CH. 7 - Investments Flashcards
Investment Income
income received from portfolio-type investments. Portfolio income includes capital gains and losses, interest, dividend, annuity, and royalty income not derived in the ordinary course of a trade or business. When computing the deductibility of investment interest expense, however, capital gains and dividends subject to the preferential tax rate are not treated as investment income unless the taxpayer elects to have this income taxed at ordinary tax rates.
What are two key characteristics that affect after-tax rates of return from investments?
- The timing of tax payments and tax benefits
and - the rate at which investment or gains are taxed or deductible expenses or losses generate tax savings.
Portfolio investments
investments producing dividends, interest, royalties, annuities, or capital gains.
Dividend
a distribution to shareholders of money or property from the corporation’s earnings and profits.
Income from portfolio investments may be taxed at ___________ rates or ____________ rates, or they may be _________ from taxation.
ordinary; preferential; exempt
True or false: losses from portfolio investments deferred until the investment is sold and are typically subject to limitations
True
Passive investments
direct or indirect investments (other than through a C corporation) in a trade or business or rental activity in which the taxpayer does not materially participate.
Operating income
the annual income from a trade or business or rental activity.
Operating loss
the annual loss from a trade or business or rental activity
Operating income is always taxed __________ at ________ rates, while operating losses are either __________ __________ at _________ rates or __________ and _________ later at ______ rates, depending on the investors circumstances.
annually; ordinary; deducted; annually; deferred; deducted; ordinary
Certificate of Deposit (CDs)
an interest-bearing debt instrument offered by banks and savings and loans. Money removed from the CD before maturity is subject to a penalty.
Bonds
A loan given to a company or government by an investor. By issuing a bond, the company or government borrows money from the investor who in turn is paid interest on the money they’ve loaned.
Aka “a debt instruments issued for a period of more than one year with the purpose of raising capital by borrowing.”
What are investments that generate interest income?
CDs, savings accounts, corporate bonds, and governmental bonds.
What are investments that generate dividend income?
direct equity investments in corporate stocks and investments in mutual funds and exchange traded funds (ETFs) that invest in corporate stock.
Mutual Funds
a diversified portfolio of securities owned and managed by a regulated investment company.
Exchange traded funds (ETFs)
diversified portfolios of securities owned and managed by a regulated investment company similar to mutual funds except they are traded on exchanges and the shares trade throughout the day like ordinary stock listings.
Maturity value or face value
the amount paid to a bondholder when the bond matures and the bondholder redeems the bond for cash.
What does investment income include?
capital gains and losses, interest, dividend, annuity, and royalty income not derived in the ordinary course of a trade or business.
True or false: it is possible that two investments with identical before-tax rates of return will generate different after-tax rates of return because the investments are taxed differently.
True!
True or false: tax on income from a portfolio investment may be imposed annually but may not be deferred.
False; it CAN BE imposed annually, but it can also be deferred until the taxpayer sells the investment.
passive income generates _________ and _________
operating income and operating losses.
After tax rate of return on investments depends on:
-The before tax rate of return
-When the investment income and gains are taxed
–Taxed annually
–Tax deferred
–Tax-exempt
-When investment losses are deducted
–Deductions annually
–Deductions deferred
-Rates at which investment income or gains/expenses or losses are taxed/deducted
–Ordinary tax rates
–Preferential tax rates
–Zero tax rates
True or false: shareholders are legally entitled to receive dividend payments
False; they are not. They are also not entitled to recover their initial investment.
From an investor’s perspective, debt tends to be (more/less) risky than equity. Why?
less risky.
Because by lending money to banks, governmental agencies, and corporations, investors essentially become debt holders to those entities.
However, investors who purchase stock become shareholders (aka equity holders) in a company, and are therefore more exposed to its ups and downs.
True or false: individual investors are typically taxed on both interest and divident income when they receive it.
True
Interest income is taxed at ______ rates, and dividend income is generally taxed at ________
ordinary rates; lower capital gains rates.
Taxpayers recognize interest income from investments when _______
they receive the interest payments
Bond discount
the result of issuing bonds for less than their maturity value.
Bond premium
the result of issuing bonds for more than their maturity value.
U.S. Savings bond
debt instruments issued by the U.S. Treasury at face value or at a discount, with a set maturity date. Interest earned from U.S. bonds is paid either at maturity or when the bonds are converted to cash before maturity.
Treasury bonds
a debt instrument issued by the U.S. Treasury at face value, at a discount, or at a premium, with a set interest rate and maturity date that pays interest semiannually. Treasury bonds have terms of 30 years.
