Chapter 11 Investments Howard Godfrey, Ph. D Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey

How interest income and dividend income are taxed. 11. Investments 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. Common sources of tax-exempt investment income and explain the rationale for exempting some investments from taxation. Calculate the deduction for portfolio investment-related expenses, including investment expenses and investment interest expense. Understand the distinction between portfolio investments and passive investments and apply tax basis, at-risk, and passive activity loss limits to losses from passive investments.

How interest income and dividend income are taxed.

2. Compute the tax consequences associated with the disposition of capital assets, including the netting process for calculating gains and losses.

3. Calculate the deduction for portfolio investment-related expenses, including investment expenses and investment interest expense.

4. Understand the distinction between portfolio investments and passive investments.

5. Apply tax basis, at-risk, and passive activity loss limits to losses from passive investments.

Textbook page 11-4 Discount or Premium. How is the bond price computed Textbook page 11-4 Discount or Premium. How is the bond price computed? How is the amount of the periodic interest payment determined? The amount of interest expense, and amortization? Please study illustration on next few pages.

HK Co. buys the bonds, at a price based on a 12% yield. HK Co. Bond IIlustration – Slide 1 of 19 Great Corporation issues bonds with a face value of $100,000 on 1-1-09. The bonds mature 2 years later on 12-31-11. The bonds pay interest of 10% per year, payable twice per year ($5,000 each 6 months). HK Co. buys the bonds, at a price based on a 12% yield.

Bond IIlustration – Slide 2 of 19 If the market rate for companies with similar credit standing is 10%, the bonds will sell for $100,000 (plus any accrued interest if sold between interest dates).

Bond IIlustration – Slide 3 of 19 Assume the market rate of interest is 12% compounded semiannually, the bonds will sell for less than $100,000. The bonds will sell at a discount to provide additional earnings for the investor beyond the $5,000 interest payments.

semiannual compounding). Bond IIlustration – Slide 4 of 19 Both the borrower and the investor (if held to maturity) must amortize bond discount using the constant interest rate method (with semiannual compounding).

Bond IIlustration – Slide 5 of 19 How would you compute the amount to be paid for these bonds, if yield is 12%, compounded semiannually?

Bond IIlustration – Slide 6 of 19 Discount the interest payments and principal payment, at 12%, compounded semiannually.

On 12-31-12 the bonds will mature. HK Co. Bond IIlustration – Slide 7 of 19 On 1-1-11, issue $100,000 of bonds. On 12-31-12 the bonds will mature. Bonds have stated interest of 10%. Bonds pay interest of $5,000 each 6 months. HK Co. buys bonds at price to yield 12%, with semi-annual compounding. Compute price paid by HK Co. by discounting cash flows at 6% per interest period.

Bond IIlustration – Slide 10 of 19 Prepare amortization table Bond IIlustration – Slide 10 of 19 Prepare amortization table. Note: The PV factors on preceding page were computed with Excel. These factors are a little more accurate than those taken from tables in your book (because of rounding in the textbook).

On 12-31-12 the bonds will mature. HK Co. Bond IIlustration – Slide 7 of 19 On 1-1-11, issue $100,000 of bonds. On 12-31-12 the bonds will mature. Bonds have stated interest of 10%. Bonds pay interest of $5,000 each 6 months. HK Co. buys bonds at price to yield 12%, with semi-annual compounding. Compute price paid by HK Co. by discounting cash flows at 6% per interest period.

Begin Bal. Int. 6% W/draw End. Bal. 96,535.00 5,792.10 (5,000) 97,327.10 97,327.10 5,839.63 (5,000) 98,166.73 98,166.73 5,890.00 (5,000) 99,056.73 4 99,056.73 5,943.40 (5,000) 100,000.13

How much income is recognized by HK in first year? Bond IIlustration – Slide 16 of 19 How much income is recognized by HK in first year?

How much income is recognized by HK in first year? Bond IIlustration – Slide 17 of 19 How much income is recognized by HK in first year? $5,792.09 plus $5,839.62.

