Chapter 16 Investment and Personal Financial Planning McGraw-Hill Education Copyright © 2015 by McGraw-Hill Education. All rights reserved. 16-2 Objectives • Determine the tax consequences of interest and dividend income • Explain how life insurance policies and annuity contracts defer income • Compute gain or loss recognized on security transactions • Compute the tax on short-term and long-term capital gain 16-3 Objectives (continued) • Determine the deduction for investment interest expense • Apply the passive activity loss limitation • Compute a taxable gift by applying the annual and lifetime exclusions • Determine a decedent’s taxable estate 16-4 Business versus Investment • Business activity • Taxpayer commits time and talent on regular basis • Profit is partially attributable to personal involvement • Investment activity • Taxpayer is owner of income-producing property • Profit is primarily due to invested capital • Taxpayer who devotes substantial time to managing income-producing property is still engaging in an investment activity 16-5 Investments in Financial Assets • Securities include: • Common and preferred stock • Savings accounts, CDs, notes, and bonds • Individuals can own financial assets directly or indirectly through a mutual fund • Mutual fund – diversified portfolio of securities managed by regulated investment company (RIC) • Most popular investment vehicle on the market 16-6 Investments in Financial Assets • Return on investment includes: • Interest • Dividends • Qualified dividends taxed at capital gain preferential rates • 0%, 15%, or 20% • Gain on sale of investment 16-7 Interest Income • Interest on savings accounts, CDs, and corporate bonds is ordinary income • Municipal bond interest income is exempt from federal tax • If bond is a private activity bond, interest is an AMT preference • Interest on U.S. debt (Treasury bills, notes, bonds) is subject to federal tax but exempt from state tax 16-8 Discounted Debt Obligations • Cash basis investors who purchase bonds at a market discount recognize the discount as ordinary income when the bond is redeemed or sold • Cash basis investors who purchase newly issued corporate bonds with original issue discount (OID) must amortize the discount over the life of the bond • Amortized discount is recognized as ordinary income 16-9 Deferral with Life Insurance or Annuities • Life insurance proceeds are excluded from beneficiary’s gross income • Certain life insurance policies build up cash surrender value (CSV) over period that policy is effect • Annual increase in value (inside buildup) is not recognized as income by owner • If owner liquidates the policy, excess of CSV over premiums paid is ordinary income 16-10 Deferral with Life Insurance or Annuities • Owners of annuity contracts don’t recognize annual increase in value (inside buildup) as income • Periodic annuity payment • Portion representing return of owner’s investment is excluded from gross income • Excluded portion is based on exclusion ratio • Exclusion ratio = owner’s investment/expected return • Portion representing distribution of accumulated earnings is taxed as ordinary income 16-11 Gains/Losses on Securities • Gain or loss is realized on disposition of security • Formula: Amount realized (Adjusted basis) Gain (loss) realized • Gains and losses on sale or exchange of securities is capital gain or loss 16-12 Gains/Losses on Securities • Basis issues • Reinvested dividends increase basis; nontaxable distributions reduce basis • Basis of shares sold determined under: • specific identification method • FIFO method • average basis method 16-13 Worthless Securities and Bad Debts • Worthless securities are treated as sold on the last day of the year for $0 • Loss is capital loss • Nonbusiness bad debts (e.g., personal loans) are treated as short-term capital loss 16-14 Exchanging Securities • General rule: exchanges of securities are taxable events (e.g. Intel for Nike) • Nontaxable if: • Exchange of stocks issued by the same corporation • Exchange pursuant to corporate reorganization • Basis of original stock becomes basis of new stock 16-15 Short-term and Long-term Gains and Losses • Sale or exchange of capital asset held for one year or less results in short-term gain or loss • Short-term gains and losses are netted to one number • Sale or exchange of capital asset held for more than one year results in long-term gain or loss • Separate 28% rate category for long-term gain or loss on sale of collectibles and qualified small business stock • Long-term gains and losses netted to one number 16-16 Netting of Capital Gains and Losses • Capital losses are deductible to extent of capital gains • Net short-term loss is netted against net long-term gain • $(15,000) net STCL + $22,000 net LTCG = $7,000 net LTCG • $(15,000) net STCL + $11,000 net LTCG = $(4,000) net STCL • Net long-term loss is netted against net short-term gain • $(20,000) net LTCL + $29,000 net STCG = $9,000 net STCG • $(20,000) net LTCL + $8,500 net STCG = $(11,500) net LTCL 16-17 Net Capital Gain • Net capital gain may consist