Chapter 16Chapter 16

Investment and

Personal Financial Planning

McGraw-Hill Education Copyright © 2015 by McGraw-Hill Education. All rights reserved.

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ObjectivesObjectives

• Determine the tax consequences of interest and dividend income

• Explain how life insurance policies and annuity contracts defer income

• Compute gain or loss recognized on security transactions

• Compute the tax on short-term and long-term capital gain

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Objectives (continued)Objectives (continued)

• Determine the deduction for investment interest expense

• Apply the passive activity loss limitation• Compute a taxable gift by applying the annual and

lifetime exclusions• Determine a decedent’s taxable estate

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Business versus InvestmentBusiness versus Investment

• Business activity• Taxpayer commits time and talent on regular basis• Profit is partially attributable to personal involvement

• Investment activity• Taxpayer is owner of income-producing property• Profit is primarily due to invested capital• Taxpayer who devotes substantial

time to managing income-producing property is still engaging in an investment activity

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Investments in Financial AssetsInvestments in Financial Assets

• Securities include:• Common and preferred stock• Savings accounts, CDs, notes, and bonds

• Individuals can own financial assets directly or indirectly through a mutual fund

• Mutual fund – diversified portfolioof securities managed by regulatedinvestment company (RIC)

• Most popular investment vehicle on the market

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Investments in Financial AssetsInvestments in Financial Assets

• Return on investment includes:• Interest• Dividends

• Qualified dividends taxed at capital gain preferential rates

• 0%, 15%, or 20%

• Gain on sale of investment

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Interest IncomeInterest Income

• Interest on savings accounts, CDs, and corporate bonds is ordinary income

• Municipal bond interest income is exempt from federal tax• If bond is a private activity bond,

interest is an AMT preference

• Interest on U.S. debt (Treasury bills, notes, bonds) is subject to federal tax but exempt from state tax

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Discounted Debt ObligationsDiscounted Debt Obligations

• Cash basis investors who purchase bonds at a market discount recognize the discount as ordinary income when the bond is redeemed or sold

• Cash basis investors who purchase newly issued corporate bonds with original issue discount (OID) must amortize the discount over the life of the bond• Amortized discount is recognized as ordinary income

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Deferral with Life Insurance or AnnuitiesDeferral with Life Insurance or Annuities

• Life insurance proceeds are excluded from beneficiary’s gross income

• Certain life insurance policies build up cash surrender value (CSV) over period that policy is effect

• Annual increase in value (inside buildup)is not recognized as income by owner

• If owner liquidates the policy, excess of CSV over premiums paid is ordinary income

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Deferral with Life Insurance or AnnuitiesDeferral with Life Insurance or Annuities

• Owners of annuity contracts don’trecognize annual increase in value(inside buildup) as income

• Periodic annuity payment• Portion representing return of owner’s investment is

excluded from gross income• Excluded portion is based on exclusion ratio• Exclusion ratio = owner’s investment/expected return

• Portion representing distribution of accumulated earnings is taxed as ordinary income

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Gains/Losses on SecuritiesGains/Losses on Securities

• Gain or loss is realized on disposition of security• Formula:

Amount realized(Adjusted basis)Gain (loss) realized

• Gains and losses on sale orexchange of securities is capital gain or loss

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Gains/Losses on SecuritiesGains/Losses on Securities

• Basis issues• Reinvested dividends increase basis;

nontaxable distributions reduce basis• Basis of shares sold determined under:

• specific identification method

• FIFO method

• average basis method

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Worthless Securities and Bad DebtsWorthless Securities and Bad Debts

• Worthless securities are treated as sold on the last day of the year for $0• Loss is capital loss

• Nonbusiness bad debts (e.g., personal loans) are treated as short-term capital loss

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Exchanging SecuritiesExchanging Securities

• General rule: exchanges of securities are taxable events (e.g. Intel for Nike)

• Nontaxable if:

• Exchange of stocks issued by the same corporation

• Exchange pursuant to corporate reorganization

• Basis of original stock becomes basis of new stock

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Short-term and Long-term Gains and LossesShort-term and Long-term Gains and Losses

• Sale or exchange of capital asset held for one year or less results in short-term gain or loss• Short-term gains and losses are netted to one number

• Sale or exchange of capital asset held for more than one year results in long-term gain or loss• Separate 28% rate category for long-term gain or loss on

sale of collectibles and qualified small business stock• Long-term gains and losses netted to one number

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Netting of Capital Gains and LossesNetting of Capital Gains and Losses

• Capital losses are deductible to extent of capital gains

• Net short-term loss is netted against net long-term gain• $(15,000) net STCL + $22,000 net LTCG = $7,000 net LTCG

• $(15,000) net STCL + $11,000 net LTCG = $(4,000) net STCL

• Net long-term loss is netted against net short-term gain• $(20,000) net LTCL + $29,000 net STCG = $9,000 net STCG

• $(20,000) net LTCL + $8,500 net STCG = $(11,500) net LTCL

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Net Capital GainNet Capital Gain

