Chapter 5: Investment Income and Expenses

investment income

• Form of income that can be earned from deposits, such as bank & money market accounts, notes receivable, and investments in securities such as stocks/bonds

• Some is taxable and some are not. For example, dividends are reported as taxable interest

• Includes “diviends” on deposits or shore accounts in cooperative banks, credit unions, domestic savings and loan associations, and mutual savings bonds → Can also have taxable interest from CDs, or certificate of deposits and deferred interest accounts

• Reported to the taxpayer on Form 1099-INT, typically by the financial institution or another payer if the amount of interest is $10 or more. Taxable interest must be reported, and if it exceeds $1,500, it must be reported on Schedule B, Interest and Ordinary Dividends

interest and ordinary dividends

• Noncash gifts/services given for opening a new account or making deposits, if the deposit is < $5,000, more than $10 must be reported. If deposits > $5,000,more than $20 must be reported as interest

• Credit card rewards are not taxable → IRS views these “rewards” as “rebates” and not taxable income

• The same applies to customer loyalty programs that provide a price reduction after a number of purchases, or discounts

tax-exempt interest

• Interest earned on debt obligations of the state or local government are exempt from federal income but may be subject to income tax at the state/local level

  • Even if the interest is nontaxable, may need to report a capital gain/loss when the investment is sold

• 1099-INT may include both taxable & tax-exempt interest

  • Tax-exempt interest must be reported, even if not necessarily taxable

• If money is borrowed to buy investments that generate tax-free income, it cannot be deducted as investment expense

interest on U.S. treasury bills, notes, and bonds

• Interest on U.S. debit obligations are generally exempt from federal income but not necessarily at the state/local level

  • Series EE bond is issued at a discount, and the difference between the purchase price and amount received when the bonds are later redeemed is “interest income”

  • Series I bonds are issued at face level with a maturity period of 30 years. Face value + accrued interest are payable at maturity. Generally, interest income on these types of securities are reported (EE or I bond) when:

    • The bond matures or is redeemed, whichever comes first

    • Each year as the bond’s redemption value increases (if the taxpayer makes an election)

education savings bonds program

• Qualified taxpayers can exempt the interest earned upon redemption of eligible savings bonds if used to pay for higher educational expenses, and must be used in the same year for the taxpayer, spouse, or dependents → Usually interest is also exempt at the state level

• Must use both the principal + interest to pay for these expenses

  • If earnings exceeds those expenses, amount of excludable interest is reduced

• To exclude the interest, a taxpayer must be at least 24 years old before the issue date. Rules to qualify include:

  • Bonds must be purchased by the owner, and can’t be a gift; Bond proceeds can be used to pay tuition expenses of a dependent child

• Qualified higher-education expenses (HEH) must be reduced by scholarships/tax-free benefits received and by expenses used to claim the American Opportunity and Lifetime Learning credits

• Total interest received may be excluded only if combined amounts of principal/interest don’t exceed the taxpayer’s higher education expenses

  • MFS doesn’t qualify for the education savings bonds interest exclusion

  • If you cash an education savings bond during the year and file MFS, all interest is taxable, regardless of qualifying higher education expenses

• Tuition fees are qualified HEHs, room/board + required textbooks are not, however they are a qualified HEH for the Lifetime Learning Credit and the American Opportunity Credit

  • Other forms of tuition reduction such as scholarships, tuition assistance-employer plans, or tuition reduction must further reduce the amount of qualified HeHs

• Exclusion is calculated & reported on Form 8815, Exclusion of Interest from Series EE and I Savings Bonds Issued After 1989

dividend income

A dividend is a distribution of cash, stock, or other property from a corporation/mutual fund

• Payor will usually use Form 1099-DIV to report dividend income to its shareholders

• If total dividend income exceeds $1,500, it must be reported on Schedule B, otherwise it is reported directly on Form 1040

  • In 2023 the top rate on long-term capital gains/qualified dividends is 20% → Regardless of taxpayer’s tax bracket

• High-income individuals may be subject to Net Investment Income Tax (NIIT)

ordinary dividends

Corporate distributions in cash paid out to shareholders out of earnings and profits. Unless qualified, taxed at ordinary income tax rates

qualified dividends

Dividends that meet certain requirements are taxed at lower capital gain rates:

• Dividends must be paid by a U.S. corporation or qualified foreign corporation and

• Generally must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date

nondividend distributions

• Distributions not paid out of a corporation’s earnings and profits

• Considered a recovery or return of capital and thus are generally not taxable

• These types of distributions reduces the taxpayer’s basis in the stock, and once it reaches 0, additional distributions are taxed as capital gains → Reported in Box 3 of Form 1099-DIV

money market funds

Pay dividends and should be reported as such, instead of interest

stock dividends and distributions

Distribution of stock, not cash, by corporations to its own shareholders, and are generally not a taxable event because shareholders aren’t receiving income, their total numbers of shares increases pro-rata (proportionally)

