Other Tax Rules Flashcards
Which statements are TRUE regarding dividend and capital gain distributions made by mutual funds that have been reinvested in additional fund shares?
I The dividend distribution is taxable
II The dividend distribution is tax deferred
III The capital gain distribution is taxable
IV The capital gain distribution is tax deferred
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is A.
Mutual fund capital gains and dividend distributions are taxable to the shareholder in the year they are distributed by the fund, whether or not the distributions are automatically reinvested in new fund shares.
An investor originally invested $4,000 in a mutual fund. Over the course of two years, the fund distributed $50 of dividends and $75 of capital gains which have been automatically reinvested in additional fund shares. The fund is now worth $4,250 and the customer wishes to liquidate his holding. What is the aggregate cost basis of the mutual fund holding?
A. $4,050
B. $4,075
C. $4,125
D. $4,250
The best answer is C.
The investor’s cost basis of the shares is the original purchase price plus all reinvested dividends and capital gains. This makes sense, since every year that the fund distributes dividends and capital gains, both must be included on that year’s income tax return. Since the monies have already been taxed, the cost basis will include all reinvested distributions (so that there is no double taxation). The investor’s cost basis is $4,125.
A customer owns $20,000 of a money market mutual fund. The customer exchanges the money fund shares for growth shares within the same family of funds. Which statement is TRUE?
A. The exchange is treated as a “non-taxable” swap
B. The exchange is a “taxable event” for that year
C. The exchange results in a deferral of tax as long as shares within the same “family of funds” are purchased
D. The exchange results in a deferral of tax as long as the full $20,000 is used to purchase the growth fund shares
The best answer is B.
The sale of mutual fund shares results in a tax event, whether or not the funds are reinvested in another fund. If the sale proceeds are more than the investor’s cost basis in that fund, tax is due. When the proceeds are invested in another fund, a new cost basis is established at that point.
A customer switches from a growth fund to an income fund within the same “family of funds.” Which statement is TRUE?
A. Capital gains tax will be due if the sales proceeds are higher than the cost basis
B. Capital gains tax will be due if the sales proceeds are lower than the cost basis
C. A capital loss will be incurred if the sales proceeds are higher than the cost basis
D. There is no capital gain or loss since this is a “like-kind” exchange
The best answer is A.
When the shares of one fund are sold, unless the monies are reinvested in the same fund, (resulting in a non-taxable “like-kind” exchange), capital gains tax is due on the sale proceeds versus the cost basis in the shares. The purchase of the new (different) shares results in a new cost basis. When the shares of one fund are sold, there will be a capital gain if the sale proceeds exceeds the cost basis of the fund shares; conversely, there will be a capital loss if the sale proceeds are less than the cost basis of the fund shares.
A customer switches from a growth fund to an income fund within the same “family of funds.” Which statement is TRUE?
A. No tax liability is incurred because this is treated as a “wash sale”
B. No tax liability is incurred because this is treated as a “like kind exchange” of assets
C. Tax must be paid on any amount by which the Net Asset Value of the new fund exceeds the old fund’s Net Asset Value
D. The sale results in a “taxable event” on which tax on any gain is due, and the purchase establishes a new cost basis
The best answer is D.
When the shares of one fund are sold, unless the monies are reinvested in the same fund, (resulting in a non-taxable “like-kind” exchange), capital gains tax is due on the sale proceeds versus the cost basis in the shares. The purchase of the new (different) shares results in a new cost basis.
Over the last 5 years, a client has bought 200 shares of XYZ Mutual Fund each year in a taxable account and has elected to have dividends and capital gains automatically reinvested in additional fund shares. The aggregate cost of the 1,000 purchased shares is $31,300. In addition, over these 5 years, the customer has bought 300 additional shares through dividend reinvestment at an aggregate cost of $11,300. At the end of the 5th year, the client’s statement shows that the customer owns 1,300 shares at an aggregate market value of $49,600. If the client redeems 100 of the shares, the average cost basis per share is:
A. $24.08
B. $30.43
C. $32.77
D. $38.15
The best answer is C.
