1. Personal Financial Planning
Chapter 16
Investment and
Personal Financial Planning
McGraw-Hill Education
Copyright © 2015 by McGraw-Hill Education. All rights reserved.

2. Objectives
Determine the tax consequences of interest and dividend income
Explain how life insurance policies and annuity contracts defer income
Compute gain or loss recognized on security transactions
Compute the tax on short-term and long-term capital gain 2

3. Objectives (continued)
Determine the deduction for investment interest expense
Apply the passive activity loss limitation
Compute a taxable gift by applying the annual and lifetime exclusions
Determine a decedent’s taxable estate 2

4. Business versus Investment
Business activity
Taxpayer commits time and talent on regular basis
Profit is partially attributable to personal involvement
Investment activity
Taxpayer is owner of income-producing property
Profit is primarily due to invested capital
Taxpayer who devotes substantial time to managing income-producing property is still engaging in an investment activity

5. Investments in Financial Assets
Securities include:
Common and preferred stock
Savings accounts, CDs, notes, and bonds
Individuals can own financial assets directly or indirectly through a mutual fund
Mutual fund – diversified portfolio of securities managed by regulated investment company (RIC)
Most popular investment vehicle on the market 3

6. Investments in Financial Assets
Return on investment includes:
Interest
Dividends
Qualified dividends taxed at capital gain preferential rates
0%, 15%, or 20%
Gain on sale of investment

7. Interest Income
Interest on savings accounts, CDs, and corporate bonds is ordinary income
Municipal bond interest income is exempt from federal tax
If bond is a private activity bond, interest is an AMT preference
Interest on U.S. debt (Treasury bills, notes, bonds) is subject to federal tax but exempt from state tax 4

8. Discounted Debt Obligations
Cash basis investors who purchase bonds at a market discount recognize the discount as ordinary income when the bond is redeemed or sold
Cash basis investors who purchase newly issued corporate bonds with original issue discount (OID) must amortize the discount over the life of the bond
Amortized discount is recognized as ordinary income 5

9. Deferral with Life Insurance or Annuities
Life insurance proceeds are excluded from beneficiary’s gross income
Certain life insurance policies build up cash surrender value (CSV) over period that policy is effect
Annual increase in value (inside buildup) is not recognized as income by owner
If owner liquidates the policy, excess of CSV over premiums paid is ordinary income 6

10. Deferral with Life Insurance or Annuities
Owners of annuity contracts don’t recognize annual increase in value (inside buildup) as income
Periodic annuity payment
Portion representing return of owner’s investment is excluded from gross income
Excluded portion is based on exclusion ratio
Exclusion ratio = owner’s investment/expected return
Portion representing distribution of accumulated earnings is taxed as ordinary income

11. Gains/Losses on Securities
Gain or loss is realized on disposition of security
Formula:
Amount realized
(Adjusted basis)
Gain (loss) realized
Gains and losses on sale or exchange of securities is capital gain or loss 7

12. Gains/Losses on Securities
Basis issues
Reinvested dividends increase basis; nontaxable distributions reduce basis
Basis of shares sold determined under:
specific identification method
FIFO method
average basis method

13. Worthless Securities and Bad Debts
Worthless securities are treated as sold on the last day of the year for $0
Loss is capital loss
Nonbusiness bad debts (e.g., personal loans) are treated as short-term capital loss 8

14. Exchanging Securities
General rule: exchanges of securities are taxable events (e.g. Intel for Nike)
Nontaxable if:
Exchange of stocks issued by the same corporation
Exchange pursuant to corporate reorganization
Basis of original stock becomes basis of new stock 9

15. Short-term and Long-term Gains and Losses
Sale or exchange of capital asset held for one year or less results in short-term gain or loss
Short-term gains and losses are netted to one number
Sale or exchange of capital asset held for more than one year results in long-term gain or loss
Separate 28% rate category for long-term gain or loss on sale of collectibles and qualified small business stock
Long-term gains and losses netted to one number 10

16. Netting of Capital Gains and Losses
Capital losses are deductible to extent of capital gains
Net short-term loss is netted against net long-term gain
$(15,000) net STCL + $22,000 net LTCG = $7,000 net LTCG
$(15,000) net STCL + $11,000 net LTCG = $(4,000) net STCL
Net long-term loss is netted against net short-term gain
$(20,000) net LTCL + $29,000 net STCG = $9,000 net STCG
$(20,000) net LTCL + $8,500 net STCG = $(11,500) net LTCL 10