Treasury notes
a debt instrument issued by the U.S. Treasury at face value, at a discount, or at a premium, with a set interest rate and maturity date that pays interest semiannually. Treasury notes have terms of 2, 5, or 10 years.
Zero-coupon bond
a type of bond issued at a discount that pays interest only at maturity (aka does not pay periodic interest).
What are the two primary differences between holding a corporate bond vs a treasury bond?
- Interest from Treasury bonds are exempt from state taxation while interest from corporate bonds is not
- Treasury bonds always pay interest periodically while corporate bond may or may not.
True or false: taxpayers do not include the actual interest payment they receive from corporate and U.S. Treasury bonds in gross income
false–they have to include it.
If a bond was issued at a discount, taxpayers are _____ to _________ the discount and include the amount of the current year amortization in ______ ________
Taxpayers are required to amortize the discount and include the amount of the current year amortization in gross income in addition to any interest payments the taxpayer actually receives.
Original issue discount (OID)
a type of bond issued for less than the maturity or face value of the bond.
If a bond was issued at a premium, taxpayers…
may elect to amortize the premium. The amount of the current-year amortiization offsets a portion of the actual interest payments that taxpayers must include in gross income.
Amortization
the method of recovering the cost of intangible assets over a specific time period.
If the bond was purchased in the secondary bond market at a discount, the taxpayer….
treats all or some of the market discount as interest *when they sell the bond or the bond matures. If the bond is sold prior to maturity, a ratable amount of the market discount (called accured market discount) is treated as income on the date of the sale.
Market discount
the difference between the amount paid for a bond in a market purchase rather than at original issuance when the amount paid is less than the maturity value of the bond.
Maturity
the amount of time to the expiration date, or maturity date, of a debt instrument. The maturity of a debt instrument is generally the life of the instrument, at which point a payment of the face value is due or the instrument terminates.
Accured market discount
a ratable amount of the market discount at the time of purchase (based on the number of days the bond is held over the number of days until maturity when the bond is purchased) that is treated as interest income when a bond with market discount is sold before it matures.
True or false: in a bond is purchased in the secondary bond market at a premium, the premium is treated exactly like original issue bond premiums.
True!
And as a result, the taxpayer may elect to amortize the market preium to reduce teh annual interest income received from the bond.
Market premium
the difference between the amount paid for a bond in a market purchase rather than at original issuance when the amount paid is greater than the maturity value of the bond.
True or false: U.S. Savings bonds (such as series EE) pay periodic interest
False, they do not. Instead, interest accumulates over the term of the bond and is paid when investors redeem them at maturity or earlier.
What is the amount of interest income that taxpayers recognize when the redeem U.S. Treasury bonds?
The excess of the bond proceeds over the taxpayers basis in the bonds, meaning the purchase price
Basis
the initial purchase price
Aka a taxpayer’s unrecovered investment in an asset that provides a reference point for measuring gain or loss when an asset is sold.
Can interest from Series EE and Series I bonds be excluded from gross income to the extent the bond proceeds are used to pay for qualifying educational expenses?
Yes
True or false: U.S. Treasury bond interest income that is excludable from gross income to pay for qualifying educational expenses is not subject to limitations.
False; it is subject to phase out-basd on the taxpayers AGI.
What types of investments issue interest annually and are taxed annually?
-Savings accounts
-CDs
-Money market accounts
-Bond interest payments actually received in the year
What interest is received at sale or maturity and taxed at sale or maturity as well?
-Accrued makret discounts on bonds
-Interest earned on U.S. Savings Bonds
What interest is received at sale or maturity but taxed annually?
Original issue discount (OID) on corporate and treasury bonds
Dividend payments are taxed _______
Annually
Qualified Dividends
paid by domestic or certain qualified foreign corporations provided the investors hold the dividend-paying stock for more than 60 days during the 121 day period that begins before the ex-dividend date (the first day on which purchasers of the stock would not be entitled to receive a declared dividend on the stock)
Qualified dividends are taxed at _____
preferential rates– 0, 15, or 20% depending on the taxpayers filing status and amount of taxable income
Ex-dividend date
the relevant date for determining who receives a dividend from a stock. Anyone purchasing stock before this date will receive current dividends. Otherwise, the purchaser must wait until subsequent dividends are declared before receiving them.
True or false: nonqualified dividends are taxed at preferential rates
False; they are taxed at ordinary rates
What are the key facts of interest and dividend income?