When redeeming mutual fund shares, the IRS requires that average cost basis be used, unless another acceptable method is elected (FIFO or specific identification). Because dividends and capital gains are taxable each year, when reinvested in additional share purchases, those dollars increase the number of shares owned. To find the average cost basis, add the cost of the original 1,000 shares ($31,300) and the cost of the additional 300 shares purchased through dividend reinvestment ($11,300) = $42,600 divided by 1,300 shares owned = $32.77 cost per share.
Over the last 5 years, a client has bought 100 shares of ABC Mutual Fund each year in a taxable account and has elected to have dividends and capital gains automatically reinvested in additional fund shares. The aggregate cost of the 500 purchased shares is $6,215. In addition, over these 5 years, the customer has bought 100 additional shares through dividend reinvestment at an aggregate cost of $1,572. At the end of the 5th year, the client’s statement shows that the customer owns 600 shares at an aggregate market value of $8,934. If the client redeems 100 of the shares, the average cost basis per share is:
A. $10.36
B. $12.43
C. $12.98
D. $14.89
The best answer is C.
When redeeming mutual fund shares, the IRS requires that average cost basis be used, unless another acceptable method is elected (FIFO or specific identification). Because dividends and capital gains are taxable each year, when reinvested in additional share purchases, those dollars increase the number of shares owned. To find the average cost basis, add the cost of the original 500 shares ($6,215) and the cost of the additional 100 shares purchased through dividend reinvestment ($1,572) = $7,787 divided by 600 shares owned = $12.98 cost per share.
A U.S. investor has realized a $4,000 capital gain on Kingdom of Norway bonds. Which statement is TRUE regarding the taxation of the gain?
A. The gain is 100% taxable within the United States at U.S. tax rates
B. The gain is 100% taxable within Norway at Norwegian tax rates
C. The gain is 100% taxable within the United States at Norwegian tax rates
D. The gain is not taxed in the United States
The best answer is A.
U.S. holders of foreign securities are subject to Federal (and State) taxation on these holdings. Both the interest income is taxable in the U.S., and any capital gains on these holdings are taxable in the U.S. as well. This is the same treatment as for corporate obligations.
A customer has purchased 10,000 shares of Ladbroke’s stock, a British gaming company. The stock is not traded in the United States. Ladbroke’s declares and pays a dividend of 1,500 British Pounds, which when converted to dollars equals $2,000. Britain imposes a 15% withholding tax on dividends repatriated outside its borders. How is the dividend reported on this investor’s U.S. tax return?
A. No dividends are reported, since the investment is made outside the United States
B. $1,700 of dividends are reported, since $300 was withheld in Britain
C. $2,000 of dividends are reported
D. $2,000 of dividends are reported, along with a $300 tax credit for monies withheld in Britain
The best answer is D.
If a direct investment is made in a foreign security, that foreign country often withholds tax on dividends repatriated out of that country. If this occurs, the tax withheld is applied as a tax credit on that person’s U.S. tax return. Thus, this person who received $2,000 of dividends, but who has $300 of taxes withheld on those dividends in Britain, would report the entire $2,000 of dividends received, along with a $300 tax credit for the tax withheld in Great Britain.
A customer has purchased 10,000 shares of Hot Tamale stock, a Mexican enchilada company. The stock is not traded in the United States. Hot Tamale declares and pays a dividend of 20,000 Mexican Pesos, which when converted to dollars, equals $150. Mexico imposes a 10% withholding tax on dividends repatriated outside its borders. How is the dividend reported on this investor’s U.S. tax return?
A. No dividends are reported, since the investment is made outside the United States
B. $150 of dividends are reported, with no tax credit available
C. $150 of dividends are reported, along with a $15 tax credit for monies withheld in Mexico
D. $165 of dividends are reported, along with a $15 tax credit for monies withheld in Mexico
The best answer is C.
