1. McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Principles of Taxation Chapter 15 Investment and Personal Financial Planning

2. Slide 15-2 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-3 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Business versus Investment  What describes a business activity?  What describes an investment activity?  Is managing a portfolio investment activity?

4. Slide 15-4 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-5 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-6 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-7 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-8 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-9 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-10 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.

11. Slide 15-11 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 What to Do with Capital Gains and Losses  SHORT TERM asset held for <=____ year.  LONG TERM asset held for >____ 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 28%LT).

12. Slide 15-12 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-13 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-14 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Putting It All Together  The ONLY way to see this is to use the tax form  Review Appendix 15-A carefully at home.  Let’s 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.

15. Slide 15-15 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Investments in Small Business  Qualified small business stock (<=$____ million assets after issue; issued after 8/10/93).  Exclude _____ gain if held >___ 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. Slide 15-16 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-17 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-18 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.

19. Slide 15-19 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-20 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-21 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-22 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-23 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-24 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-25 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-26 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Lifetime Transfer Tax Exclusion  Lifetime exclusion  2001 $_________  2006 $1,000,000  Tax legislation may change estate and gift in 2001.

27. Slide 15-27 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-28 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Kiddie Tax  Unearned income of children < 14years old  In excess of $_____ in 2001  is taxed at the __________ marginal tax rate.  Child < 14 standard deduction is limited to GREATER of  $_____, or  earned income + $250.

29. Slide 15-29 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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. Slide 15-30 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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.