11-2Learning Objectives1. Explain how interest income and dividend income aretaxed2. Compute the tax consequences associated with thedisposition of capital assets, including the netting processfor calculating gains and losses3. Describe common sources of tax-exempt investmentincome and explain the rationale for exempting someinvestments from taxation4. Calculate the deduction for portfolio investment-relatedexpenses, including investment expenses and investmentinterest expense5. Understand the distinction between portfolio investmentsand passive investments and apply tax basis, at-risk andpassive activity loss limits to losses from passiveinvestments
11-3Investments Overview Before-tax rate of return on investment After-tax rate of return on investment Depends on when investment income is taxed Relates to timing tax planning strategy Depends on the rate at which the income istaxed Relates to the conversion tax planningstrategy Portfolio vs. Passive investments Portfolio losses deferred until investment is sold Passive losses may be deducted annually
11-4Portfolio Income: Interest andDividends Usually taxable when received Interest from bonds CDs, savings accounts Ordinary income taxed at ordinary rate unlessmunicipal bond interest Interest from U.S. Treasury bonds not taxable bystates Dividends on stock Typically taxed at preferential capital gains rate
11-5Portfolio Income: Dividends Qualified Dividends Dividends must be paid by domestic or certain foreigncorporations that are held for a certain length of time Subject to preferential tax rate 15% generally 0% if would have been taxed at 10% or 15% if it had beenordinary income After tax rate of return assuming 8% before-tax rate ofreturn .08(1 - .15) = 6.8% Nonqualified dividends are taxed as ordinary income
11-6 Investments held for appreciation potential Gains deferred for tax purposes Generally taxed at preferential rates Special loss rules apply These types of investments are generallyinvestments in capital assetsPortfolio Income:Capital Gains and Losses
11-7Portfolio Income:Capital Gains and Losses Capital asset is any asset other than: Asset used in trade or business Accounts or notes receivable acquired inbusiness from sale of services or property Inventory Sale of capital assets generates capital gainsand losses Specific identification vs. FIFO Long-term if capital asset held more than a year Short-term if capital asset held for year or less
11-8Portfolio Income:Capital Gains and Losses Capital gains Net short-term capital gains taxed at ordinary rates Generally net capital gains taxed at a maximumpreferential rate of 15% Unrecaptured §1250 gain from the sale of depreciable realestate is taxed at a maximum rate of 25% Long-term capital gains from collectibles and qualified smallbusiness stock are taxed at a maximum rate of 28%.
11-9Portfolio Income:Capital Gains and Losses Capital losses Individuals allowed to deduct up to $3,000 of netcapital loss against ordinary income. Remaindercarries over indefinitely to subsequent years.
11-10Limitations on Capital Losses The “wash sale” rule disallows the loss onstocks sold if the taxpayer purchases thesame or “substantially identical” stock withina 61-day period centered on the date of sale. 30 days before the sale the day of sale 30 days after the sale Intended to ensure that taxpayers cannotdeduct losses from stock sales whileessentially continuing their investment.
11-11Tax Planning Strategies for CapitalAssets After-tax rate of return (FV/I)1/n– 1 FV = future value of the investment I = amount of the initial nondeductible investment n = number of years the taxpayer holds asset beforeselling See Example 11-12
11-12Tax Planning Strategies for CapitalAssets After-tax rate of return Increases the longer taxpayer holds asset Present value of tax decreases Increases because of the lower the rate at whichlong-term capital gains are taxed Preferential rate generally applies because gains aregenerally long-term capital gains.
11-13Tax Planning Strategies for CapitalAssets Tax planning strategies Hold capital assets for more than a year Taxed at preferential rate Tax deferred Loss harvesting $3,000 offset against ordinary income Offset other (short-term) capital gains Must balance tax with nontax factors What happened to the stock market in 2008?
11-14Municipal Bonds Offer a lower rate of interest because the interest istax exempt. Differences in rates of returns of municipal bondsand taxable bonds are sometimes referred to as“implicit taxes.” This is different than “explicit taxes” which areactually levied by and paid to governmental entities. In choosing between taxable and nontaxable bondmarginal tax rate is important Natural “clienteles”
11-15Life Insurance Life insurance can be an investment vehiclebecause life insurance companies offer lifeinsurance policies with an investment component Life insurance proceeds are tax exempt if held untildeath After-tax rate of return = Before-tax rate of return no matterhow long the investment horizon However, if the policy is cashed in early the cash surrendervalue in excess of the taxpayer’s cost of the insurance issubject to tax at ordinary rates.
11-16Qualified Tuition Program(529 plan) Allows parents, grandparents, and otherindividuals to contribute up to the maximumallowed by each state to the 529 plan. Earnings of the plan accumulate tax free. Distributions from the plan are tax free if used forqualified higher education expenses such astuition, books, and supplies. If distributions to the beneficiary made foranother purpose they are taxed at the rate of thebeneficiary and are subject to 10% penalty tax.
11-17Coverdell EducationalSavings Account Similar to 529 plans except thatcontributions to the plan are limited to$2,000 per year for each beneficiary. Distributions may be used to pay for thetuition and other qualified costs ofKindergarten – 12thgrade students. The $2,000 contribution is phased out: $190,000 to $220,000 married filing jointly $95,000 to $110,000 all other tax payers
11-18Passive Activity Income andLosses Passive Investments Typically an investment in a partnership, S corporation,or direct ownership in rental real estate. Ordinary income from these investments is taxableannually as it is earned. Ordinary losses may be deducted currently if able toovercome: Tax basis limitation At-risk limitation Passive loss limitation