If a direct investment is made in a foreign security, that foreign country often withholds tax on dividends repatriated out of that country. If this occurs, the tax withheld is applied as a tax credit on that person’s U.S. tax return. Thus, this person who received $150 of dividends, but who has $15 of taxes withheld on those dividends in Mexico, would report the entire $150 of dividends received, along with a $15 tax credit for the tax withheld in Mexico.
An individual sells 200 shares of stock short at $60 per share and buys back the position 2 years later at $50 per share. The investor has a:
A. $2,000 short term capital gain
B. $2,000 short term capital loss
C. $2,000 long term capital gain
D. $2,000 long term capital loss
The best answer is A.
When an individual sells stock short, a holding period is never established. Because of this, all gains and losses are always short term.
A customer sells short 1,000 shares of PDQ stock at $55 in a margin account. The stock starts to drift lower in price and 15 months later, the customer covers the short positions by purchasing the shares at $30. The customer will have a:
A. $25,000 short term capital gain
B. $25,000 short term capital loss
C. $25,000 long term capital gain
D. $25,000 long term capital loss
The best answer is A.
When there is a short sale of stock, the stance of the IRS is that, since the position is never “owned,” there can never be a holding period. Thus, all gains and losses on short positions are always short-term. This customer sold the stock short for $55,000 and, 15 months later, purchased the shares to cover at $30,000. The customer has a $25,000 gain, but it is taxed as a short-term capital gain.
When an individual sells stock short that the individual owns, this is termed:
A. shorting the stock
B. short against the box
C. long against the short
D. long against short exempt
The best answer is B.
When an individual sells stock short which he owns, this is termed “short against the box.” This locks in a capital gain, however, under 1997 tax law revisions, any gain is taxable at this point. Thus this strategy generally cannot be used to defer taxation of a gain.
Selling short against the box:
A. turns a short term gain into a long term gain
B. defers taxation of a gain to the next year
C. locks in a gain and is taxable that year
D. eliminates taxation of a gain
The best answer is C.
When an individual sells stock short which he owns, this is termed “short against the box.” This locks in a capital gain, however, under 1997 tax law revisions, any gain is taxable at this point. Thus this strategy generally cannot be used to defer taxation of a gain.
Which of the following statements are TRUE about selling short against the box?
I It “locks-in” a gain on the stock
II It defers taxation of a gain
III It stretches a short term capital gain to a long term capital gain
IV It is performed in an arbitrage account
A. I and IV
B. II and III
C. I, II, III
D. I, II, III, IV
The best answer is A.
When an individual sells stock short which he owns, this is termed “short against the box.” This locks in a capital gain, however, under 1997 tax law revisions, any gain is taxable at this point. Thus this strategy generally cannot be used to defer taxation of a gain; nor does it reduce or eliminate taxation. Such transactions are effected in arbitrage accounts, since the margins are extremely low (5% minimum margin; there is no Regulation T margin since the account has a net “0” position).
Which statement is TRUE about selling short against the box?
A. It “locks-in” a gain on the stock
B. It defers taxation of a gain
C. It stretches a short term capital gain to a long term capital gain
D. It converts ordinary income into a long term capital gain
The best answer is A.
When an individual sells stock short which he owns, this is termed “short against the box.” This locks in a capital gain, however, under 1997 tax law revisions, any gain is taxable at this point. Thus this strategy generally cannot be used to defer taxation of a gain; nor does it reduce or eliminate taxation.
Which of the following transactions can affect the counting of the holding period of ABC stock, a position that has been held for 10 months?
I Selling ABC “short against the box”
II Buying an ABC put contract
III Selling an ABC put contract
A. I only
B. II only
C. I and II
D. II and III
The best answer is C.