of short-term gain, long-term gain, or both • Short-term capital gain taxed at ordinary rate • Long-term gain taxed at preferential rate • 28% rate gain taxed at a maximum 28% rate • Other long-term gain taxed at: • 0% if marginal rate on ordinary income is 10 or 15% • 15% if marginal rate on ordinary income is 25, 28, 33, or 35% • 20% if marginal rate on ordinary income is 39.6% 16-18 Unrecaptured Section 1250 Gain • Gain on sale of business realty (including rental property) is taxed under a special rule • Unrecaptured Section 1250 gain taxed at 25% • Gain that would be recaptured as ordinary income under full recapture rule (Section 1245 gain) • Any remaining gain is treated as other capital gain 16-19 Net Capital Loss • Limited deduction for net capital loss • $3,000 deductible against ordinary income • Nondeductible net capital loss carried forward indefinitely • Carryforward retains character as short-term or longterm loss 16-20 Investment Expenses • Investment expenses are miscellaneous itemized deductions (subject to 2% AGI floor) • Investment fees, investment publications, seminars • Investment interest expense is itemized deduction • Deduction limited to net investment income (investment income less investment expenses) 16-21 Real Estate Investments • Land is generally a capital asset – gain on sale is taxed at preferential rates • Real estate taxes paid are itemized deductions • Mortgage interest payments are investment interest expense • Frequent sales of land may cause land to be viewed as inventory 16-22 Rental Real Estate • Rental income and expenses reported on Part I, 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 16-23 Passive Activities • Passive activity is: • Any rental activity • An interest in a business in which taxpayer doesn’t materially participate • Material participation requires involvement in day-to-day operations on a regular, continuous and substantial basis • Classification of a rental or business activity as passive doesn’t effect how income is taxed but does effect the deductibility of losses 16-24 Passive Loss Limitation • Loss on passive activity is only deductible to the extent of other passive income • No deduction against active income (wages, income from material activities), and portfolio income (interest, dividends) • Nondeductible losses are carried forward indefinitely • Taxpayer can deduct unused losses upon disposition of the business interest 16-25 Exception for Rental Real Estate • Passive rental losses up to $25,000 can be deducted without limit • Taxpayer must actively manage the rent property • $25,000 exception is reduced by 50% of AGI in excess of $100,000 • Exception reduced to zero when AGI exceeds $150,000 16-26 Unearned Income Medicare Contribution Tax • High-income individuals must pay 3.8% tax on unearned income • Revenues are earmarked for Medicare trust fund • Tax imposed on lesser of: • Net investment income • Taxable interest, dividends, annuities, royalties, rents, passive activity income, net capital gain • Excess of AGI over threshold amount • $200,000 for unmarried individuals (S and HH) • $250,00 ($125,000) for MFJ (MFS) 16-27 Transfer Tax System • Federal transfer tax system has three components • Gift tax • Estate tax • Generation-skipping transfer taxes • Unified gift and estate tax is based on cumulative transfers during lifetime and at death 16-28 Gift Tax • Gifts are excluded from donee’s gross income • No income tax cost to donee • Donor’s basis carries over to donee • Donor may exclude $14,000 (2014) per year per donee from taxable gifts • Married couple can treat a gift made by one spouse as made equally by each • Gift-splitting doubles annual exclusion • Gifts to spouse or charities are nontaxable • Payment of tuition or medical costs of another individual is not a taxable gift 16-29 Gift Tax Lifetime Exclusion • If FMV of a gift exceeds the annual exclusion, excess is a taxable gift • Only the amount of a donor’s cumulative taxable gifts in excess of a lifetime transfer tax exclusion is taxed • Exclusion is $5,340,000 in 2014 • Tax rate for taxable gifts in excess of the exclusion is 40% 16-30 Taxable Estate • Taxable estate includes the FMV of all assets: • Owned by the decedent and transferred under a valid will • Other property transferred because of death (e.g., life insurance) • Taxable estate is reduced by: • Decedent’s debts • Administrative and funeral expenses • Unlimited marital deduction • Bequests to charity 16-31 Estate Tax • Taxable estate is reduced by decedent’s lifetime transfer tax exclusion • Exclusion is $5,340,000 in 2014 • Exclusion is reduced by any amount used during decedent’s life to reduce taxable gifts for gift tax purposes • Exclusion is increased by any amount of deceased spouse’s exclusion not used at spouse’s death • Tax rate for taxable estate in excess of exclusion is 40% 16-32 Income Tax Consequences • Bequests and inheritances are excluded from the beneficiary’s gross income • Beneficiary’s basis in inherited property equals property’s FMV • Appreciation in property escapes income taxation 16-33