1. #15-1 McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 15 Investment and Personal Financial Planning

2. #15-2 Objectives Interest and dividends Tax deferral: life insurance and annuities Capital gains and losses Qualified small business stocks & Sec. 1244 stock Investment interest expense Passive losses Estate and gift rules

3. #15-3 Business versus Investment Business activity The taxpayer commits time and talent on regular basis. Profit is partially attributable to personal involvement. Investment activity Taxpayer assumes a passive role as owner of income- producing property Profit is primarily due to invested capital.

4. #15-4 Business versus Investment Even a taxpayer who devotes substantial time to managing income-producing property is still engaging in an investment activity.

5. #15-5 Investments in Financial Assets Securities include: common and preferred stock savings accounts, CDs, notes, and bonds Individuals who invest in financial assets can own the assets directly or indirectly through a mutual fund. Mutual fund – diversified portfolio of securities owned and managed by a regulated investment company (RIC); the most popular investment vehicle on the market.

6. #15-6 Investments in Financial Assets Return on investment includes: interest dividends Reinvested dividends are still taxable but increase total basis. Jobs Act of 2003 created new 15% (5% for those in the lowest two tax brackets) preferential tax rate for qualified dividend income earned by noncorporate shareholders. gains (losses). Mutual funds may report ‘distributed’ capital gains/losses. These are still taxable and increase basis even if no cash received.

7. #15-7 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. U.S. debt (bills, notes, bonds) interest is taxable at federal level (often exempt at state level). Most pay interest every six months – which is taxable on receipt.

8. #15-8 Interest Income - Discount Bonds Cash basis method generally recognizes income when cash is received. Interest income rules are an 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 (or may elect to be taxed currently). OID is amortized using effective interest method. Market discount recognized when bond sold or matured.

9. #15-9 Discount Bond Example Mr. Ed bought a publicly-traded corporate bond for a price less than the face value of the bond. When is the discount recognized as interest income? When the bond is sold or redeemed. What if Mr. Ed purchased a bond through a new public offering. When is the discount recognized as interest income? Over the life of the bond even though no cash interest is received by Mr. Ed.

10. #15-10 Deferral with Life Insurance or Annuities Life insurance proceeds are NOT taxable income at death. Life insurance policies (but not TERM life policies) build up cash surrender value (CSV) for every year that the policy remains in effect. The owner does not recognize the annual increase in value – inside buildup – as taxable income unless the policy is liquidated, Then the excess of CSV over premiums paid is taxable.

11. #15-11 Deferral with Life Insurance or Annuities 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).

12. #15-12 Gains/Losses on Securities Realization requires a sale or exchange Gain/loss = [Proceeds – selling expenses] - adjusted basis Character is capital - time period matters for favorable tax treatment.

13. #15-13 Gains/Losses on Securities Basis issues: Reinvested dividends increase total basis, while nontaxable distributions reduce total 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.

14. #15-14 Sale of Securities Example Mr. Ed owns 100 shares of Oats Inc. for which he paid $100 in 1980. He also purchased an additional 100 shares in 1990 for $250. Oats has paid dividends only twice - $1 per share in 1985 (when FMV was $1.25 per share) and $2 per share in 1995 (when FMV was $2.50 per share), both of which were reinvested. Mr. Ed sells 200 shares in the current year for $490, paying selling expenses of $49. He can’t determine which specific shares were sold. Calculate gain or loss on the sale of securities.

15. #15-15 Sale of Securities Example (continued) Cost of shares purchased in 1980$100 Reinvested dividends ($100 / $1.25 = 80 sh.) 100 Basis of 180 shares in 1985$ 200 Cost of shares purchased in 1990$ 250 Reinvested dividends ($360 / $2.50 = 144 sh.) 360 Basis of 424 shares in 1995$810 Amount realized on sale ($490 - $49)$441 Basis of first 180 shares(200) Basis of remaining 20 shares ($250/100)x20( 50) Gain on sale of securities$191

16. #15-16 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 (e.g., personal loans) are treated as a short-term capital loss.

17. #15-17 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 a nontaxable reorganization –such as a merger. Basis of original stock becomes basis of new stock - this creates DEFERRAL of gain or loss.