How much would the bonds sell for if they pay zero interest? Bond IIlustration – Slide 19 of 19 How much would the bonds sell for if they pay zero interest? Answer: $79,209.37 (Slide 9 of 19)

Carr uses the interest method of amortizing discount. On Jan. 1, 2007, Carr Corp purchased Fay Corp. 9%. 10-year bonds with a face amount of $400,000 for $375,600, to yield 10%. The bonds are dated January 1, 2007, mature on December 31, 2017, and pay interest annually on Dec. 31. Carr uses the interest method of amortizing discount. What is Carr’s interest revenue for 2007? $40,000 b. $37,560 c. $36,000 d. $34,440 (Source: CPA) Ignore some rounding in the price computation

2. Compute the tax consequences associated with the disposition of capital assets, including the netting process for calculating gains and losses.

Capital Gains and Losses A capital asset is “any asset other than inventory, receivables, copyrights, assets created by the taxpayer, and depreciable or real property used in a trade or business.” A collectible gain or loss results from the sale or exchange of works of art, gems, metals, antiques, rugs, stamps, wine, etc. held more than 12 months.

Tax Treatment for Net Long-term Gain Individual Taxpayers Collectibles held more than 12 months are taxed at a maximum rate of 28%. 50% of the gain on qualified small business stock is excluded, the remainder taxed at a maximum rate of 28%. Unrecaptured Section 1250 gain is taxed at a maximum rate of 25%.

Example Results: “28% rate gain” = ($10,000 -$5,000 - $2,000) = $3,000 ANCG = $15,000 - $3,000 = $12,000 NLTCG is added to taxable income Net capital gain, taxed at 15% = $12,000 Collectibles gain, taxed at 28% = $3,000

Tax Treatment for Net Short-term Gain Individual Taxpayers Net short-term capital gain is taxed as ordinary income (i.e., taxpayer’s marginal tax rate).

Gain Treatment for Corporations Corporations do not receive special treatment for capital gains.

Tax Treatment for Net Loss Net Capital Loss Individuals may use only $3,000 to offset other income Excess loss is carried forward indefinitely and retains its short term or long term class for netting purposes Corporations cannot deduct a net capital loss Excess loss carried back 3 then forward 5 years to offset capital gains

Sharon’s Capital Asset Sales-1 Sharon has salary income of $68,000, a net short-term capital gain of $15,000, and a net long-term capital loss of $24,000. What is Sharon’s adjusted gross income if she has no other income items?

Qualified Small Business Stock Qualified stock Held for more than 5 years Purchased directly from corporation Corporation with gross assets < $50 million Purchased after 8/10/93 Up to 50% of gain may be excluded Limited to the greater of 10 times basis in the stock, or $10 million for each small business Exclusion is based on a 28% rate

Planning Strategies Net Capital Gain position Sell assets with unrealized losses Net Capital Loss position Sell assets with unrealized gains Optimize at $3,000 (deduct $3,000 from Ord. Inc.) Worthless Securities Worthlessness deemed to occur on the last day of the year Realized loss = basis in the worthless security Basis determination FIFO Specific identification

Section 1231 Net Section 1231 gains may be allowed capital gain treatment even though they arise from “ordinary” assets. Net Sec. 1231 losses are ordinary.

Section 1231 Netting Results Net Section 1231 gain is classified as long-term capital gain Lookback rule may reclaim some gains as ordinary to the extent of Section 1231 loss reported in the previous 5 years Net Section 1231 loss is classified as ordinary loss

Section 1231 Disposition of Rental Activities Disposition of rental property held for the production of income (investment) yields capital gain or loss Disposition of rental property used in a trade or business yields Section 1231 gain or loss

Depreciation Recapture Prevents taxpayers from receiving the dual benefits of a depreciation deduction and special Section 1231 gain treatment. Applies to Sec. 1231 gain property only Requires gains to be treated as ordinary to the extent of prior depreciation deductions

Depreciation Recapture-Section 1245 Requires full recapture of all depreciation Gains are treated as ordinary income to the extent of any depreciation taken Any gain in excess of depreciation is netted under Section 1231

Depreciation Recapture-Section 1245 Applies to Depreciable personal property and Nonresidential real estate placed in service between 1981 and 1986 and depreciated under ACRS

Depreciation Recapture Depreciation recapture converts part or all of the gain on the sale of depreciable assets to ordinary income to the extent of the reduction in basis attributable to depreciation expense previously claimed The amount of income recaptured as ordinary income can never exceed either the realized gain or prior depreciation deductions Recapture rules cannot apply to assets on which there is a realized loss

Section 1245 Full Recapture Applies to machinery, equipment, furniture, and fixtures (but not to buildings or structural components) Any gain on the sale of section 1245 property is ordinary income to the extent of all depreciation allowed or allowable for the property Any amount expensed under section 179 is included in the depreciation allowed The income recaptured is the lesser of all depreciation taken or the realized gain

The next slide has an illustration of how the tax law worked for accelerated depreciation on residential real estate. However, only the straight-line method has been allowed for buildings acquired in last 25 years. Buildings bought more than 25 years ago would actually already be fully depreciated by now (shorter life used then). But this shows how it worked.

