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ACC351CH7.pptxTaxation of Individuals and Business Entities
Investments
2021 Edition
Chapter 7
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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.
Learning Objectives
7-2
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 is taxed
Relates to the conversion tax planning strategy
Portfolio versus passive investments
Portfolio losses deferred until investment is sold
Passive investment losses may be deducted annually
Investments Overview
7-3
Usually taxable when received
Interest from bonds, CDs, savings accounts
Ordinary income taxed at ordinary rate unless municipal bond interest.
Interest from U.S. Treasury bonds not taxable by states.
Dividends on stock
Typically taxed at preferential capital gains rate
Portfolio Income: Interest and Dividends (1 of 2)
7-4
Why invest in assets yielding interest or dividends?
Nontax factors
Risk
Diversification
Others
Portfolio Income: Interest and Dividends (2 of 2)
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Qualified Dividends
Dividends must be paid by domestic or certain foreign corporations that are held for a certain length of time.
Subject to preferential tax rate
15 percent generally
0 percent if income is below the maximum 0 percent amount
20 percent if income is above the maximum 15 percent amount
After-tax rate of return assuming 8 percent before-tax rate of return
.08(1 − .15) = 6.8%
Portfolio Income: Dividends (1 of 2)
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Nonqualified dividends are taxed as ordinary income.
Portfolio Income: Dividends (2 of 2)
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Investments held for appreciation potential
Growth stocks
Land
Mutual funds
Other assets (precious metals, collectibles, etc.)
Portfolio Income: Capital Gains and Losses (1 of 5)
7-8
Investments held for appreciation potential
Gains deferred for tax purposes
Generally taxed at preferential rates
Special loss rules apply
These types of investments are generally investments in capital assets.
Portfolio Income: Capital Gains and Losses (2 of 5)
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Capital asset is any asset other than:
Asset used in trade or business
Accounts or notes receivable acquired in business from sale of services or property
Inventory
Sale of capital assets generates capital gains and losses.
Specific identification versus FIFO
Long-term if capital asset held more than a year
Short-term if capital asset held for year or less
Portfolio Income: Capital Gains and Losses (3 of 5)
7-10
Capital gains
Net short-term capital gains are taxed at ordinary rates.
Generally net capital gains (net long-term capital gains in excess of net short-term capital losses) are taxed at a maximum preferential rate of 0, 15, or 20 percent, depending on the taxpayer’s filing status and income (see Exhibit 7-3).
Certain gains from the sale of depreciable real estate held long term are taxed at a maximum rate of 25 percent (unrecaptured §1250 gain).
Portfolio Income: Capital Gains and Losses (4 of 5)
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Long-term capital gains from collectibles and qualified small business stock are taxed at a maximum rate of 28 percent.
Capital losses
Individuals (including MFJ) are allowed to deduct up to $3,000 of net capital loss against ordinary income.
Remainder carries over indefinitely to subsequent years.
Portfolio Income: Capital Gains and Losses (5 of 5)
7-12
We use a seven-step process to combine capital gains and losses:
Step 1: Combines all short-term capital gains and losses.
Step 2: Separates long-term capital gains and losses into separate groups (28 percent, 25 percent, and 0/15/20 percent) and combines gains and losses in each group.
Step 3: Provides guidance on how to net the combined long-term capital gains and losses from each group.
Steps 4–7: Provide guidance on how to net the resulting short-term and long-term amounts from steps 1 and 3.
Capital Gain/Loss Netting Process
7-13
Ferdinand has the following gains/losses:
Short-term capital gain: $13,000
Short-term capital loss: ($8,000)
Long-term capital gain: $3,000
Long-term capital loss: ($12,000)
What is the amount and character of Ferdinand’s gains and/or losses for the year?
Capital Gain/Loss Question
7-14
Steps 1 and 2: Combine short-term items and long-term items.
Net short-term gain: $5,000
Net long-term loss: ($9,000)
Step 3(A): Proceed to step 4.
Step 4: Continue to step 5.
Capital Gain/Loss Solution (1 of 2)
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Step 5: Because step 1 results in a net short-term gain and step 2 results in a net long-term loss, we combine the two amounts to end up with a net long-term capital loss of $4,000.
Ferdinand can deduct ($3,000) of the loss as a for AGI deduction this year. The remaining ($1,000) loss will carry forward indefinitely but will retain its character as a long-term capital loss.
Steps 6 and 7: Not required.
Capital Gain/Loss Solution (2 of 2)
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Special rules apply to the sale of personal-use assets.
Gains are taxable as capital gains.
Losses are not deductible.
Capital losses from sales to “related parties” are not deducted currently.
The related party may eventually be able to deduct all, a portion, or none of the disallowed loss on a subsequent sale of the property.
Limitations for Capital Loss Deductions (1 of 2)
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The “wash sale” rule disallows the loss on stocks sold if the taxpayer purchases the same or “substantially identical” stock within a 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 cannot deduct losses from stock sales while essentially continuing their investment
Limitations for Capital Loss Deductions (2 of 2)
7-18
Kim owns 10 shares of Tower Inc. with a basis of $40 per share. On December 5 of year 1, she acquires 10 more shares of Tower Inc. for $30 a share. On December 31 of year 1, she sells her original 10 shares for $30 a share.
What loss does Kim recognize on the sale?
What is the basis in Kim’s remaining 10 shares of Tower Inc.?
