Unit 13 - Investment Returns and Taxation

Current Yield

measurement of the amount of income an investor will receive as a percentage of the cot of the investment

annual income (in dollars) / current market value = CY

Capital Gains and Losses

• open position → when a customer buys a security and holds

• closed position → selling the security

• short sale → customer opens the position by selling and closes the position by buying

• capital gains generated from closing an open position at a profit

• sales proceeds – adjusted cost basis = (capital gains if a positive number, capital losses if a negative number)

  • Adjusted cost basis is the amount paid for a position modified by any adjustments (from stock split or stock dividend)

Realized vs Unrealized Gain/Loss

• Realized Gain or loss

  • comes from closing a position

  • positioned was opened (either by buying or by selling short) and is then closed (either by selling or by buying back) and the position is flat

  • flat → the position no longer exists

• Unrealized Gain or loss

  • comes from an open position

  • use the current market value in place of the closing price of the security

  • use the CMV

Total Return

total return = (income + gains or – losses) / cost basis

Types of Income

Ordinary income is combined of the following and is used to determine the income tax rate

• Earned Income

  • salary, wages, bonuses, tips, and other income that is derived from active participation in a trade or business

• Investment Income

  • earned from one’s investments

  • portfolio income

  • includes dividends and interest payments

  • derived from an asset the investor holds

• Passive Income

  • derived from certain investments, primarily direct participation programs like limited partnerships and many real estate investments

  • these investments may produce passive losses/income

  • a taxpayer who has passive losses can use them to offset any passive income received that tax year

Taxation on Long-term vs Short-term Capital Gains

• long-term capital gain

  • a position must have been held for MORE than one year

  • taxed at a lower rate than ordinary income

• short-term capital gain

  • one year or less

  • taxed as ordinary income

  • ordinary income tax rate will be higher than the long-term capital gains tax rate

Use Capital Losses to reduce taxable income

• on a dollar-for-dollar basis

• if an investor has losses that exceed gains in a given year, they may use up to $3,000 of those losses to reduce ordinary income

• if an investor still has losses in excess of gains and the $3,000, they may carry those losses into the next tax year

  • Carry-forward losses

  • carried forward until used with no time limit

Wash Sale

• if an investor creates a capital loss only to offset capital gains for tax purposes (sell at a loss), while still maintaining ownership of the securities

• If the investor repurchases the same securities on or within 30 days before or after the date establishing the loss, that would be recognized as maintaining ownership

  • the loss may not be used for tax purposes

• A wash sale is not illegal. Attempting to use the losses from the wash sale in order to reduce taxes is illegal

• The rule applies to recreating long positions and to recreating short positions.

• The rule applies for attempts to recreate the same position using not only the exact same security but also substantially identical securities.

  • Any position that may be converted or exercised into the same security as the one that was sold for a loss may be substantially identical

• example: long position they want to offset → buy put options

  • Call options, warrants, and convertible bonds are considered substantially identical to the stock because they provide upside participation or conversion into the same stock.

  • Put options do not provide ownership or the right to acquire the stock → not substantially identical.