Depreciation Recapture-Section 1250 Requires partial recapture of depreciation Gains are treated as ordinary income to the extent of depreciation taken in excess of straight-line amount Any gain in excess of depreciation is netted under Section 1231

Depreciation Recapture-Section 1250 Applies to depreciable real property Not covered by Section 1245 and Not depreciated using the straight-line method Eliminates most MACRS realty

Unrecaptured Section 1250 Gain Requires that the portion of the gain attributable to depreciation that is not Section 1250 recapture is taxed at a rate of 25%. Applies to depreciable real property sold after 5/7/97. Any gain not attributable to depreciation (SP in excess of original cost) is a Section 1231 gain taxed at 15%.

Section 1231 Look-Back Rules Net Section 1231 gains are taxed as ordinary income to the extent of any unrecaptured net Section 1231 losses in the five preceding years This prevents taxpayers from generating tax savings by bunching their Section 1231 gains into one year (to receive tax-favored long-term capital gains treatment) and losses into alternate years (deducting the Section 1231 losses in full against ordinary income)

Wash Sales Wash sale - identical securities acquired within 30 days before or after the sale date (a 61-day period) Wash sale losses are disallowed but gains are taxed Loss is deferred by adding disallowed loss to basis of new shares If more stock is sold than is purchased within the 61-day period, only a portion of the loss representing the repurchased stock is deferred

3. Calculate the deduction for portfolio investment-related expenses, including investment expenses and investment interest expense.

Note that business expenses are deductible under Section 162, while non-business expenses of earning income are deductible under Sec. 212. Investment interest is deductible under 163(d). Note the limits. Sec. 62, and Sec. 67 determine where to take the deductions.

See Page 11-27+ for discussion of Educational Savings Plans

Text H/W no. 78 [LO 4] Mickey & Jenny file a joint tax return Text H/W no. 78 [LO 4] Mickey & Jenny file a joint tax return. They itemize deductions. They incur $2,000 in employment-related mis. itemized deductions. They also incur $3,000 of investment interest expense. Their income consists of $150,000 in salary, and $2,500 of interest income. Investment interest expense deduction? Investment interest expense deduction, if they also had a ($2,000) long-term capital loss?

 a. The $3,000 of investment interest expense is deductible to the extent of net investment income. In this problem, investment income and net investment income are $2,500 because there are no investment expenses. Consequently, $2,500 of the investment interest expense is deductible and $500 is carried forward to next year.  

b. If the Porters also have a $2,000 long-term capital loss, their net investment income is reduced to $500 (i.e., $2,500 + ($2,000)). Consequently, only $500 of the investment interest expense is deductible and $2,500 is carried over to next year.

4. Understand the distinction between portfolio investments and passive investments.

Tax Shelter Losses Passive Activity Loss A passive activity is any trade or business in which the taxpayer does not materially participate. Passive Activity Loss Rules disallow the deduction of passive activity losses from other forms of income

Types of Income and Losses Active: salary and wages of an employee and income earned from a business in which the owner/recipient materially participates Portfolio: interest and dividends Passive: tax shelter income, income passed through to limited partners, and income from other businesses in which owner/recipient does not materially participate

Passive Activity Loss Taxpayers subject to the limitations: All non-corporate taxable entities Conduit entity passive losses flow-through to owners Taxpayers not subject to the limitations: Publicly held corporations PAL can offset active and portfolio income Closely held corporations PAL can offset active income, but not portfolio

Passive Activity Loss General Rules for Limitations Passive activity losses must be netted against passive activity income Net passive losses are not deductible Net passive gains are reported with other income

Passive Activity Loss Exception for Rental Real Estate By definition, all rental activities and limited partnership interests are passive But, taxpayers who materially participate in rental real estate business are allowed to offset any losses against other active or portfolio income

Passive Activity Loss Disposition of Passive Activities Excess (suspended) losses must be accounted for in the year of disposition Disposition by sale frees the suspended loss to offset income of any other activity First, offsets other passive income Second, offsets gain from disposal Third, any remaining PAL offsets ordinary income