• Total basis of shareholder’s stock isn’t affected, basis of individual shares is adjusted by the inclusion of the new shares

• If the shareholders chooses to receive cash instead of stock, the dividend is taxable in the year it’s distributed

  • Recipient must include the FMV of the newly issued stock in gross income, same amount is the basis of shares received

dividend reinvestment plans (DRIP)

Allows shareholders to use their dividends to purchase more stock → Dividends reported as income

• In the case of buying shares at a price less than FMV, dividend income is reported as the difference between the two

mutual fund distributions

Mutual funds allow investors to pool their money to invest in securities

• Distributions may include ordinary/qualified dividends, capital gain distributions, exempt-interest/nondividend distributions

• Remember that ordinary dividends are taxable as income

• Capital Gain Distributions (CGD) are always treated on a long-term basis from mutual funds

• Investing in tax-exempt securities yield tax-exempt interest in a mutual fund → Still have to be reported

• If a mutual fund/REIT declares a dividend but doesn’t pay until the following year, the taxpayer is required to report it on their 1099-DIV as a dividend received Dec 31 of the prior year (reports the dividend in the year it was declared)

constructive distributions and constructive dividends

Certain transactions between a corporation and its shareholders → Considered dividends and taxable to shareholders + non-deductible to the corporation. Examples include:

• Payment of Personal Expenses: Amounts should be classified as a distribution, rather than expenses of the corporation

• Unreasonable Compensation: Unreasonable high salary? Excessive part may be treated as a taxable distribution

• Unreasonable Rents: Higher than what shareholders would normally charge? Excessive part of rent could be a taxable distribution

• Cancellation of Shareholder’s Debt: Cancels debt without repayment? Amount cancelled can be treated as a distribution

• Property Transfers for Less than FMV: Transfers property for less than FMV? Excess can be treated as a distribution

• Below-market/Interest-free Loans: Giving loans on an interest-free basis or below the applicable federal rate? Uncharged interest can be treated as a distribution

asset classification

1. Real Property

2. Personal Property

real property

Real estate, includes land and anything permanently attached to it. Examples include buildings, farmland, residential houses, commercial properties, rental properties, and subsurface mineral rights

personal property

Encompasses all assets not classified as real estate. Includes items such as furniture, equipment, vehicles, household goods, collectibles, and livestock. Also covers intangible assets such as stocks, trademarks, cryptocurrency, and copyrights

• Tax treatment of an assets differs depending on whether it’s used for personal/business use, or investment

personal-use property

Refers specifically to assets used personally by the taxpayer and not for trade, business or investment

basis

Original “basis” of an asset is typically its purchase price. Can also be calculated based on the FMV at the time of acquisition, such as when property is inherited/gifted

• Can include sales tax charged during purchase, freight-in charges and shipping fees, installation/testing fees, delinquent real estate taxes, cost of any major improvements to the property, legal/accounting fees for transferring the asset

• Cost of extending utility service lines to the property + impact fees, legal/court fees perfecting title to a property, legal f ees for obtaining a decrease in an assessment levied against property to pay for local improvement; Zoning costs + capitalized value of redeemable ground rent

depreciation deduction

Decreases the basis of an asset over several years → Meant to account for wear & tear, deterioration, or obsolescence of assets. Eventually they won’t become depreciable because the basis will have been fully recovered or if sold/retired from service

• Some types of property like land are never depreciated but most tangible assets are (residential property is usually depreciated over 27.5 years)

dispositions and holding period

Holding period for an asset begins the day after it’s acquired and ends on the day it’s sold

• Difference between its initial cost and selling price may result in a taxable gain/loss

• In some cases, gain/loss may not be recognized until a later date after it has been disposed of or sold

To report a taxable gain/loss from the sale/disposal of an asset, a taxpayer must identify:

• Whether the asset is for personal-use or for business/investment purposes

• Asset’s basis/adjusted basis

• Asset’s holding period (short/long-term)

• Proceeds from the sale

basis of real property (real estate)

• Basis of real estate may include additional costs in addition to the purchase price

• If the property is constructed rather than purchased, basis of property includes all the expenses of construction, such as payments to contractors, building materials, and fees for inspection. Any fees/expenses incurred for “preparing” the land adds to the basis of the land itself, rather than the property constructed on it

settlement costs

Closing costs that can be included in a property’s basis: Abstract fees, installation of utilities, legal fees, recording fees/land surveys, transfer taxes, owner’s title insurance

• Settlement costs do not include any amounts placed in escrow for the future payment of items, such as taxes/insurance