This document discusses tax rules related to different types of investments. It covers how interest, dividends, capital gains and losses are taxed. It also discusses tax-exempt sources of investment income like municipal bonds, life insurance, and education savings accounts. The document explains the distinction between portfolio and passive investments and limitations on deducting losses from passive investments.

1. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 11
Investments

2. 11-2
Learning Objectives
1. Explain 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. Describe common sources of tax-exempt investment
income and explain the rationale for exempting some
investments from taxation
4. Calculate the deduction for portfolio investment-related
expenses, including investment expenses and investment
interest expense
5. 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

3. 11-3
Investments Overview
 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 vs. Passive investments
 Portfolio losses deferred until investment is sold
 Passive losses may be deducted annually

4. 11-4
Portfolio Income: Interest and
Dividends
 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

5. 11-5
Portfolio Income: Dividends
 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% generally
 0% if would have been taxed at 10% or 15% if it had been
ordinary income
 After tax rate of return assuming 8% before-tax rate of
return
 .08(1 - .15) = 6.8%
 Nonqualified dividends are taxed as ordinary income

6. 11-6
 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

7. 11-7
Portfolio Income:
Capital Gains and Losses
 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 vs. FIFO
 Long-term if capital asset held more than a year
 Short-term if capital asset held for year or less

8. 11-8
Portfolio Income:
Capital Gains and Losses
 Capital gains
 Net short-term capital gains taxed at ordinary rates
 Generally net capital gains taxed at a maximum
preferential rate of 15%
 Unrecaptured §1250 gain from the sale of depreciable real
estate is taxed at a maximum rate of 25%
 Long-term capital gains from collectibles and qualified small
business stock are taxed at a maximum rate of 28%.

9. 11-9
Portfolio Income:
Capital Gains and Losses
 Capital losses
 Individuals allowed to deduct up to $3,000 of net
capital loss against ordinary income. Remainder
carries over indefinitely to subsequent years.

10. 11-10
Limitations on Capital Losses
 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.

11. 11-11
Tax Planning Strategies for Capital
Assets
 After-tax rate of return
 (FV/I)
1/n
– 1
 FV = future value of the investment
 I = amount of the initial nondeductible investment
 n = number of years the taxpayer holds asset before
selling
 See Example 11-12

12. 11-12
Tax Planning Strategies for Capital
Assets
 After-tax rate of return
 Increases the longer taxpayer holds asset
 Present value of tax decreases
 Increases because of the lower the rate at which
long-term capital gains are taxed
 Preferential rate generally applies because gains are
generally long-term capital gains.

13. 11-13
Tax Planning Strategies for Capital
Assets
 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?

14. 11-14
Municipal Bonds
 Offer a lower rate of interest because the interest is
tax exempt.
 Differences in rates of returns of municipal bonds
and taxable bonds are sometimes referred to as
“implicit taxes.”
 This is different than “explicit taxes” which are
actually levied by and paid to governmental entities.
 In choosing between taxable and nontaxable bond
marginal tax rate is important
 Natural “clienteles”

15. 11-15
Life Insurance
 Life insurance can be an investment vehicle
because life insurance companies offer life
insurance policies with an investment component
 Life insurance proceeds are tax exempt if held until
death
 After-tax rate of return = Before-tax rate of return no matter
how long the investment horizon
 However, if the policy is cashed in early the cash surrender
value in excess of the taxpayer’s cost of the insurance is
subject to tax at ordinary rates.

16. 11-16
Qualified Tuition Program
(529 plan)
 Allows parents, grandparents, and other
individuals to contribute up to the maximum
allowed by each state to the 529 plan.
 Earnings of the plan accumulate tax free.
 Distributions from the plan are tax free if used for
qualified higher education expenses such as
tuition, books, and supplies.
 If distributions to the beneficiary made for
another purpose they are taxed at the rate of the
beneficiary and are subject to 10% penalty tax.

17. 11-17
Coverdell Educational
Savings Account
 Similar to 529 plans except that
contributions to the plan are limited to
$2,000 per year for each beneficiary.
 Distributions may be used to pay for the
tuition and other qualified costs of
Kindergarten – 12th
grade students.
 The $2,000 contribution is phased out:
 $190,000 to $220,000 married filing jointly
 $95,000 to $110,000 all other tax payers

18. 11-18
Passive Activity Income and
Losses
 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