CH. 7 - Investments

Question 1

Investment Income

Answer 1

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.

Question 2

What are two key characteristics that affect after-tax rates of return from investments?

Answer 2

1. The timing of tax payments and tax benefits
   and
2. the rate at which investment or gains are taxed or deductible expenses or losses generate tax savings.

Question 3

Portfolio investments

Answer 3

investments producing dividends, interest, ­royalties, annuities, or capital gains.

Question 4

Dividend

Answer 4

a distribution to shareholders of money or property from the corporation’s earnings and profits.

Question 5

Income from portfolio investments may be taxed at ___________ rates or ____________ rates, or they may be _________ from taxation.

Answer 5

ordinary; preferential; exempt

Question 6

True or false: losses from portfolio investments deferred until the investment is sold and are typically subject to limitations

Answer 6

True

Question 7

Passive investments

Answer 7

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.

Question 8

Operating income

Answer 8

the annual income from a trade or business or rental activity.

Question 9

Operating loss

Answer 9

the annual loss from a trade or business or rental ­activity

Question 10

Operating income is always taxed __________ at ________ rates, while operating losses are either __________ __________ at _________ rates or __________ and _________ later at ______ rates, depending on the investors circumstances.

Answer 10

annually; ordinary; deducted; annually; deferred; deducted; ordinary

Question 11

Certificate of Deposit (CDs)

Answer 11

an interest-bearing debt instrument ­offered by banks and savings and loans. Money removed from the CD before maturity is subject to a penalty.

Question 12

Bonds

Answer 12

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.”

Question 13

What are investments that generate interest income?

Answer 13

CDs, savings accounts, corporate bonds, and governmental bonds.

Question 14

What are investments that generate dividend income?

Answer 14

direct equity investments in corporate stocks and investments in mutual funds and exchange traded funds (ETFs) that invest in corporate stock.

Question 15

Mutual Funds

Answer 15

a diversified portfolio of securities owned and managed by a regulated investment company.

Question 16

Exchange traded funds (ETFs)

Answer 16

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.

Question 17

Maturity value or face value

Answer 17

the amount paid to a bondholder when the bond ­matures and the bondholder redeems the bond for cash.

Question 18

What does investment income include?

Answer 18

capital gains and losses, interest, dividend, annuity, and royalty income not derived in the ordinary course of a trade or business.

Question 19

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.

Answer 19

True!

Question 20

True or false: tax on income from a portfolio investment may be imposed annually but may not be deferred.

Answer 20

False; it CAN BE imposed annually, but it can also be deferred until the taxpayer sells the investment.

Question 21

passive income generates _________ and _________

Answer 21

operating income and operating losses.

Question 22

After tax rate of return on investments depends on:

Answer 22

-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

Question 23

True or false: shareholders are legally entitled to receive dividend payments

Answer 23

False; they are not. They are also not entitled to recover their initial investment.

Question 24

From an investor’s perspective, debt tends to be (more/less) risky than equity. Why?

Answer 24

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.

Question 25

True or false: individual investors are typically taxed on both interest and divident income when they receive it.

Answer 25

True

Question 26

Interest income is taxed at ______ rates, and dividend income is generally taxed at ________

Answer 26

ordinary rates; lower capital gains rates.

Question 27

Taxpayers recognize interest income from investments when _______

Answer 27

they receive the interest payments

Question 28

Bond discount

Answer 28

the result of issuing bonds for less than their maturity value.

Question 29

Bond premium

Answer 29

the result of issuing bonds for more than their maturity value.

Question 30

U.S. Savings bond

Answer 30

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.

Question 31

Treasury bonds

Answer 31

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.

Question 32

Treasury notes

Answer 32

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.

Question 33

Zero-coupon bond

Answer 33

a type of bond issued at a discount that pays interest only at maturity (aka does not pay periodic interest).

Question 34

What are the two primary differences between holding a corporate bond vs a treasury bond?

Answer 34

1. Interest from Treasury bonds are exempt from state taxation while interest from corporate bonds is not 2. Treasury bonds always pay interest periodically while corporate bond may or may not.

Question 35

True or false: taxpayers do not include the actual interest payment they receive from corporate and U.S. Treasury bonds in gross income

Answer 35

false--they have to include it.

Question 36

If a bond was issued at a discount, taxpayers are _____ to _________ the discount and include the amount of the current year amortization in ______ ________

Answer 36

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.

Question 37

Original issue discount (OID)

Answer 37

a type of bond issued for less than the maturity or face value of the bond.

Question 38

If a bond was issued at a premium, taxpayers...

Answer 38

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.

Question 39

Amortization

Answer 39

the method of recovering the cost of intangible assets over a specific time period.

Question 40

If the bond was purchased in the secondary bond market at a discount, the taxpayer....

Answer 40

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.

Question 41

Market discount

Answer 41

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.

Question 42

Maturity

Answer 42

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.

Question 43

Accured market discount

Answer 43

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.

Question 44

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.

Answer 44

True! And as a result, the taxpayer may elect to amortize the market preium to reduce teh annual interest income received from the bond.

Question 45

Market premium

Answer 45

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.

Question 46

True or false: U.S. Savings bonds (such as series EE) pay periodic interest

Answer 46

False, they do not. Instead, interest accumulates over the term of the bond and is paid when investors redeem them at maturity or earlier.

Question 47

What is the amount of interest income that taxpayers recognize when the redeem U.S. Treasury bonds?

Answer 47

The excess of the bond proceeds over the taxpayers basis in the bonds, meaning the purchase price

Question 48

Basis

Answer 48

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.

Question 49

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?