• Net capital gain may consist of short-term gain, long-term gain, or both

• Short-term capital gain taxed at ordinary rate

• Long-term gain taxed at preferential rate• 28% rate gain taxed at a

maximum 28% rate

• Other long-term gain taxed at:• 0% if marginal rate on ordinary income is 10 or 15%

• 15% if marginal rate on ordinary income is 25, 28, 33, or 35%

• 20% if marginal rate on ordinary income is 39.6%

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Unrecaptured Section 1250 GainUnrecaptured Section 1250 Gain

• Gain on sale of business realty(including rental property) is taxed under a special rule

• Unrecaptured Section 1250 gain taxed at 25%

• Gain that would be recaptured as ordinary income under full recapture rule (Section 1245 gain)

• Any remaining gain is treated as other capital gain

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Net Capital LossNet Capital Loss

• Limited deduction for net capital loss• $3,000 deductible against ordinary income• Nondeductible net capital loss carried forward

indefinitely• Carryforward retains character as short-term or long-

term loss

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Investment ExpensesInvestment Expenses

• Investment expenses are miscellaneous itemized deductions (subject to 2% AGI floor)• Investment fees, investment publications,

seminars

• Investment interest expense is itemized deduction• Deduction limited to net investment income (investment

income less investment expenses)

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Real Estate InvestmentsReal Estate Investments

• Land is generally a capital asset – gain on sale is taxed at preferential rates• Real estate taxes paid are itemized deductions

• Mortgage interest payments are investment interest expense

• Frequent sales of land may cause land to be viewed asinventory

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Rental Real EstateRental Real Estate

• Rental income and expenses reported on Part I, Schedule E• Rental property is depreciated using either a 27.5 or 39

year recovery period

• While rental real estate activities may have many business characteristics, they are actually passive activities

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Passive ActivitiesPassive Activities

• Passive activity is:• Any rental activity

• An interest in a business in which taxpayer doesn’t materially participate

• Material participation requires involvement in day-to-day operations on a regular, continuous and substantial basis

• Classification of a rental or business activity as passive doesn’t effect how income is taxed but does effect the deductibility of losses

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Passive Loss LimitationPassive Loss Limitation

• Loss on passive activity is only deductible to the extent of other passive income • No deduction against active income (wages, income from

material activities), and portfolio income (interest, dividends)

• Nondeductible losses are carried forward indefinitely• Taxpayer can deduct unused losses

upon disposition of the business interest

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Exception for Rental Real EstateException for Rental Real Estate

• Passive rental losses up to $25,000 can be deducted without limit• Taxpayer must actively manage the rent property • $25,000 exception is reduced by 50% of AGI

in excess of $100,000• Exception reduced to zero when AGI exceeds $150,000

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Unearned Income Medicare Contribution Tax Unearned Income Medicare Contribution Tax

• High-income individuals must pay3.8% tax on unearned income• Revenues are earmarked for

Medicare trust fund

• Tax imposed on lesser of:• Net investment income

• Taxable interest, dividends, annuities, royalties, rents, passive activity income, net capital gain

• Excess of AGI over threshold amount• $200,000 for unmarried individuals (S and HH)

• $250,00 ($125,000) for MFJ (MFS)

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Transfer Tax SystemTransfer Tax System

• Federal transfer tax system has three components• Gift tax• Estate tax • Generation-skipping transfer taxes

• Unified gift and estate tax is based on cumulative transfers during lifetime and at death

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Gift TaxGift Tax

• Gifts are excluded from donee’s gross income• No income tax cost to donee• Donor’s basis carries over to donee

• Donor may exclude $14,000 (2014) per year per donee from taxable gifts• Married couple can treat a gift made by one spouse

as made equally by each• Gift-splitting doubles annual exclusion

• Gifts to spouse or charities are nontaxable• Payment of tuition or medical costs of another individual is

not a taxable gift

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Gift Tax Lifetime ExclusionGift Tax Lifetime Exclusion

• If FMV of a gift exceeds the annual exclusion, excess is a taxable gift

• Only the amount of a donor’s cumulative taxable gifts in excess of a lifetime transfer tax exclusion is taxed• Exclusion is $5,340,000 in 2014

• Tax rate for taxable gifts inexcess of the exclusion is 40%

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Taxable EstateTaxable Estate

• Taxable estate includes the FMV of all assets:• Owned by the decedent and transferred under a valid will

• Other property transferred because of death (e.g., life insurance)

• Taxable estate is reduced by:• Decedent’s debts

• Administrative and funeral expenses

• Unlimited marital deduction

• Bequests to charity

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Estate TaxEstate Tax

• Taxable estate is reduced by decedent’s lifetime transfer tax exclusion

• Exclusion is $5,340,000 in 2014• Exclusion is reduced by any amount used during decedent’s

life to reduce taxable gifts for gift tax purposes• Exclusion is increased by any amount of deceased spouse’s

exclusion not used at spouse’s death

• Tax rate for taxable estate in excess of exclusion is 40%

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Income Tax ConsequencesIncome Tax Consequences

• Bequests and inheritances are excluded from the beneficiary’s gross income

• Beneficiary’s basis in inherited property equals property’s FMV• Appreciation in property escapes income taxation

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