Principles of Taxation
Chapter 15
Investment and Personal
Financial Planning
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Objectives
Slide 15-2
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business versus investment
interest income
tax deferral: insurance and annuities
capital gains and losses
investment interest expense
passive losses
estate and gift rules
©The McGraw-Hill Companies, Inc., 2000
Business versus Investment
Slide 15-3
 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.
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Investments in financial assets
Slide 15-4
 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.
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Interest income
Slide 15-5
 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
Slide 15-6
 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
Slide 15-7
 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
Slide 15-8
 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
Slide 15-9
 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
Slide 15-10
 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
Slide 15-11
 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).
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Netting and tax rates - net loss
Slide 15-12
 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
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Netting and tax rates - net gain
Slide 15-13
 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%.
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ARGGHH!! - What was that last
slide?
Slide 15-14
 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.
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Investments in Small
Business
Slide 15-15
 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
Slide 15-16
 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
Slide 15-17
 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
Slide 15-18
 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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©The McGraw-Hill Companies, Inc., 2000
Rental RE
Slide 15-19
 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.
Slide 15-20
 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).
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Rental RE example
Slide 15-21
 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?
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Passive Activities
Slide 15-22
 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.
Slide 15-23
 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.
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Wealth transfer planning
Slide 15-24
 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
Slide 15-25
 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
Slide 15-26
 Lifetime exclusion
 1997 $600,000
 1998 $625,000
 1999 $650,000 . . .
 2006 $1,000,000
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Income tax effects of gifts
Slide 15-27
 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
Slide 15-28
 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.
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Estate tax
Slide 15-29
 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.
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©The McGraw-Hill Companies, Inc., 2000
Income tax effect of bequests
Slide 15-30
 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.
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