If a customer goes “short against the box” on a stock position that has been held short term, the holding period of the underlying stock stops counting as of the short sale date. The worry of the IRS is that once the long position has been hedged, the customer will simply wait out the extra time needed to enjoy a long term capital gains holding period, which would be taxed at a lower rate.
IRS rules require that if one goes “short against the box,” any gain is taxable at that point. Thus, a short term holding period cannot be stretched into a long term holding period. (Note that there is a 15% maximum long term capital gains tax rate if the position is held over 12 months (20% for very high earners); instead of a 37% maximum tax rate for short term capital gains.)
If a put is purchased on a stock position that has been held short term, the holding period stops counting and reverts to “0,” but no tax is due at that moment. If the stock’s price falls, the put will be exercised, and tax is due at that point. If the stock’s price rises, the put expires, and the stock is sold in the market. Tax on the resulting higher gain is due at this point.
Selling a put has no effect on a long stock position’s holding period, since an exercise requires that person to buy more shares (not sell them).
An investor goes short against the box to lock in a gain on a stock position that has been held for 11 months. 3 months later, the investor closes the short position with his long shares. Which of the following statements are TRUE?
I The holding period of the underlying stock stopped counting as of the short sale date
II The holding period of the underlying stock stopped counting as of the delivery to cover the short position
III The gain will be taxed as a short term capital gain
IV The gain will be taxed as a long term capital gain
Correct A. I and III
StatusB B. I and IV
StatusC C. II and III
StatusD D. II and IV
The best answer is A.
If a customer goes “short against the box” on a stock position that has been held short term, the holding period of the underlying stock stops counting as of the short sale date. The worry of the IRS is that once the long position has been hedged, the customer will simply wait out the extra time needed to enjoy a long term capital gains holding period, which would be taxed at a lower rate. IRS rules require that if one goes “short against the box,” any gain is taxable at that point.
Thus, a short term holding period cannot be stretched into a long term holding period. Note that there is a 15% maximum long term capital gains tax rate if the position is held over 12 months (20% for very high earners - instead of a 37% maximum tax rate for short term capital gains.)
The “Wash Sale Rule” applies to sales of securities at a loss, that are repurchased within:
A. 30 days
B. 45 days
C. 60 days
D. 90 days
The best answer is A.
Under the wash sale rule, if a security is sold at a loss, but is repurchased between 30 days prior to the sale until 30 days after the sale, the loss deduction is disallowed. To avoid the rule, wait 31 days.
Under the “wash sale rule,” a loss on the sale of a security is disallowed, if between 30 days prior to the sale until 30 days after the sale, the customer:
I buys a security convertible into that which was sold
II buys a call option on the security which was sold
III sells a call option on the security which was sold
IV sells a put option on the security which was sold
A. I and II
B. III and IV
C. II and III
D. I and IV
The best answer is A.
The wash sale rule states that if a security is sold at a loss, and from 30 days prior to the sale date until 30 days after the sale date, the same security is purchased; or an equivalent security such as a convertible is purchased; or a call option, warrants or rights are purchased; then the loss deduction is disallowed. All of these “equivalents” effectively restore long the position, “washing out” the sale.
A customer purchases a stock. Two years later, he sells his stock position at a loss. Under the “Wash Sale Rule,” the loss will be disallowed if the customer, within 30 days of the sale:
I buys a call option on that stock
II sells a call option on that stock
III buys a put option on that stock
IV sells a “deep in the money” put option on that stock
A. I or II
B. III or IV
C. I or IV
D. II and III
The best answer is C.
Under the wash sale rule, if a stock is sold at a loss and is then repurchased within 30 days of the sale date, the loss deduction is disallowed. It is disallowed if the customer buys an equivalent security, such as a convertible, call option, right or warrant. Furthermore, instead of buying the stock or an equivalent, if the customer sells a put that is “deep in the money,” the contract is virtually guaranteed to be exercised prior to expiration - forcing the customer to buy the stock. Tax rules state that the sale of the “deep in the money” put is essentially the same as buying the stock, and the loss deduction is disallowed. Please note that if the put was sold “at the money,” there would be no certainty of exercise forcing the customer to buy back the stock. In this case, the “Wash Sale Rule” does not apply.