18. #15-18 Exchange of Securities Examples Identify the following exchanges as either nontaxable or taxable: Jay exchanged 5 shares of ABC common stock for 2 shares of XYZ common stock. Taxable exchange Jay exchanged 5 shares of ABC Class A voting common stock for 7 shares of ABC Class B voting common stock. Nontaxable exchange

19. #15-19 Exchange of Securities Examples Jay exchanged 2 shares of ABC common stock for 2 shares of ABC preferred stock. Taxable exchange Jay exchanged 10 shares of ABC common stock for 5 shares of XYZ common stock as part of a reorganization. Nontaxable exchange

20. #15-20 Taxation of 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).

21. #15-21 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 $3,000 against ordinary income, carryforward remainder indefinitely. Ken sold ABC stock which he had owned for more than 12 months at a loss of $5,000. He earned $25,000 in wage income. What is Ken’s gross income? $25,000 - $3,000 = $22,000 $2,000 long-term capital loss carryover

22. #15-22 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 15% (5% if the individual is in 10/15% ordinary bracket). The section 1231 gain treated as capital which is attributed to unrecaptured realty depreciation (Sec. 1250) is taxed at maximum 25%.

23. #15-23 Capital Gains/Losses Example Ken sold the following investments during the year: Purchased Sold Basis Proceeds ABC stock 02/02/02 02/10/05 $ 500 $ 450 LMN stock 07/20/04 10/25/04 $1,000 $ 600 Coins 04/30/01 07/05/04 $ 200 $ 750 If Ken is in the 35% tax bracket, how much tax will Ken pay on the above transactions?

24. #15-24 Capital Gains/Losses Example Purchased Sold Basis Proceeds ABC stock 02/02/02 02/10/05 $ 500 $450 ($50) LT LMN stock 07/20/04 10/25/04 $1,000 $600 ($400) ST Coins 04/30/01 07/05/04 $ 200 $750 $550 LT 28% Net gains/losses in each class: [$550 - $50] = $500 LT 28% gain; $400 ST capital loss Net the net ST gain/loss with the net LT gain/loss: [$500 - $400] = $100 LT 28% gain; $100 x.28 = $28 tax

25. #15-25 Capital Gains/Losses Example Purchased Sold Basis Proceeds ABC stock 02/02/02 02/10/05 $ 500 $450 ($50) LT LMN stock 07/20/04 10/25/04 $1,000 $600 ($400) ST Coins 04/30/01 07/05/04 $ 200 $750 $550 LT 28% What if Ken were in the 15% tax bracket instead? The netting remains the same, but the resulting $100 of 28% gain is taxed at 15%. $100 x.15 = $15 capital gain

26. #15-26 Investments in Small Business To encourage individuals to invest in risky start-up corporations, the tax law contains two preferential provisions: Qualified small business stock gain (<=$50 million assets after issue; issued after 8/10/93). Exclude 50% gain if held >5 years. Remaining gain is 28% rate gain. Only applies to the original purchaser of the stock Loss on Section 1244 stock (1st $1million issued stock) is ordinary loss up to $100,000 for MFJ ($50,000 single, MFS) returns. Excess loss is capital loss. Gains still qualify as capital.

27. #15-27 Investment Expenses Other expenses (but not interest) are allowed to the extent they (together with other miscellaneous expenses) EXCEED 2% of AGI e.g., investment fees, investment publications, seminars Investment interest expense is deductible UP TO net investment income [investment income less investment expenses other than interest]: Investment income includes interest, dividend, annuities, STCG PLUS, if ELECT to be taxed at ordinary rates, may include LTCG in investment income Carry forward any excess interest expense indefinitely and deduct in future tax years.

28. #15-28 Investment Interest Expense: Example AGI = $100,000 Investment advice fees = $3,000 Investment interest expense = $15,000 Dividends = $13,000 and LTCG = $5,000 What is the MAXIMUM investment interest expense the taxpayer can deduct? ($13,000 + $5,000) – [$3,000 – ($100,000 x.02)] = $17,000; the full $15,000 of investment interest may be deducted. If taxpayer does NOT elect to include LTCG, how much investment interest expense can he deduct? $13,000 – $1,000 = $12,000 only

29. #15-29 Real Estate Investments Land is generally a capital asset - appreciation is taxed at favorable rates upon sale. Real estate (RE) taxes paid are deductible in determining investment income. Mortgage interest payments are investment interest expense. Frequent sales of land may cause land to be viewed as inventory: especially if substantial improvements are made.

