Individual Tax Consequences
of Investment Activity
 Timing
issues in income recognition
 Expenses related to investment activity
 Tax basis of investment assets
 Gain/loss on disposition
 Character
of gain or loss
 Capital gains tax rates for individuals
 Limits
on deductibility of passive activity
losses
 Wealth transfer taxation
15-1
Income Recognition
 General
rule: interest/dividend income taxable
when actually or constructively received
 Exceptions:
municipal bond interest, return-ofcapital dividends, discounts on short-term bonds,
market discount on long-term bonds
 Original
issue discount on long-term bonds taxed as
effective interest income over life of the bonds
 Proceeds
of life insurance policies
 Liquidation
prior to death is taxable, in excess of
premiums paid
 Death benefits not taxable
15-2
Investment Expenses
 Expenses
such as safety deposit box rental,
investment management fees, subscriptions to
investment newsletters are miscellaneous
itemized deductions, deductible only to the
extent that total exceeds 2% of AGI
 Investment interest expense
 Not
deductible if proceeds used to purchase taxexempt bonds
 If used to purchase other investment property,
itemized deduction cannot exceed taxpayers net
investment income
15-3
Tax Basis of Investment
Property
 Initial
tax basis generally equals cost plus
acquisition fees
 Basis adjustments:
 Basis
15-4
in bonds increased for taxable OID
 Basis in securities increased (decreased) by
dividend reinvestments (return of capital
distributions)
 Basis in partnership and S corporation investments
adjusted to reflect allocations of income and
expense, contributions and distributions
 Basis in rental property reduced by annual cost
recovery deductions
Sales of Investment Property
 If
investor holds several blocks of identical
securities, acquired at different prices, and
sells a portion of shares owned, basis is
assigned using FIFO unless shares sold can be
specifically identified
 Sales of mutual fund shares typically use an
average basis method
15-5
Gain/Loss on Disposition of
Investment Property
 Each
gain/loss categorized as: capital,
ordinary, Sec. 1231
 Capital
gain/loss further categorized as short-term
(assets held 1 year or less), long-term (assets held
more than one year), 28% gain (collectibles), or
25% gain (unrecaptured Sec. 1250 gain)
 Gains and losses within each category are
combined to obtain a net gain or loss
15-6
Netting Rules for Capital
Gains/Losses
 If
any capital category has a net loss, such loss
can be deducted first against net 28% gains,
then against other gains
 An individual taxpayer’s overall net capital
loss is deductible only up to $3,000 annually,
as a deduction ‘for’ AGI
 Any
non-deductible net capital loss can be carried
forward
 Net
15-7
capital gains taxed at special tax rates
Capital Gains Tax Rates
 Excess
of net short-term capital gains over net
long-term capital losses taxed as ordinary income
 Excess of net long-term capital gains over net
short-term capital losses:
 28%
15-8
(25%) gains taxed at maximum of 28% (25%) or
taxpayer’s ordinary income tax rate
 Other long-term capital gains taxed at 15% (NEW
LAW – formerly 20%). However, if taxpayer’s
ordinary income tax rate is 15% or less, long-term
capital gains are taxed at 5% (NEW LAW – formerly
10%).
Special Rules Affecting
Gain/Loss on Investments
 Individuals
may exclude 50% of gain on
qualified small business stock held more than
5 years
 portion
of gain recognized is 28% gain
 stock must be issued directly by a qualifying small
business (< $50 M gross assets) after 8/10/93
 Loss
on sale of Sec. 1244 stock deductible as
ordinary
 annual
limit of $100,000 (MFJ) or $50,000 (single)
 First $1 M of stock issued directly by corporation
to investors for money or other property
15-9
PAL Limitations - Overview
 Apply
to individuals, fiduciaries, closely-held
and personal service corporations
 Income/loss separated into baskets
 active
 Losses
(including compensation), portfolio, passive
from passive activities can offset
income from other passive activities
 Net passive activity losses cannot offset active
or portfolio income, until the taxpayer
completely disposes of the passive activity
15-10
Definitions
 Passive
activity loss - net loss for the taxable
year from all passive activities
 Passive activity - two types:
 Any
trade or business in which the taxpayer does
not materially participate
 Any rental activity
 Material
participation: Taxpayer must be
involved in the operations of the business on a
regular, continuous, and substantial basis
(based on facts and circumstances)
15-11
PAL Rules for Interests in
Passthrough Entities
 Classification
of income and deductions as
active/passive made at partner or shareholder
level
 Limited partners cannot, by law, materially
participate
 General partners and S corporation
shareholders may treat their share of entity
business income as active only if they
materially participate in the business
operations of the entity
15-12
Dispositions of Passive
Activities
 Any
suspended losses from a passive activity
are fully deductible in the year in which the
entire interest is disposed of in a taxable
transaction
 Partial dispositions or dispositions in
nontaxable transactions do not trigger
suspended losses
15-13
Special Rules for Rental Real
Estate
 Individuals
can deduct up to $25,000 annually
of rental real estate losses if:
 AGI
is less than $100,000 (allowance reduced by
50% for AGI in excess of $100,000) AND
 Taxpayer actively participates in the rental activity
 Owns
at least a 10% interest
 Is significantly involved in the management of the
property (approves tenants, sets lease terms, authorizes
repairs, selects management service)
15-14
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%
 Under
new law, maximum rate drops to 45% by
2007. In 2010, maximum gift tax rate drops to
35%, and estate tax is eliminated (BUT it returns
in 2011!)
Lifetime Transfer Tax
Exclusion
 Gift
tax exclusion
 Estate tax exclusion
 2002
$1 million
and 2003
$1 million
 2004 and 2005
$1.5 million
 2006, 2007, and 2008
$2 million
 2009
$3.5 million
 Estate tax eliminated in 2010
 Estate tax reinstated in 2011 with exclusion of $1
million
 Estate tax exclusion reduced by any lifetime gift
tax exclusion used during decedent’s life
Gift Tax
 Remember,
all receipts of gifts are excluded
from INCOME taxation
 We are now discussing GIFT taxation
 Gift
tax paid by the giver, not the recipient
 Can exclude $11,000 per year per donee from
taxable gifts
 Can
treat gift by one spouse as made 1/2 by other
spouse
 No
gift tax on gifts to spouse, charity, paying
tuition or medical costs
Income Tax Effects of Gifts
 Gift
is not taxable income to recipient
 Donor’s adjusted basis in the property
carries over to become the recipient’s
basis
 exception
 After
- use FMV if less than adjusted basis
gift, any income derived from the
property belongs to the recipient
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
Income Tax Effect of Bequests
 Receipt
of a bequest is not taxable
income to heir
 Basis of inherited property = FMV at date
of death
 Free
income tax step-up in basis
 Trade-off:
 Gift
now at low basis, avoid some transfer tax
 Keep and include in estate, but heirs get high basis