income tax acct ch 7

why timing matters for investments

money available sooner can pay a bill or earn more - higher promised payoff gives more risk

after tax rate of return on investment depends on:

• before tax rate of return

• when investment income and gains are taxed

  • annually, tax deferred, tax exempt

• when investment losses are deducted - annually, deferred

• rate at which investment income, gains/losses are taxed

interest

payment for use of your money

• bond makes you a lender , repayment still depends on borrower

dividend

payment to owners. company may retain its earnings instead - dividends and share prices can change

portfolio income: interest and dividends

• taxable when received

  • interest from bonds, CDs, savings accounts:

    • ordinary income taxed at ordinary rate UNLESS municipal bond interest

    • interest from US treasury bonds are not taxable by state but is federally taxed

  • dividends on stock - taxed at preferential capital gains rate

why invest in assets yielding interest or dividends?

non tax factors

• risk

• diversification

• others

qualified dividends

• eligible US or foreign payer - 0%, 15%, 20% based on income + filing status

• common stock - hold at least for 61 days within 60 day time frame (before and after) of ex dividend date

• preferred dividends covering 366 days - hold at least 91 days within 90 day time frame of date

• count sale day not purchase day - exclude reduced risk days

ex-dividend date

cutoff date set by the stock exchange

• If you buy a stock on or after its ex-dividend date, you will not receive the upcoming dividend (the seller gets it).

nonqualified dividends

• taxed at ordinary rates when

  • fail the required holding period, even if it’s qualified

  • foreign payer doesn’t qualify

  • payment is an excluded TYPE - REIT dividends, money market fund dividends

  • ex dividend date - buyer on this date doesn't get dividend

portfolio income: capital gains and losses

investments held for appreciation potential - capital assets

• growth stocks

• land

• mutual funds

• other assets - precious metals, collectibles …

investments in capital assets

• gains deferred for tax purposes

• generally taxed at preferential rates

• special loss rules apply

capital asset

any asset that’s not

• used in trade or business

• A/R or N/R acquired in business from sale of services/property

• inventory

sale of capital assets generates capital gains/losses

• special identification vs FIFO to determine tax basis of shares sold

• long term = capital asset held for more than a year

• short term = capital asset held for a year or less

capital gains

• net short term capital gains - taxed at ordinary rates

• net capital gains (net long term capital gains in excess of net short term capital losses) taxed at max preferential rates (0, 15, 20) dependent on filing status and income

• certain gains from sale of depreciable real estate held long term are taxed at max rate of 25%

• long term capital gains from collectibles and qualified small business stock taxed at max rate of 28%

capital losses

• individuals (including MFJ) can deduct up to 3000 of net capital loss against ordinary income

• remainder carries over

netting process for capital gain/loss

1. combine short term gains/losses and separately combine long term 0/15/20% gains and losses (including losses carried over from prior yr)

2. if both categories yield gains or losses - netting process is complete

3. if not, taxpayer is to combine short and long term outcomes against each other to produce a final net gain or loss

   1. determine if short term or long term classification depending on which outcome is greater

why the kind of loss matters

• economic loss and deductible tax loss can differ - personal use and related party rules treat these situations differently

  • laptop loses resale value while it’s being used for your enjoyment - the loss in selling it isn’t tax deductible

  • related party transactions within family don’t allow for deductibles

limitations for capital loss deductions

• gains are taxable as capital gains

• losses are not deductible

  • related party transaction capital losses are non deductible

  • related party can eventually deduct all, a portion, or none of the loss on a subsequent sale - special allowance/disallowance rules

wash sale rule - selling and buying it right back

• disallows loss on stocks sold if the taxpayers purchases the same or “substantially identical” stock within a 61 day period centered on date of sale

• so that taxpayers cannot deduct loses from stock sales while essentially continuing their investment

investment expenses

• expenses (other than interest) incurred to generate investment income

• not deductible

investment interest expense

• interest expense on loans used to acquire investments

• deductible as an itemized deduction

• limited to investment income of taxpayer

• carry over indefinitely

passive investments

• investment in partnership, S corporation, or direct ownership in rental real estate

• ordinary income from this is taxable annually as it’s earned

• ordinary losses deducted if able to overcome:

  • tax basis limitation

  • at risk limitation

  • passive loss limitation

tax basis limitation

• losses may not exceed investor’s tax basis in activity

  • excess loss carried over until event occurs to create more tax basis

• tax basis = recourse debt, standard nonrecourse debt, and qualified nonrecourse debt

increases to tax basis

• cash invested

• share of undistributed income

• share of debt

decreases to tax basis

• cash distributions

• prior year losses

at risk basislimitation

• losses may not exceed an investor’s amount at risk in activity

• excess loss carried forward until event occurs to create additional amount at risk

• at risk basis = recourse debt, qualified nonrecourse debt

at risk amount calculated like tax basis except:

• may not include investor’s share of debt that investor is not responsible for repaying

• includes investor’s share of mortgage debt secured by real estate because it is “qualified nonrecourse financing”

passive losses and separate categories

• passive losses can only offset passive income - wages, interests, and dividends are not in the category

passive activity limitation

• applied after tax basis and at risk limitations

• losses from passive activities only deducted to extent the taxpayer has income from passive activities or when the passive activity is sold

passive activity

trade, business, or rental activity in which the taxpayer does not materially participate

• participants in rental real estate and limited partners

• considered passive unless involvement is “regular, continuous, and substantial”

testing for material participation

meet one:

1. individual participates in activity more than 500 hours during year

2. individual’s activity constitutes substantially all of the participation in activity by all individuals, including nonowners

3. individual participates more than 100 hours during year and is not less than any other individual’s participation

4. activity qualifies as a “significant participation activity” and aggregate of all significant participation activities is greater than 500 hours for the year

5. individual materially participated in activity for any 5 of the preceding 10 taxable years

6. individual materially participated for any three preceding years in any personal service activity (health, law, accounting, architecture)

7. taking into account all facts and circumstances - individual participates on a regular, continuous, and substantial basis during the year

rental losses: active participation exception

• rental real estate is passive - losses offset passive income so they don’t reduce tax on wages

• exception: active participation can let qualifying owners deduct up to 25000 against other income

  • active participation - own at least 10% and make real management decisions (like approving tenants or repairs)