17. Net Capital Gain
Net capital gain may consist of short-term gain, long-term gain, or both
Short-term capital gain taxed at ordinary rate
Long-term gain taxed at preferential rate
28% rate gain taxed at a maximum 28% rate
Other long-term gain taxed at:
0% if marginal rate on ordinary income is 10 or 15%
15% if marginal rate on ordinary income is 25, 28, 33, or 35%
20% if marginal rate on ordinary income is 39.6% 11

18. Unrecaptured Section 1250 Gain
Gain on sale of business realty (including rental property) is taxed under a special rule
Unrecaptured Section 1250 gain taxed at 25%
Gain that would be recaptured as ordinary income under full recapture rule (Section 1245 gain)
Any remaining gain is treated as other capital gain 11

19. Net Capital Loss Limited deduction for net capital loss
$3,000 deductible against ordinary income
Nondeductible net capital loss carried forward indefinitely
Carryforward retains character as short-term or long-term loss 11

20. Investment Expenses
Investment expenses are miscellaneous itemized deductions (subject to 2% AGI floor)
Investment fees, investment publications, seminars
Investment interest expense is itemized deduction
Deduction limited to net investment income (investment income less investment expenses) 14

21. Real Estate Investments
Land is generally a capital asset – gain on sale is taxed at preferential rates
Real estate taxes paid are itemized deductions
Mortgage interest payments are investment interest expense
Frequent sales of land may cause land to be viewed as inventory 15

22. Rental Real Estate
Rental income and expenses reported on Part I, Schedule E
Rental property is depreciated using either a 27.5 or 39 year recovery period
While rental real estate activities may have many business characteristics, they are actually passive activities 16

23. Passive Activities Passive activity is:
Any rental activity
An interest in a business in which taxpayer doesn’t materially participate
Material participation requires involvement in day-to-day operations on a regular, continuous and substantial basis
Classification of a rental or business activity as passive doesn’t effect how income is taxed but does effect the deductibility of losses 17

24. Passive Loss Limitation
Loss on passive activity is only deductible to the extent of other passive income
No deduction against active income (wages, income from material activities), and portfolio income (interest, dividends)
Nondeductible losses are carried forward indefinitely
Taxpayer can deduct unused losses upon disposition of the business interest

25. Exception for Rental Real Estate
Passive rental losses up to $25,000 can be deducted without limit
Taxpayer must actively manage the rent property
$25,000 exception is reduced by 50% of AGI in excess of $100,000
Exception reduced to zero when AGI exceeds $150,000 18

26. Unearned Income Medicare Contribution Tax
High-income individuals must pay 3.8% tax on unearned income
Revenues are earmarked for Medicare trust fund
Tax imposed on lesser of:
Net investment income
Taxable interest, dividends, annuities, royalties, rents, passive activity income, net capital gain
Excess of AGI over threshold amount
$200,000 for unmarried individuals (S and HH)
$250,00 ($125,000) for MFJ (MFS)

27. Transfer Tax System Federal transfer tax system has three components
Gift tax
Estate tax
Generation-skipping transfer taxes
Unified gift and estate tax is based on cumulative transfers during lifetime and at death 19 19 19

28. Gift Tax Gifts are excluded from donee’s gross income
No income tax cost to donee
Donor’s basis carries over to donee
Donor may exclude $14,000 (2014) per year per donee from taxable gifts
Married couple can treat a gift made by one spouse as made equally by each
Gift-splitting doubles annual exclusion
Gifts to spouse or charities are nontaxable
Payment of tuition or medical costs of another individual is not a taxable gift 20

29. Gift Tax Lifetime Exclusion
If FMV of a gift exceeds the annual exclusion, excess is a taxable gift
Only the amount of a donor’s cumulative taxable gifts in excess of a lifetime transfer tax exclusion is taxed
Exclusion is $5,340,000 in 2014
Tax rate for taxable gifts in excess of the exclusion is 40% 21

30. Taxable Estate Taxable estate includes the FMV of all assets:
Owned by the decedent and transferred under a valid will
Other property transferred because of death (e.g., life insurance)
Taxable estate is reduced by:
Decedent’s debts
Administrative and funeral expenses
Unlimited marital deduction
Bequests to charity 24

31. Estate Tax
Taxable estate is reduced by decedent’s lifetime transfer tax exclusion
Exclusion is $5,340,000 in 2014
Exclusion is reduced by any amount used during decedent’s life to reduce taxable gifts for gift tax purposes
Exclusion is increased by any amount of deceased spouse’s exclusion not used at spouse’s death
Tax rate for taxable estate in excess of exclusion is 40% 24

32. Income Tax Consequences
Bequests and inheritances are excluded from the beneficiary’s gross income
Beneficiary’s basis in inherited property equals property’s FMV
Appreciation in property escapes income taxation 25