Chapter 11

1. Chapter 11 Investments

2. Learning Objectives • Explain how interest income and dividend income are taxed • Compute the tax consequences associated with the disposition of capital assets, including the netting process for calculating gains and losses • Describe common sources of tax-exempt investment income and explain the rationale for exempting some investments from taxation • Calculate the deduction for portfolio investment-related expenses, including investment expenses and investment interest expense • Understand the distinction between portfolio investments and passive investments and apply tax basis, at-risk and passive activity loss limits to losses from passive investments

3. Investments Overview • Before-tax rate of return on investment • After-tax rate of return on investment • Depends on when investment income is taxed • Relates to timing tax planning strategy • Depends on the rate at which the income is taxed • Relates to the conversion tax planning strategy • Portfolio vs. Passive investments • Portfolio losses deferred until investment is sold • Passive losses may be deducted annually

4. Portfolio Income: Interest and Dividends • Usually taxable when received • Interest from bonds CDs, savings accounts • Ordinary income taxed at ordinary rate unless municipal bond interest • Interest from U.S. Treasury bonds not taxable by states • Dividends on stock • Typically taxed at preferential capital gains rate

5. Portfolio Income: Dividends • Qualified Dividends • Dividends must be paid by domestic or certain foreign corporations that are held for a certain length of time • Subject to preferential tax rate • 15% generally • 0% if would have been taxed at 10% or 15% if it had been ordinary income • After tax rate of return assuming 8% before-tax rate of return • .08(1 - .15) = 6.8% • Nonqualified dividends are taxed as ordinary income

6. Portfolio Income: Capital Gains and Losses • Investments held for appreciation potential • Gains deferred for tax purposes • Generally taxed at preferential rates • Special loss rules apply • These types of investments are generally investments in capital assets

7. Portfolio Income: Capital Gains and Losses • Capital asset is any asset other than: • Asset used in trade or business • Accounts or notes receivable acquired in business from sale of services or property • Inventory • Sale of capital assets generates capital gains and losses • Specific identification vs. FIFO • Long-term if capital asset held more than a year • Short-term if capital asset held for year or less

8. Portfolio Income: Capital Gains and Losses • Capital gains • Net short-term capital gains taxed at ordinary rates • Generally net capital gains taxed at a maximum preferential rate of 15% • Unrecaptured §1250 gain from the sale of depreciable real estate is taxed at a maximum rate of 25% • Long-term capital gains from collectibles and qualified small business stock are taxed at a maximum rate of 28%.

9. Portfolio Income:Capital Gains and Losses • Capital losses • Individuals allowed to deduct up to $3,000 of net capital loss against ordinary income. Remainder carries over indefinitely to subsequent years.

10. Limitations on Capital Losses • The “wash sale” rule disallows the loss on stocks sold if the taxpayer purchases the same or “substantially identical” stock within a 61-day period centered on the date of sale. • 30 days before the sale • the day of sale • 30 days after the sale • Intended to ensure that taxpayers cannot deduct losses from stock sales while essentially continuing their investment.

11. Tax Planning Strategies for Capital Assets • After-tax rate of return • (FV/I)1/n – 1 • FV = future value of the investment • I = amount of the initial nondeductible investment • n = number of years the taxpayer holds asset before selling • See Example 11-12

12. Tax Planning Strategies for Capital Assets • After-tax rate of return • Increases the longer taxpayer holds asset • Present value of tax decreases • Increases because of the lower the rate at which long-term capital gains are taxed • Preferential rate generally applies because gains are generally long-term capital gains.

13. Tax Planning Strategies for Capital Assets • Tax planning strategies • Hold capital assets for more than a year • Taxed at preferential rate • Tax deferred • Loss harvesting • $3,000 offset against ordinary income • Offset other (short-term) capital gains • Must balance tax with nontax factors • What happened to the stock market in 2008?

14. Municipal Bonds • Offer a lower rate of interest because the interest is tax exempt. • Differences in rates of returns of municipal bonds and taxable bonds are sometimes referred to as “implicit taxes.” • This is different than “explicit taxes” which are actually levied by and paid to governmental entities. • In choosing between taxable and nontaxable bond marginal tax rate is important • Natural “clienteles”

15. Life Insurance • Life insurance can be an investment vehicle because life insurance companies offer life insurance policies with an investment component • Life insurance proceeds are tax exempt if held until death • After-tax rate of return = Before-tax rate of return no matter how long the investment horizon • However, if the policy is cashed in early the cash surrender value in excess of the taxpayer’s cost of the insurance is subject to tax at ordinary rates.

16. Qualified Tuition Program (529 plan) • Allows parents, grandparents, and other individuals to contribute up to the maximum allowed by each state to the 529 plan. • Earnings of the plan accumulate tax free. • Distributions from the plan are tax free if used for qualified higher education expenses such as tuition, books, and supplies. • If distributions to the beneficiary made for another purpose they are taxed at the rate of the beneficiary and are subject to 10% penalty tax.

17. Coverdell Educational Savings Account • Similar to 529 plans except that contributions to the plan are limited to $2,000 per year for each beneficiary. • Distributions may be used to pay for the tuition and other qualified costs of Kindergarten – 12th grade students. • The $2,000 contribution is phased out: • $190,000 to $220,000 married filing jointly • $95,000 to $110,000 all other tax payers

18. Passive Activity Income and Losses • Passive Investments • Typically an investment in a partnership, S corporation, or direct ownership in rental real estate. • Ordinary income from these investments is taxable annually as it is earned. • Ordinary losses may be deducted currently if able to overcome: • Tax basis limitation • At-risk limitation • Passive loss limitation