Investments - In Depth Notes

Learning Objectives

• Explain how interest income and dividend income are taxed.
• Compute the tax consequences associated with the disposition of capital assets, including the netting process for calculating gains and losses.
• Calculate the deduction for investment interest expense.
• Apply tax-basis, at-risk, and passive activity loss limits to losses from passive investments.

Portfolio Income: Interest and Dividends

• Interest Income:

  • Usually taxable when received.
  • Sources include bonds, CDs, savings accounts.
  • Taxed as ordinary income unless it comes from municipal bonds.
  • Interest from U.S. Treasury bonds isn’t taxable by state tax.

• Dividend Income:

  • Typically taxed at preferential capital gains rates.
  • Reported on Schedule B.

Qualified Dividends

• Must be paid by domestic or certain foreign corporations.
• Held for more than 60 days in a 121-day period starting 60 days before the ex-dividend date.
• Tax Rates:
  • 0%: if income < maximum 0% threshold.
  • 15%: generally applicable rate.
  • 20%: if income > maximum 15% threshold.

Capital Gains and Losses

• Investments held for appreciation potentials, e.g., growth stocks, land, mutual funds, collectibles.

• Tax Rate Summary:

  • Net short-term capital gains taxed at ordinary rates.
  • Net long-term capital gains are taxed at 0%, 15%, or 20%, based on filing status and income.
  • Special rates apply for certain long-term gains (25% for unrecaptured §1250 gains; 28% for collectibles).

• Net Capital Gain/Loss Calculation:

  • Formula: $ext{Capital Gain or Loss} = ext{Amount Realized} - ext{Adjusted Basis}$.

Short-term vs Long-term Capital Assets

• Long-term Capital Assets: Held for more than one year.
• Short-term Capital Assets: Held for one year or less.
• Long-term capital losses can offset long-term capital gains only.

Capital Loss Deduction

• Up to $3,000$ of net capital loss can be deducted against ordinary income for individuals.
• Losses beyond that amount carry over indefinitely to subsequent years.

Netting Process for Capital Gains/Losses

1. Combine short-term gains and losses.
2. Separate long-term gains and losses.
3. Assess net short-term and net long-term results:
   • If both are losses or both are gains, proceed without further action.
   • If one is a gain and the other is a loss, combine them to produce a net figure.

Limitations on Capital Loss Deductions

• Wash Sale Rule: Disallows deduction on a loss if the same or substantially identical stock is bought within a 61-day period.
  • Example: If sold at a loss but repurchased within 30 days before or after, the loss is not deductible and is instead added to the basis of the repurchased stock.

Tax Planning Strategies for Capital Assets

• Hold capital assets longer than a year to benefit from preferential tax rates, deferring taxes.
• Engage in