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Principles of Taxation

Chapter 15Investment and Personal

Financial Planning

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Objectives

business versus investment interest income tax deferral: insurance and annuities capital gains and losses investment interest expense passive losses estate and gift rules

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Business versus Investment

Business activityTime and talent on regular basisProfit 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 assets

Securities include:common and preferred stocksavings accounts, CDs, notes, bonds

Return on investment includes interestdividends

Reinvested dividends are still taxable but increase basis.

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 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 AP 2 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 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 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 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 use an average

basis.

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Capital losses on worthless securities and 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 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 AP10, 11.

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What to do with capital gains and losses

SHORT TERM asset held for <= 1 year

LONG TERM asset held for > 1 yearSeparate 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 loss

Net the net ST gain/loss with the net LT gain/loss

IF the total net capital gain/loss is a LOSSdeduct $3000 against ordinary

incomecarryforward remainder indefinitely

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Netting and tax rates - net gain

IF the total net capital gain/loss is a GAINany NET ST gain is taxed at regular rates.any NET 28% is taxed at maximum 28% rateany other NET LT is taxed at 20% (or 10% 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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ARGGHH!! - What was that last slide?

The ONLY way to see this is to use the tax form Review Appendix 15-A carefully at home. Let’s work this one in class:

Stock A bought 1/1/98 $1000 sold 2/1/98 $1500Stock B bought 4/1/98 $1000 sold 3/1/98 $2000Stock C bought 1/1/96 $2000 sold 11/30/98

$5000Stock D bought 4/1/95 $1500 sold 6/30/98 $1200Building E bought 1/1/90 $100,000, SL depr

$20,000, sold 5/10/97 $120,000.

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Investments 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 married filing joint returns. Excess loss is capital loss.Gains still qualify as capital.

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Investment 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: 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 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 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 use.

Losses are limited to rental income IF you use the house personally for more than the greater of1) 14 days2) 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 example

Rental income = $10,000Depreciation = $5,000 Interest expense = $8,000Utilities = $2,000What 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 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 RE.

Passive rental losses up to $25000 can be deducted ifactive managementmarried AGI less than $100,000

(phases out fully at $150000).

The passive activities rules are far more complex than this text explores.

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Wealth transfer planning

gift, estate, and generation skipping transfer taxes

The unified gift and estate tax is based on cumulative transfers over time (life + death).

Graduated rates up to 55%

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Gift tax

Remember, all receipts of gifts are excluded from INCOME taxation. We are now discussing GIFT taxation.

Exclude $10,000 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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Lifetime transfer tax exclusion

Lifetime exclusion1997 $600,0001998 $625,0001999 $650,000 . . . 2006 $1,000,000

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Income 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 tax

Unearned income of children < 14years old

In excess of $700 in 1999 is taxed at the parent’s marginal

tax rate.Child < 14 standard deduction is

limited to GREATER of$700, orearned income + $250.

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Estate tax

Taxed at unified estate and gift rate schedule

FMV of estate is taxed. Unlimited marital deductionReduce estate by taxes, charity,

administrative expenses See AP23.

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Income 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

Trade-off - gift now at low basis, perhaps avoid

some transfer taxkeep and include in estate, but heirs

get high basisSee AP24.