Disposition of Passive Activities Disposition upon death leaves the passive activity in the decedent’s estate Passive activity with unrealized gain Beneficiary takes passive activity with stepped-up basis Released excess loss is deductible against other income, but Any unrealized gain on activity decreases amount of suspended loss to release Passive activity with unrealized loss No suspended loss is released

5. Apply tax basis, at-risk, and passive activity loss limits

Study the information given on the building on the preceding page Study the information given on the building on the preceding page. Assume the owner only pays interest on the mortgage. What is gain or loss on sale of the building, if it is sold on 1-1-Yr2, for $500,000? What happens to the taxable loss from Yr 1? We will also consider what happens if the value of the building declines over the period of ownership. You can lose from operations and from selling the property for less than basis.

Assume Taxpayer owns the building for exactly 4 years and in each year the income statement looks like the one on the preceding slide. After 4 years (12-31-Yr-4), Taxpayer sells the building for $350,000. Taxpayer has been paying interest only. What is the gain or loss on the building? What happens to 4 years of losses?

Rental Real Estate Relief Taxpayers can qualify for up to $25,000 deduction for rental real estate losses Taxpayer must own at least 10% and actively participate in management Set rents, qualify renters, approve repairs Deduction phases out for AGIs between $100,000 and $150,000

Bud is single & received wages of $140,000 from IBM in 2010 Bud is single & received wages of $140,000 from IBM in 2010. Bud is a 50% partner in a partnership engaged in a rental real estate activity which generated a $60,000 loss for the partnership. Bud was an active participant in the rental real estate activity. He had no other income. How much of the partnership rental loss may Bud deduct on his 20 income tax return? (Sec. 469(i)) a. $0 b. $5,000 c. $15,000 d. $25,000

Real Property Business Exception Taxpayers must spend more than half their time in real property businesses in which they materially participate and time spent equals or exceeds 750 hours

A taxpayer has this income (losses) for the current year: Active Income $43,000 Portfolio Income $29,000 Passive Income $(27,000) What is the taxpayers taxable income (loss) if:

T/P is single individual & passive income is not from rental T/P is single individual & passive income is not from rental? An individual cannot deduct passive losses against active or portfolio income. The individual taxpayer has taxable income of $72,000 ($43,000 + $29,000) and a suspended loss of $27,000.

T/P is single. Passive income results from a rental activity for which the taxpayer qualifies as a real estate professional? A real estate professional can deduct all losses from the activity against active and portfolio income. The taxable income is $45,000 ($43,000 + $29,000 - $27,000).

T/P is a single individual T/P is a single individual. Passive income results from a rental activity for which the taxpayer fails to qualify as a real estate professional? Individual - active participant in a rental real estate activity - is allowed to deduct up to $25,000 of losses from rental activities against active and portfolio income. The taxable income is $47,000 ($43,000 + $29,000 - $25,000).

Laura owns a commercial office building Laura owns a commercial office building. She spends more than 500 hours a year managing the building. She also spends 1,700 hours working in her own real estate development firm.

Laura qualifies as a real estate professional Laura qualifies as a real estate professional. She spends more than 50% of her personal service time in a real property trade or business, the amount of time spent in the real property trade or business is greater than 750 hours, and she materially participates in the rental activity (i.e., spends greater than 500 hours managing the rental activity). Because she qualifies as a real estate professional, office building is not passive activity.

Assume same facts as in preceding slide, except that Laura hires a full-time manager for the commercial office building. She spends 75 hours meeting with manager and reviewing operations.   The office building is a passive activity. Because Laura does not spend more than 500 hours managing the rental property, she does not qualify as a real estate professional.

Sale to Related Party The remaining slides cover a topic mentioned on page 11-21, but is covered in Chapter 10.

Sale to Related Party Losses on sales to related parties are disallowed Related parties include brothers, sisters, spouse, ancestors and lineal descendents, as well as a more-than 50% owned corporation If related buyer later sells property at a gain, this gain can be reduced (not below zero) by the seller’s previously disallowed loss

Loss on Sale to Relative - 1 In April 2011, Pam sold stock with a cost basis of $17,000, to Lisa, her sister, for $10,000. In September 2011, Lisa sold the same shares of stock to her neighbor, Niki, for $20,000. What is Lisa's gain for 2011? a. $0 b. $3,000 c. $7,000 d. $10,000

The End