Chapter 7 Tax Notes
Chapter 7 Tax Notes ACCT 404
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This 4 page Class Notes was uploaded by Victoria Andreski on Sunday March 27, 2016. The Class Notes belongs to ACCT 404 at Clemson University taught by Sarah Martin in Spring 2016. Since its upload, it has received 17 views. For similar materials see Individual Taxation in Accounting at Clemson University.
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Date Created: 03/27/16
CHAPTER 7—Investments Investments • 2 investments w/ identical before-tax rates of return will generate different after- tax rates of return b/c the investments are taxed differently • An investment w/ a lower before-tax rate of return compared to an alternative investment will have a higher after-tax rate of return b/c income from the investment is taxed at a later date or taxed at a lower rate than the alternative investment • Before-tax rate of return on investment • After-tax rate of return on investment o Depends on WHEN investment income is tax § Relates to timing tax planning strategy o Depends on the RATE at which the income is taxed § Relates to the conversion tax planning strategy • Portfolio vs. Passive Investments o Portfolio—losses deferred until investment is sold § Typically subject to limitations § Income from these investments (from producing dividends, interest, royalties, annuities, or capital gains) may be taxed at ordinary rates, preferential rates, or it may be exempt from taxation • Tax on income may be imposed annually or may be deferred until the taxpayer sells the investment o Passive—losses MAY be deducted annually § Generate operating income & losses • Operating income is always taxed annually at ordinary rates while operating losses are either deducted annually at ordinary rates • Operating losses are either deducted annually at ordinary rates or deferred & deducted later at ordinary rates depending on the investor’s circumstances o Subject to limitations Portfolio Income—Interest & Dividends • Usually taxable when received • Interest from bonds, CDs, savings accounts o Ordinary income taxed at ordinary rates unless municipal bond interest o Interest from US Treasury bonds not taxable by states • Dividends on stock o Typically taxes at preferential capital gains rate o 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 o Nonqualified dividends are taxed as ordinary income • Why invest in assets yielding interest or dividends? o Non-tax factors § Risk, diversification, others Portfolio Income—Capital Gains & Losses • Investments held for appreciation potential o Growth stocks o Land o Mutual funds o Other assets (precious metals, collectibles, etc.) § Typically have more risk but potentially have more growth if they’re doing well (results in a gain) o Gains deferred for tax purposes o Generally taxed at preferential rates o Special loss rules apply • These types of investments are generally investments in capital assets • Capital asset is any asset other than: o Asset used in trade or business o Accounts or notes receivable acquired in business from sale of services or property o Inventory • Sale of capital assets generates capital gains & losses o Specific identification vs. FIFO o Long-term if capital asset held more than a year o Short-term if capital asset held for a year or less Capital Gain/Loss Netting Process • Step 1: Combine all short-term capital gains & losses for the year & any short- term capital loss carry forward. If negative, a net short-term capital loss or if positive, a net long-term capital gain • Step 2: Combine all long-term capital gains & losses for the year & any long-term capital loss carry forward. If negative, a net long-term capital loss or if positive a net long-term capital gain • Step 3: If the results from steps 1 & 2 are both positive or negative, stop the netting process. Otherwise, met the results from steps 1 & 2 o If additional netting is required, 4 outcomes are possible: § Net short-term capital gain if net short-term capital gains exceed net long-term capital losses § Net long-term capital gain (aka net capital gain) if net long-term capital gains exceed net short-term capital losses § Net short-term capital loss if net short-term capital losses exceed net long-term capital gains § Net long-term capital loss if net long-term capital losses exceed short-term capital gains Limitations on Capital Losses • Special rules apply to the sale of personal-use assets o Gains are taxable as capital gains o Losses are NOT deductible • Capital losses from sales to “related persons” are not deducted currently o The related person may subsequently be able to deduct, all, a portion, or none of the disallowed loss on a subsequent sale of the property by the related party o 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 o Intended to ensure that taxpayers cannot deduct losses from stock sales while essentially continuing their investment Tax Planning Strategies for Capital Assets • After-tax rate of return o (FV/I)^ (1/n) – 1 § FV= future value of the investment § I= amount of the initial nondeductible investment § n= # of years the taxpayer holds asset before selling o Increases the longer taxpayer holds asset § Present value of tax decreases o Increases b/c of the lower rate at which long-term capital gains are taxed § Preferential rate generally applies b/c gains are general long-term capital gains • Tax planning strategies o Hold capital assets for more than a year § Taxed at preferential rate § Tax deferred o Loss harvesting § $3,000 offset against ordinary income § Offset other (short-term) capital gains o Must balance tax w/ nontax factors Passive Investment Income & Losses • Passive Investments o Typically an investment in a partnership, S corporation, or direct ownership in rental real estate (where they do not materially participate— how much time as an investor that I spend in the management) o Ordinary income from these investments is taxable annually as it is earned o Ordinary losses may be deducted currently if able to overcome: § Tax basis limitation • Losses may not exceed an investor’s tax basis in the activity. Excess loss carried over until event occurs to create more tax basis • Increases to tax basis o Cash invested o Share of undistributed income o Share of debt • Decreases to tax basis o Cash distributions o Prior year losses § At-risk limitation § Passive loss limitation • Applied after tax basis & at-risk limitations • Losses from “passive activities” may only be deducted to the extent the taxpayer has income from passive activities or when the passive activity is sold • A passive activity is a trade or business or rental activity in which the taxpayer does not materially participate o Participants in rental real estate & limited partners are generally considered to be passive participants o All other participants are considered to be passive unless their involvement is “regular, continuous, & substantial” o 7 factors for testing material participation
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