Interest:
-Interest is taxed at ordinary rates
-Cash interest payments are taxed annually
-Accrued market discount is taxed at sale or maturity
-Savings bonds are taxed at sale or maturity
-Original issue discount is taxed annually
Dividends:
-Dividends are taxed annually
-Qualified dividends are taxed at preferential rates
Capital assets
Typically, investment-type assets and personal-use assets.
in general, an asset other than an asset used in a trade or business or an asset such as an account or note receivable acquired in a business from the sale of services or property.
What are the advantages of investing in capital assets?
- Gains are deferred for tax purposes until the taxpayer sells or otherwise disposes of the asset.
- Gains generally are taxed at preferential rates relative to ordinary income.
Why do capital gains and losses receive favorable tax treatment over interest and dividend style investments?
Taxpayers may not have the wherewithal (cash) to pay the tax on their gains until they sell the investments.
Also, the preferential tax rates provide an incentive for taxpayers to invest in assets that may stimulate the economy.
amount realized
the value of everything received by the seller in a transaction (cash, FMV of other property, and relief of liabilities) less selling costs.
Tax basis
Generally the taxpayer’s cost of acquiring the asset, including the initial purchase price and other costs incurred to purchase or improve the asset.
First in, first out (FIFO) method
an accounting method that values the cost of assets sold under the assumption that the assets are sold in the same order in which they are purchased (i.e., first purchased, first sold).
Taxpayers are required to use the __________ method of determining the tax basis of the shares they sell
FIFO
What is this?
“an elective method for determining the cost of an asset sold. Under this method, the taxpayer specifically chooses the assets that are to be sold.”
Specific identification method
True or false: taxpayers using the specific identifiation method can choose to sell their highest tax basis stock first, minimizing their gains or increasing their losses on stock dispositions.
True!
True or false: over time, as taxpayers sell their stock, the FIFO and specific identification methods will result in different amounts recovered in the cost of their investment.
False; both methods will eventually allow the taxpayer to fully recover the cost of their investments.
However, applying the specific identification method will result in lower capital gains taxes currently and thereby minimize the present value of the taxes paid on the stock sales.
Short-term capital gains or losses are from capital assets that have been held for _________
a year or less
Long-term capital gains or losses are from capital assets that have been held for ______
a year or more
Short-term capital gains are taxed at ______ rates
Ordinary
Long-term capital gains are taxed at ___________ rates
preferential
What are the rates that capital gains are taxed at?
Typically 0%, 15%, or 20% depending on the taxpayers filing status and taxable income
Maximum zero percent rate amount
threshold for the zero percent rate to apply to long-term capital gains. Any 0/15/20 percent capital gains included in taxable income up to the maximum zero percent amount are taxed at 0 percent. It is based on a taxpayer’s filing status and income level.
Maximum 15% rate amount
threshold for the 15 percent rate to apply to long-term capital gains. Any 0/15/20 percent capital gains included that result in taxable income above the maximum zero rate amount and up to the maximum 15 percent rate amount are taxed at 15 percent. The threshold is based on a taxpayer’s filing status and income.
Unrecaptured §1250 gain
a type of §1231 gain derived from the sale of real estate held by a noncorporate taxpayer for more than one year in a trade or business or as rental property attributable to tax depreciation deducted at ordinary tax rates. This gain is taxable at a maximum 25 percent capital gains rate.
Collectibles
a type of capital asset that includes a work of art, a rug or antique, a metal or gem, a stamp or coin, an alcoholic beverage, or other similar items held for investment for more than one year.
Qualified small business stock
stock received at original issue from a corporation with a gross tax basis in its assets both before and after the issuance of no more than $50,000,000 and with 80 percent of the value of its assets used in the active conduct of certain qualified trades or businesses.
Gains from collectibles and qualified small business stock are taxed at __________ %
28% for collectibles held for more than a year, and small business stock held for more than 5 years.
When individuals sell depreciable real property held for more than one year at a gain, a portion (or even all) of the gain may be taxed at maximum rate of ___________ (the unrecaptured 1250 gain portion) and a portion may be taxed as a _________ percent gain.
25%;
0/15/20%
Explain the netting process
Net short-term capital gains are taxed at _______
ordinary rates
Net long-term capital gains are taxed at ___________
20% to the extend the taxpayers taxable income exceeds the maximum 15% breakpoint based on filing status; at 0% to the extent taxable income is below the maximum 0% rate breakpoint based on filing status, and 15% otherwise.
