1. McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Principles of Taxation Chapter 15 Investment and Personal Financial Planning

2. Slide 15-2 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.

3. Slide 15-3 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.

4. Slide 15-4 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.

5. Slide 15-5 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.

6. Slide 15-6 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.

7. Slide 15-7 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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).

8. Slide 15-8 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.

9. Slide 15-9 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.

10. Slide 15-10 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.

11. Slide 15-11 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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).

12. Slide 15-12 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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%

13. Slide 15-13 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.

14. Slide 15-14 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Lifetime Transfer Tax Exclusion  Lifetime exclusion  2001 $675,000  2006 $1,000,000  Tax legislation may change estate and gift in 2001

15. Slide 15-15 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.

16. Slide 15-16 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Kiddie Tax  Unearned income of children < 14years old  In excess of $750 in 2001  Is taxed at the parent’s marginal tax rate  Child < 14 standard deduction is limited to GREATER of  $750, or  earned income + $250.

17. Slide 15-17 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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

18. Slide 15-18 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.