
Graduated rates up to 48% In 2001, Congress repealed the estate and
generation-skipping taxes effective in 2010
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Gift TaxGift Tax
Remember, all receipts of gifts are excluded from INCOME taxation. We are now discussing GIFT taxation.
Exclude $11,000 per year per donee from taxable gifts.
No gift tax on gifts to spouse, charity, paying tuition or medical costs.
Can treat gift by one spouse as made 1/2 by other spouse.
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Gift Tax ExclusionGift Tax Exclusion
Lifetime exclusion 2003 $1,000,000
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Income Tax Effects of GiftsIncome Tax Effects of Gifts
Gift is not taxable income to donee. Donor’s adjusted basis in the property carries
over to become the donor’s basis. exception - use FMV if less than adjusted basis
After gift, any income derived from the property belongs to the donee.
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Kiddie TaxKiddie Tax
Unearned income of children < 14 years old In excess of $800 in 2004 Is taxed at the parent’s marginal tax rate Child < 14 standard deduction is limited to
GREATER of $800, or earned income + $250.
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Estate TaxEstate Tax
Taxed at unified estate and gift rate schedule FMV of estate is taxed Unlimited marital deduction Reduce estate by taxes, charity,
administrative expenses. See AP23.
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Income Tax Effect of BequestsIncome Tax Effect of Bequests
Receipt of a bequest is not taxable income to heir.
Basis = FMV at date of death = free income tax step-up in basis. (In 2010, wealthy estates generate carryover basis).
Trade-off - gift now at low basis, perhaps avoid some transfer tax keep and include in estate, but heirs get high basis See AP24.