15-1 Individual Tax Consequences of Investment Activity  Timing issues in income recognition  Expenses related to investment activity  Tax basis of investment assets  Gain/loss on disposition  Character of gain or loss  Capital gains tax rates for individuals  Limits on deductibility of passive activity losses  Wealth transfer taxation

15-2 Income Recognition  General rule: interest/dividend income taxable when actually or constructively received  Exceptions: municipal bond interest, return-of- capital dividends, discounts on short-term bonds, market discount on long-term bonds  Original issue discount on long-term bonds taxed as effective interest income over life of the bonds  Proceeds of life insurance policies  Liquidation prior to death is taxable, in excess of premiums paid  Death benefits not taxable

15-3 Investment Expenses  Expenses such as safety deposit box rental, investment management fees, subscriptions to investment newsletters are miscellaneous itemized deductions, deductible only to the extent that total exceeds 2% of AGI  Investment interest expense  Not deductible if proceeds used to purchase tax- exempt bonds  If used to purchase other investment property, itemized deduction cannot exceed taxpayers net investment income

15-4 Tax Basis of Investment Property  Initial tax basis generally equals cost plus acquisition fees  Basis adjustments:  Basis in bonds increased for taxable OID  Basis in securities increased (decreased) by dividend reinvestments (return of capital distributions)  Basis in partnership and S corporation investments adjusted to reflect allocations of income and expense, contributions and distributions  Basis in rental property reduced by annual cost recovery deductions

15-5 Sales of Investment Property  If investor holds several blocks of identical securities, acquired at different prices, and sells a portion of shares owned, basis is assigned using FIFO unless shares sold can be specifically identified  Sales of mutual fund shares typically use an average basis method

15-6 Gain/Loss on Disposition of Investment Property  Each gain/loss categorized as: capital, ordinary, Sec  Capital gain/loss further categorized as short-term (assets held 1 year or less), long-term (assets held more than one year), 28% gain (collectibles), or 25% gain (unrecaptured Sec gain)  Gains and losses within each category are combined to obtain a net gain or loss

15-7 Netting Rules for Capital Gains/Losses  If any capital category has a net loss, such loss can be deducted first against net 28% gains, then against other gains  An individual taxpayer’s overall net capital loss is deductible only up to $3,000 annually, as a deduction ‘for’ AGI  Any non-deductible net capital loss can be carried forward  Net capital gains taxed at special tax rates

15-8 Capital Gains Tax Rates  Excess of net short-term capital gains over net long-term capital losses taxed as ordinary income  Excess of net long-term capital gains over net short-term capital losses:  28% (25%) gains taxed at maximum of 28% (25%) or taxpayer’s ordinary income tax rate  Other long-term capital gains taxed at 15% (NEW LAW – formerly 20%). However, if taxpayer’s ordinary income tax rate is 15% or less, long-term capital gains are taxed at 5% (NEW LAW – formerly 10%).

15-9 Special Rules Affecting Gain/Loss on Investments  Individuals may exclude 50% of gain on qualified small business stock held more than 5 years  portion of gain recognized is 28% gain  stock must be issued directly by a qualifying small business (< $50 M gross assets) after 8/10/93  Loss on sale of Sec stock deductible as ordinary  annual limit of $100,000 (MFJ) or $50,000 (single)  First $1 M of stock issued directly by corporation to investors for money or other property

15-10 PAL Limitations - Overview  Apply to individuals, fiduciaries, closely-held and personal service corporations  Income/loss separated into baskets  active (including compensation), portfolio, passive  Losses from passive activities can offset income from other passive activities  Net passive activity losses cannot offset active or portfolio income, until the taxpayer completely disposes of the passive activity

15-11 Definitions  Passive activity loss - net loss for the taxable year from all passive activities  Passive activity - two types:  Any trade or business in which the taxpayer does not materially participate  Any rental activity  Material participation: Taxpayer must be involved in the operations of the business on a regular, continuous, and substantial basis (based on facts and circumstances)

15-12 PAL Rules for Interests in Passthrough Entities  Classification of income and deductions as active/passive made at partner or shareholder level  Limited partners cannot, by law, materially participate  General partners and S corporation shareholders may treat their share of entity business income as active only if they materially participate in the business operations of the entity

15-13 Dispositions of Passive Activities  Any suspended losses from a passive activity are fully deductible in the year in which the entire interest is disposed of in a taxable transaction  Partial dispositions or dispositions in nontaxable transactions do not trigger suspended losses

15-14 Special Rules for Rental Real Estate  Individuals can deduct up to $25,000 annually of rental real estate losses if:  AGI is less than $100,000 (allowance reduced by 50% for AGI in excess of $100,000) AND  Taxpayer actively participates in the rental activity  Owns at least a 10% interest  Is significantly involved in the management of the property (approves tenants, sets lease terms, authorizes repairs, selects management service)

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 55%  Under new law, maximum rate drops to 45% by In 2010, maximum gift tax rate drops to 35%, and estate tax is eliminated (BUT it returns in 2011!)

Lifetime Transfer Tax Exclusion  Gift tax exclusion $1 million  Estate tax exclusion  2002 and 2003$1 million  2004 and 2005$1.5 million  2006, 2007, and 2008$2 million  2009$3.5 million  Estate tax eliminated in 2010  Estate tax reinstated in 2011 with exclusion of $1 million  Estate tax exclusion reduced by any lifetime gift tax exclusion used during decedent’s life

Gift Tax  Remember, all receipts of gifts are excluded from INCOME taxation  We are now discussing GIFT taxation  Gift tax paid by the giver, not the recipient  Can exclude $11,000 per year per donee from taxable gifts  Can treat gift by one spouse as made 1/2 by other spouse  No gift tax on gifts to spouse, charity, paying tuition or medical costs

Income Tax Effects of Gifts  Gift is not taxable income to recipient  Donor’s adjusted basis in the property carries over to become the recipient’s basis  exception - use FMV if less than adjusted basis  After gift, any income derived from the property belongs to the recipient

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

Income Tax Effect of Bequests  Receipt of a bequest is not taxable income to heir  Basis of inherited property = FMV at date of death  Free income tax step-up in basis  Trade-off:  Gift now at low basis, avoid some transfer tax  Keep and include in estate, but heirs get high basis