Principles of Taxation

1
Principles of Taxation

• Chapter 15
• Investment and Personal Financial Planning

2
Objectives

• Business versus investment
• Interest income
• Tax deferral Insurance and annuities
• Capital gains and losses
• Investment interest expense
• Passive losses
• Estate and gift rules

3
Business versus Investment

• What describes a business activity?
• What describes an investment activity?
• Is managing a portfolio investment activity?

4
Investments in Financial Assets

• Securities include
• Return on investment includes
• interest
• dividends
• What do you do with reinvested dividends?
• gains (losses)
• Mutual funds may report distributed capital
  gains/losses. These are still taxable but
  increase basis even if no cash received.

5
Interest Income

• Municipal bond interest income is tax-free at
  _____________ level for regular tax.
• If the bond is a private activity bond, the
  interest is an __________ preference.
• See AP 2 for an interesting problem with
  interaction of federal and state rates.
• U.S. debt (bills, notes, bonds) are taxable at
  federal level (often exempt at ________level).
  Most pay interest every six months - taxable on
  receipt.

6
Interest Income - Discount Bonds

• Cash basis generally says recognized interest
  income when_________.
• Interest income rules are exception - must
  recognize when earned, such as when original
  issue discount ACCRUES.
• Exception for Series EE U.S. savings bond - delay
  income tax until__________________.
• Exception allows ELECTION to be taxed currently
  on EE bonds.
• OID is amortized using ________ _________ method.
  Market discount recognized when
  bond____________. See AP3.

7
Deferral with Life Insurance or Annuities

• Are life insurance proceeds taxable income at
  death to the recipient?
• Life insurance policies (but not TERM life
  policies) build up cash surrender value (CSV). If
  liquidate policy, excess of ______ over ________
  _____ is taxable.
• Annuity contracts are not taxed until annuity
  payments are made. Taxation is like installment
  sales rules portion of annuity excluded
  _________ x ratio of ___________
  /___________________. See AP6 and 7.

8
Gains/Losses on Securities

• Realization requires a sale or exchange
• Gain/loss __________ -____________
• Character is capital time period matters
• Basis issues
• How do reinvested dividends affect basis?
• Sale of stock uses either specific ID or _______
  method of matching basis with sales.
• Mutual fund shares sold use an ________ basis.

9
Capital Losses on Worthless Securities and Bad
Debts

• Worthless securities are treated as if they are
  sold on the ______ day of the tax year for 0.
  Capital loss results - often long-term.
• Nonbusiness bad debts are treated as a short-term
  __________ loss. See AP9.

10
Exchanging Securities

• General rule is that exchanges are taxable. (e.g.
  Intel for Nike)
• Nontaxable if the stocks are in the SAME
  corporation, or
• part of the ___________ reorganization.
• Keep your old basis - this creates DEFERRAL of
  gain or loss.
• See AP10, 11.

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What to Do with Capital Gains and Losses

• SHORT TERM asset held for lt____ year.
• LONG TERM asset held for gt____ year.
• Separate ____ rate category for collectibles
  and sale of qualified small business stock.
• Net the gains and losses in each class (net ST,
  net LT, net 28LT).

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Netting and Tax Rates - Net Loss

• Net the net ST gain/loss with the net LT
  gain/loss
• IF the total net capital gain/loss is a LOSS
• deduct ______ against _________ income
• carryforward remainder for how long?

13
Netting and Tax Rates - Net Gain

• IF the total net capital gain/loss is a GAIN
• Any NET ST gain is taxed at ___________ rates.
• Any NET 28 is taxed at maximum 28 rate.
• Any other NET LT is taxed at ____ (or ___ if
  the individual is in a 15 ordinary bracket).
• The section 1231 gain treated as capital which is
  attributed to unrecaptured realty depreciation
  (section 1250) is taxed at maximum ____.

14
Putting It All Together

• The ONLY way to see this is to use the tax form
• Review Appendix 15-A carefully at home.
• Lets work this one in class
• Stock A bought 1/1/98 1000 sold 2/1/99 1500
• Stock B bought 4/1/99 1000 sold 6/1/99 2000
• Stock C bought 1/1/96 2000 sold 11/30/99 5000
• Stock D bought 4/1/95 1500 sold 6/30/99 1200
• Building E bought 1/1/90 100,000, SL depr
  20,000, sold 5/10/99 120,000.