Taxpayers can deduct up to ______ of net capital losses against ordinary income (_________ if ____________)
$3000;
$1500 if MFS
Net capital losses in excess of $3000 (1500 MFS) _______ their short or long-term character and are _____________
retain;
carried forward and treated as though they were incurred in the next year.
net long-term capital loss
the excess of long-term capital losses for the taxable year over the long-term capital gains for such year.
net short-term capital loss
the excess of short-term capital losses for the taxable year over the short-term capital gains for such year.
Net short-term capital gain
the excess of short-term capital gains for the taxable year over the short-term capital losses for such year.
Net short-term capital gains are taxed at _______
ordinary rates
Net long-term capital gain are taxed at _______
A maximum of 25% if from the unrecaptured 1250 gain category, of the 0/15/20 % fpr all other long-term capital gains.
What are the key fact for 25% and 28% rate capital gains?
-Certain gains from the sale of depreciable real property held long-term are taxed at a maximum rate of 25% (aka an unrecaptured 1250 gain)
-Gains from collectibles and from qualified small business stock NOT held for 5 years are taxed at a maximum rate of 28%
-When taxpayers have 25% or 28% rate capital gains, the netting process requires that losses be applied to higher rate groups before lower rate groups.
-When taxable income without long-term capital gains exceeds the maximum 15% rate amount, 25% and 28% capital gains are taxed at their maximum rate. Otherwise, appliable capital gains rates must be adjusted to reflect their inclusion in lower ordinary income rate brackets.
When taxpayers sell capital assets, they report the details of their sales on ______
Form 8949
Brokerage firms will provide taxpayers with details of securities transactions on _________
Form 1099-B
After listing their sales on _______, taxpayers use _________ to summarize the sales and apply the basic capital gains netting process
Form 8949; Schedule D
How do we go about calculating how gains affect taxpayer’s tax liability?
-If the taxpayers ordinary income (total taxable income excluding long-term capital gains and qualified dividends) is above the maximum 15% rate breakpoint, the capital fains for each of the 0/15/20%, 25%, and 28% groups are taxed at their maximum rates.
-If the taxpayers taxable income (including capital gains and qualified dividends) is below the maximum zero rate breakpoint, the capital gains for the 0/15/20% group are taxed at 0%, and the 25% and 28% gains are taxed at the taxpayer’s ordinary rate.
What are the exceptions to the rule of being able to deduct capital losses against capital gains in the netting process, and the rule that taxpayers may deduct up to 3000 (1500 MFS) of net capital losses against ordinary income in a given year?
-Losses on the sale of personal-use assets are NOT deductible
-When taxpayers sell capital assets at a loss to related people, they are also not deductible.
True or false: the gain from the sale of a pesonal-use asset is not taxable.
False; it IS taxable; the tax rate on the gain depends on the amount of time between the purchase and selling date, and on the netting process involving the sellers other capital gains and losses during the year.
wash sale
the sale of an investment if that same investment (or substantially identical investment) is purchased within 30 days before or after the sale date. Losses on wash sales are deferred.
What are the key facts on capital gains and losses?
-Tax on the appreciation of capital assets is deferred until the asset is sold
-The longer the holding period, the greater the after-tax rate of return for a given
before-tax rate of return
-FIFO is the default method for tracking the basis of stock sold, but specific identification is also allowed.
-Capital gains and losses:
-Long-term capital gains are if the asset was held for more than a year; short-term if
held for less than a year
-Net long-term capital gains are taxed at the maximum of 0/15/20% rate
-$3000 of net capital loss is deductible annually against ordinary income
-Losses on personal-use assets are not deductible
-Losses on wash sales are not deductible but are added to the basis of the new
shares acquired
What are some basic tax planning strategies?
-Hold capital assets for more than a year before selling
-Sell loss capital assets to offset gains
When taxpayers borrow money to acquire investments, the interest expense they pay on the loan is ___________ ___________ expense and the deduction is limited to the taxpayer’s _____________ __________ ___________ for the year
When taxpayers borrow money to acquire investments, the interest expense they pay on the loan is investment interest expense and the deduction is limited to the taxpayer’s net investment income for the year
If a taxpayer is an active participant in a rental activity, she may be allowed to deduct up to $_____________ in rental losses against other types of income.
If a taxpayer is an active participant in a rental activity, she may be allowed to deduct up to $25,000 in rental losses against other types of income.
True or false: Net passive income is included with net investment income and, therefore, may be subject to the 3.8% additional tax on net investment income.
True
True or false: interest received is always received on the maturity of the bond
True!
Aka if a bond has a face value of $50,000 but was bought for $45,000, interest will be issued on the $50,000