30. #15-30 Rental RE Report rent income and expenses on 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.

31. #15-31 Passive Activities Definition: an interest in a business where the owner does not MATERIALLY PARTICIPATE. Material participation requires involvement in day-to-day operations on a regular, continuous and substantial basis. Passive income is equivalently equal to investment income. The classification of an interest as a passive activity does not effect how income is taxed but does effect the taxation of losses.

32. #15-32 Passive Loss Limitation LOSS on passive activity is ONLY deductible to the extent of OTHER PASSIVE INCOME. Excludes active income (wages, income from material activities); and excludes portfolio income (interest, dividends). Excess losses are carried forward indefinitely Taxpayer can deduct unused losses at disposition of the business interest.

33. #15-33 Rental Activities Rental activities in which revenues are mainly derived from the lease of tangible property for an extended period of time is passive. Passive rental activities do NOT include: Hotels Automobile rentals Tuxedo rentals Videocassette or DVD rentals.

34. #15-34 Passive Activity Exception for Rental RE Passive rental losses up to $25,000 can be deducted if the taxpayer engages in the: active management of the property, and Has married AGI less than $100,000 (phases out fully at $150,000). The passive activities rules are far more complex than this text explores.

35. #15-35 Passive Activity Loss Example Sue, a physician, bought shares in an S Corp. for $500,000. During the first year of operations, Sue’s share of S Corp. losses were $20,000 and her wages were $150,000. What is Sue’s gross income if the S Corp. operates a chain of laundromats? $150,000; the S Corp. income is passive and cannot be deducted against wage income. What is Sue’s gross income if the S Corp. operates an apartment building? $150,000; no passive losses allowed unless the owner manages the rental property and income limits are met.

36. #15-36 The Transfer Tax System The federal transfer tax system has 3 components: Gift, estate, and generation skipping transfer taxes The unified gift and estate tax is based on cumulative transfers during lifetime and at death. Graduated rates up to 47% in 2005. In 2001, Congress repealed the estate and generation-skipping taxes effective in 2010.

37. #15-37 Gift Tax Remember, all receipts of gifts are excluded from INCOME taxation. We are now discussing GIFT taxation. A donor may exclude $11,000 per year per donee from taxable gifts. No gift tax on gifts to spouse or charities, and payment of tuition or medical costs of another individual. Can treat gift by one spouse as made 1/2 by other spouse allowing a couple to gift $22,000 per donee.

38. #15-38 Gift Tax Exclusion If the FMV of a gift exceeds the annual exclusion, the excess is a taxable gift. However, a donor does not pay gift tax until the cumulative amount of taxable gifts exceeds the donor’s lifetime gift tax exclusion of : $1,500,000 in 2005, and $2,000,000 in 2006 – 2008.

39. #15-39 Income Tax Effects of Gifts Gift is not taxable income to donee. Donor’s adjusted basis in the property carries over to become the donee’s new basis. exception - use FMV if less than donor’s adjusted basis After the gift, any income derived from the property belongs to the donee and is taxable. Can result in significant tax savings within a family.

40. #15-40 Kiddie Tax Unearned income of children < 14 years old in excess of $800 in 2005 is taxed at the parent’s marginal tax rate. Child’s standard deduction is limited to the GREATER of: $800, or earned income + $250. Families can avoid the kiddie tax by giving assets that yield deferred rather than current income.

41. #15-41 Estate Tax The taxable estate includes the FMV of all assets owned by the decedent and transferred under a valid will and other property transferred because of death (e.g., life insurance). Taxed at unified estate and gift rate schedule. Unlimited marital deduction is allowed. Reduce estate by taxes, charitable contributions, administrative expenses, and decedent’s debts.

42. #15-42 Income Tax Effect of Bequests Receipt of a bequest is not taxable income to heir. Basis = FMV at date of death Appreciation in property is never taxed. In 2010, bequests will have a carryover basis.

43. #15-43