Wash Sale Question
7-19
Because Kim purchased Tower stock within 30 days of the day she sold the Tower stock at a loss, the wash sale provisions apply to disallow the entire ($100) loss.
Kim adds the disallowed loss of ($100) to the basis of the 10 shares she acquired on December 5. Her basis in these shares is increased from $300 to $400.
If Kim had purchased the stock on November 30 or earlier, or if she had purchased the stock on January 31 of year 2 or later, she would have been able to deduct the entire loss.
Wash Sale Solution
7-20
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?
Tax Planning Strategies for Capital Assets
7-21
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 taxpayer’s investment income
Carry over indefinitely
Investment Interest Expense
7-22
Passive Investments
Typically an investment in a partnership, S corporation, or direct ownership in rental real estate
Ordinary income from these investments is taxable annually as it is earned.
Ordinary losses may be deducted currently if able to overcome:
Tax-basis limitation
At-risk limitation
Passive loss limitation
Passive Activity Income and Losses
7-23
Losses may not exceed an investor’s tax basis in the activity.
Excess loss carried over until event occurs to create more tax basis.
Increases to tax basis
Cash invested
Share of undistributed income
Share of debt
Decreases to tax basis
Cash distributions
Prior-year losses
Tax-Basis Limitation
7-24
Losses may not exceed an investor’s amount at risk in the activity.
Excess loss carried forward until event occurs to create additional amount at risk.
At-risk amount calculated like tax basis except:
May not include investor’s share of debt she is not responsible to repay
However, usually include investor’s share of mortgage debt secured by real estate because it is “qualified nonrecourse financing”
At-Risk Limitation
7-25
Lon purchased an interest in a limited liability company (LLC) for $50,000 and the LLC has no debt. Lon’s share of the loss for the current year is $70,000.
How much of the loss is limited by his tax basis?
How much of the loss is limited by his at-risk amount?
Tax-Basis and At-Risk Limitation Question
7-26
Lon’s tax basis is $50,000, consisting of his $50,000 investment. As a result, $20,000 of his $70,000 loss is limited by his tax basis, leaving $50,000 of loss.
His at-risk amount is also $50,000 because the LLC does not have any debt. Thus, there is no additional loss limited by Lon’s at-risk amount.
Tax Basis and At-Risk Limitation Solution
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Applied after tax basis and at-risk limitations
Losses from “passive activities” may only be deducted to the extent the taxpayer has income from passive activities or when the passive activity is sold.
Passive Activity Limitation (1 of 2)
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A passive activity is a trade, business, or rental activity in which the taxpayer does not materially participate.
Participants in rental real estate and limited partners are generally considered to be passive participants.
All other participants are considered to be passive unless their involvement is “regular, continuous, and substantial.”
Seven factors for testing material participation
Passive Activity Limitation (2 of 2)
7-29
EXHIBIT 7-8 Tests for Material Participation
Individuals are generally considered material participants for the activity if they meet any one of these tests:
The individual participates in the activity more than 500 hours during the year.
The individual’s activity constitutes substantially all of the participation in such activity by all individuals, including nonowners.
Testing for Material Participation (1 of 3)
7-30
The individual participates more than 100 hours during the year, and the individual’s participation is not less than any other individual’s participation in the activity.
The activity qualifies as a “significant participation activity” (more than 100 hours spent during the year) and the aggregate of all “significant participation activities” is greater than 500 hours for the year.
The individual materially participated in the activity for any 5 of the preceding 10 taxable years.
Testing for Material Participation (2 of 3)
7-31
The individual materially participated for any three preceding years in any personal service activity (personal services in health, law, accounting, architecture, etc.)
Taking into account all the facts and circumstances, the individual participates on a regular, continuous, and substantial basis during the year.
Testing for Material Participation (3 of 3)
7-32
In addition to his interest in the LLC, Lon owns a rental property that produced $5,000 of rental income during the year.
How much of Lon’s remaining $50,000 loss (after applying the tax-basis and at-risk limitations) can he deduct currently?
What happens to any portion of the loss he can’t deduct?
Passive Activity Loss Limitation Question
7-33
Generally, income from rental real estate is considered to come from a passive activity.
Lon may use $5,000 of his passive activity loss from the LLC to offset his $5,000 of passive income from his rental real estate.
He must carry forward the remaining $45,000 passive activity loss until he either receives more passive income or until he sells his interest in the LLC.
At the end of the day, Lon is able to deduct $5,000 of his loss from the LLC currently, and he has a $20,000 tax basis and at-risk carryforward and a $45,000 passive activity loss carryforward.
Passive Activity Loss Limitation Solution
7-34
Mom and Pop own a home they rent out to students at the local university. Pop approves new tenants and makes repairs when needed. Their AGI before considering any income or loss from the rental property is $90,000. Their loss from the rental property for the current year is $16,000.
If Mom and Pop have no other sources of passive income, how much of the passive loss from the rental home can they deduct currently?
Mom and Pop Exception for Rental Estate Question
7-35
Taxpayers like Mom and Pop may currently deduct up to $25,000 of losses from rental real estate even if they don’t have passive income from other sources.
However, their ability to deduct these losses phases out by 50 cents for every dollar of AGI they earn above $100,000. Once their AGI hits $150,000 they will no longer be able to deduct the loss from their rental property unless they have passive income from another source.
Because their AGI is less than $100,000, Mom and Pop may deduct all $16,000 of loss from their rental property.
Mom and Pop Exception for Rental Estate Solution
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End of Presentation
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