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Investments in Small Business

• Qualified small business stock (lt____ million
  assets after issue issued after 8/10/93).
• Exclude _____ gain if held gt___ years.
• Remaining gain is ____ rate gain.
• Loss on Section 1244 stock (1st __ million
  issued stock) is ________ up to 100,000 for
  married filing joint returns. Excess loss is
  _________ loss.
• Gains still qualify as capital.

16
Investment Expenses

• Other expenses (not interest) allowed to the
  extent they EXCEED ____ of AGI (jointly with
  unreimbursed employee expenses and some others).
• investment fees, investment publications,
  seminars
• Investment interest expense is deductible UP TO
  net investment income
• Interest, dividend, annuities, STCG.
• PLUS, if ELECT to be taxed at ordinary rates, may
  include_______.
• C/F any excess interest expense __________ and
  deduct in future.

17
Investment Interest Expense Example

• AGI 100,000
• Investment advice fees 3000
• Investment interest expense 15,000
• Dividends 13,000
• LTCG 5000
• What is the MAXIMUM investment interest expense
  you can deduct? If you do NOT elect to include
  LTCG, how much do you deduct? How would you
  decide?

18
Real Estate Investments

• Land is generally a capital asset - appreciation
  is taxed at favorable rates on sale.
• RE taxes paid are deductible.
• Mortgage interest payments are investment
  interest expense.
• Frequent sales of land may cause land to be
  viewed as____________.
• No depreciation - other expenses may be
  deductible.

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Rental RE

• Report rent income and expenses on Schedule E.
  Rental property is depreciated using residential
  rates.
• Allocate deductions to rental income in
  proportion of days rented/days used (by you or
  tenant).
• Exception may allocate interest expense and tax
  expense to rental income in proportion of days
  rented/365.

20
Rental RE and Personal Use

• Losses are limited to rental income IF you use
  the house personally for more than the greater
  of
• 1) 14 days
• 2) 10 of the rental days.
• Even if not violate above test, net losses may be
  limited due to basis rules (remember Chapter 9)
  or passive activity limits (see below).

21
Rental RE Example

• Rental income 10,000
• Depreciation 5,000
• Interest expense 8,000
• Utilities 2,000
• What would we do if rental days 190 and
  personal days 10?
• What would we do if rental days 200 and
  personal days 50?

22
Passive Activities

• Definition an interest in a business where the
  owner does not MATERIALLY PARTICIPATE - what does
  this mean?
• LOSS on passive activity is ONLY deductible to
  the extent of OTHER __________ INCOME. (Excludes
  active income - e.g. wages, material activities
  excludes portfolio income - e.g. interest,
  dividends.) See AP19.
• Excess losses are carried forward ____________ -
  can deduct unused losses against future passive
  income or at disposition.

23
Passive Activity Exception for Rental RE.

• Passive rental losses up to _______ can be
  deducted if
• active management,
• married AGI less than 100,000 (phases out fully
  at ________).
• The passive activities rules are far more complex
  than this text explores.

24
Wealth Transfer Planning

• Gift, estate, and generation skipping transfer
  taxes
• The unified gift and estate tax is based on
  cumulative transfers over time (life death).
• Graduated rates up to ____

25
Gift Tax

• Remember, all receipts of gifts are excluded from
  INCOME taxation. We are now discussing GIFT
  taxation.
• Exclude _________ per year per donee from
  taxable gifts.
• No gift tax on gifts to spouse, charity, paying
  tuition or medical costs.
• Can treat gift by one spouse as made 1/2 by other
  spouse.

26
Lifetime Transfer Tax Exclusion

• Lifetime exclusion
• 2001 _________
• 2006 1,000,000
• Tax legislation may change estate and gift in
  2001.

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Income Tax Effects of Gifts

• Gift is not taxable income to donee.
• How does the donee determine his or her basis in
  gift property received?
• Exception - use FMV if less than adjusted basis.
• After gift, any income derived from the property
  belongs to the donee.

28
Kiddie Tax

• Unearned income of children lt 14years old
• In excess of _____ in 2001
• is taxed at the __________ marginal tax rate.
• Child lt 14 standard deduction is limited to
  GREATER of
• _____ , or
• earned income 250.

29
Estate Tax

• Taxed at unified estate and gift rate schedule.
• FMV of estate is taxed.
• Unlimited marital deduction.
• Reduce estate by taxes, charity, administrative
  expenses See AP23.

30
Income Tax Effect of Bequests

• Receipt of a bequest is not taxable income to
  heir.
• Basis _______ at date of death free income
  tax step-up in basis.
• Trade-off
• Gift now at low basis, perhaps avoid some
  transfer tax.
• Keep and include in estate, but heirs get high
  basis.
• See AP24.