Answer 49

Yes

Question 50

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.

Answer 50

False; it is subject to phase out-basd on the taxpayers AGI.

Question 51

What types of investments issue interest annually and are taxed annually?

Answer 51

-Savings accounts -CDs -Money market accounts -Bond interest payments actually received in the year

Question 52

What interest is received at sale or maturity and taxed at sale or maturity as well?

Answer 52

-Accrued makret discounts on bonds -Interest earned on U.S. Savings Bonds

Question 53

What interest is received at sale or maturity but taxed annually?

Answer 53

Original issue discount (OID) on corporate and treasury bonds

Question 54

Dividend payments are taxed _______

Answer 54

Annually

Question 55

Qualified Dividends

Answer 55

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)

Question 56

Qualified dividends are taxed at _____

Answer 56

preferential rates-- 0, 15, or 20% depending on the taxpayers filing status and amount of taxable income

Question 57

Ex-dividend date

Answer 57

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.

Question 58

True or false: nonqualified dividends are taxed at preferential rates

Answer 58

False; they are taxed at ordinary rates

Question 59

What are the key facts of interest and dividend income?

Answer 59

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

Question 60

Capital assets

Answer 60

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.

Question 61

What are the advantages of investing in capital assets?

Answer 61

1. Gains are deferred for tax purposes until the taxpayer sells or otherwise disposes of the asset. 2. Gains generally are taxed at preferential rates relative to ordinary income.

Question 62

Why do capital gains and losses receive favorable tax treatment over interest and dividend style investments?

Answer 62

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.

Question 63

amount realized

Answer 63

the value of everything received by the seller in a transaction (cash, FMV of other property, and relief of liabilities) less selling costs.

Question 64

Tax basis

Answer 64

Generally the taxpayer's cost of acquiring the asset, including the initial purchase price and other costs incurred to purchase or improve the asset.

Question 65

First in, first out (FIFO) method

Answer 65

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).

Question 66

Taxpayers are required to use the __________ method of determining the tax basis of the shares they sell

Answer 66

FIFO

Question 67

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."

Answer 67

Specific identification method

Question 68

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.

Answer 68

True!

Question 69

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.

Answer 69

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.

Question 70

Short-term capital gains or losses are from capital assets that have been held for _________

Answer 70

a year or less

Question 71

Long-term capital gains or losses are from capital assets that have been held for ______

Answer 71

a year or more

Question 72

Short-term capital gains are taxed at ______ rates

Answer 72

Ordinary

Question 73

Long-term capital gains are taxed at ___________ rates

Answer 73

preferential

Question 74

What are the rates that capital gains are taxed at?

Answer 74

Typically 0%, 15%, or 20% depending on the taxpayers filing status and taxable income

Question 75

Maximum zero percent rate amount

Answer 75

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.

Question 76

Maximum 15% rate amount

Answer 76

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.

Question 77

Unrecaptured §1250 gain

Answer 77

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.

Question 78

Collectibles

Answer 78

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.

Question 79

Qualified small business stock

Answer 79

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.

Question 80

Gains from collectibles and qualified small business stock are taxed at __________ %

Answer 80

28% for collectibles held for more than a year, and small business stock held for more than 5 years.

Question 81

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.

Answer 81

25%; 0/15/20%

Question 82

Explain the netting process

Question 83

Net short-term capital gains are taxed at _______

Answer 83

ordinary rates

Question 84

Net long-term capital gains are taxed at ___________

Answer 84

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.

Question 85

Taxpayers can deduct up to ______ of net capital losses against ordinary income (_________ if ____________)

Answer 85

$3000; $1500 if MFS

Question 86

Net capital losses in excess of $3000 (1500 MFS) _______ their short or long-term character and are _____________

Answer 86

retain; carried forward and treated as though they were incurred in the next year.

Question 87

net long-term capital loss

Answer 87

the excess of long-term capital losses for the taxable year over the long-term capital gains for such year.

Question 88

net short-term capital loss

Answer 88

the excess of short-term capital losses for the taxable year over the short-term capital gains for such year.

Question 89

Net short-term capital gain

Answer 89

the excess of short-term capital gains for the taxable year over the short-term capital losses for such year.

Question 90

Net short-term capital gains are taxed at _______

Answer 90

ordinary rates

Question 91

Net long-term capital gain are taxed at _______

Answer 91

A maximum of 25% if from the unrecaptured 1250 gain category, of the 0/15/20 % fpr all other long-term capital gains.

Question 92

What are the key fact for 25% and 28% rate capital gains?

Answer 92

-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.

Question 93

When taxpayers sell capital assets, they report the details of their sales on ______

Answer 93

Form 8949

Question 94

Brokerage firms will provide taxpayers with details of securities transactions on _________

Answer 94

Form 1099-B

Question 95

After listing their sales on _______, taxpayers use _________ to summarize the sales and apply the basic capital gains netting process

Answer 95

Form 8949; Schedule D

Question 96

How do we go about calculating how gains affect taxpayer's tax liability?

Answer 96

-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.

Question 97

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?

Answer 97

-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.

Question 98

True or false: the gain from the sale of a pesonal-use asset is not taxable.

Answer 98

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.

Question 99

wash sale

Answer 99

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.

Question 100

What are the key facts on capital gains and losses?

Answer 100

-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

Question 101

What are some basic tax planning strategies?

Answer 101

-Hold capital assets for more than a year before selling -Sell loss capital assets to offset gains

Question 102

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

Answer 102

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

Question 103

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.

Answer 103

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.

Question 104

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.

Answer 104

True

Question 105

True or false: interest received is always received on the maturity of the bond

Answer 105

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