A customer executes the following transactions during the same year:
Jul 1st Buy 100 ABC at $30 per share
Dec 1st Buy 100 ABC at $20 per share
Dec 15 Sell 100 ABC at $22 per share
The customer uses the FIFO method of tax accounting. The tax consequence of these transactions for this tax year is:
A. No gain or loss
B. $200 loss
C. $800 loss
D. $1,000 loss
The best answer is A.
This is a very subtle question. The “wash sale” rule states that if a customer liquidates a position at a loss, and then reestablishes that position within 30 days, the loss deduction is disallowed. The 30-day time period counts from 30 days prior to the sale date, until 30 days after the sale date. Thus, if the position is reestablished in anticipation of selling at a loss, the deduction is disallowed. In this case, the stock was purchased at $30 per share on July 1st. Towards the end of the year, the customer knows that he has a loss, and that he wishes to take the loss this tax year. The customer also knows that if he or she sells first, and then buys back the position in 30 days, the loss will be disallowed. To “fool” the IRS, the customer buys the stock on December 1st at $20 before selling the stock at $22, fifteen days later.
Well, the IRS is not fooled. From the IRS’s standpoint, the stock was purchased at $30 and sold at $22 on December 15th for an $8 per share loss. The customer repurchased the stock at $20 within 15 days, so the loss is disallowed under the “wash sale rule.” The disallowed loss is added to the customer’s basis, for a new basis in the stock of $28. When the customer liquidates this position at a later date, any gain or loss is computed from the $28 adjusted basis. In essence, the loss is deferred by the “wash sale” rule.
On June 9th, a customer buys 100 shares of PDQ stock at $26 per share. On June 12th of the same year, the customer sells the stock at $23. On June 30th of the same year, the customer buys PDQ stock at $24. The customer’s cost basis in PDQ stock is:
A. $24
B. $27
C. $28
D. $29
The best answer is B.
Since the customer sold the stock at a loss, and then repurchased the position within 30 days, this is considered a “wash sale” and the loss is disallowed for tax purposes. Instead, the loss on the stock is added to the cost of the repurchased position. The customer originally bought the stock at $26 and sold it at $23, for a $3 loss per share. The customer repurchased the stock at $24. The adjusted cost basis on the stock is $24 + $3 loss = $27 per share.
A customer is short 100 shares of XYZ stock at $70 per share. The customer covers the position at $75. 20 days later, the customer reestablishes the short position by selling short 100 shares of XYZ at $73. The tax consequence of these transactions is:
A. $200 capital loss; and sale proceeds on the reestablished position of $68 per share
B. $500 capital loss; and sale proceeds on the reestablished position of $73 per share
C. No capital loss due to the “wash sale rule”; and sale proceeds on the reestablished position of $68 per share
D. No capital loss due to the “wash sale rule”; and sale proceeds on the reestablished position of $73 per share
The best answer is C.
In this transaction, the customer is attempting to take a loss and then reestablish the position. Under the “wash sale” rule, the loss deduction is disallowed if the position is reestablished within 30 days of the date the loss was generated. This question is unusual, because the loss was generated by closing out a short stock position (instead of the usual close out of a long stock position).
In this case, the customer originally sold short the stock at $70. The stock was repurchased at $75, for a $5 loss per share ($500 loss on 100 shares). Then, the customer sold short another 100 shares 20 days later at $73 - less than the 30 day limit set by the “wash sale” rule. Thus, the $500 loss is disallowed. The $5 per share loss will be deducted from the sale proceeds of $73, for a new sale proceeds of $68. In essence, this defers the taking of the loss until this short position is covered.
