1. Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Principles of Taxation Chapter 15 Investment and Personal Financial Planning

2. Slide 15-2 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Objectives  business versus investment  interest income  tax deferral: insurance and annuities  capital gains and losses  investment interest expense  passive losses  estate and gift rules

3. Slide 15-3 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Business 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.

4. Slide 15-4 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Investments 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.  gains (losses).  Mutual funds may report ‘distributed’ capital gains/losses. These are still taxable but increase basis even if no cash received.

5. Slide 15-5 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

6. Slide 15-6 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

7. Slide 15-7 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

8. Slide 15-8 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

9. Slide 15-9 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

10. Slide 15-10 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

11. Slide 15-11 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 What 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).

12. Slide 15-12 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 LOSS  deduct $3000 against ordinary income  carryforward remainder indefinitely

13. Slide 15-13 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Netting 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 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%.

14. Slide 15-14 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 $1500  Stock B bought 4/1/98 $1000 sold 3/1/98 $2000  Stock C bought 1/1/96 $2000 sold 11/30/98 $5000  Stock D bought 4/1/95 $1500 sold 6/30/98 $1200  Building E bought 1/1/90 $100,000, SL depr $20,000, sold 5/10/97 $120,000.

15. Slide 15-15 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

16. Slide 15-16 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

17. Slide 15-17 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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?

18. Slide 15-18 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

19. Slide 15-19 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

20. Slide 15-20 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Rental 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).

21. Slide 15-21 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Rental 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?

22. Slide 15-22 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

23. Slide 15-23 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Passive 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 $150000).  The passive activities rules are far more complex than this text explores.

24. Slide 15-24 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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%

25. Slide 15-25 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

26. Slide 15-26 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Lifetime transfer tax exclusion  Lifetime exclusion  1997 $600,000  1998 $625,000  1999 $650,000...  2006 $1,000,000

27. Slide 15-27 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

28. Slide 15-28 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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, or  earned income + $250.

29. Slide 15-29 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Estate 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.

30. Slide 15-30 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 tax  keep and include in estate, but heirs get high basis  See AP24.