Tax 6-5 & 6 Capital Gains and Losses

Question 1

Capital Gains and Losses

Preferential rates apply to long-term capital gains, whereas short-term capital gains are taxed at the taxpayer’s marginal income tax bracket. Thus, the holding period of the capital asset makes a tremendous difference in the taxation of that asset. The long-term holding period is _____, and the short-term holding period is _____.

(6-5,6, pg 23)

Answer 1

The long-term holding period is more than 12 months

The short-term holding period is 12 months or less

When computing a taxpayer’s holding period, the day of acquisition is not counted but the day of disposition is. The holding period is computed based on calendar months, not days. Thus, if a capital asset is acquired on March 15, it must be held until March 16 of the following year to meet the long-term holding period. Note: The trade date, not the settlement date, is used when determining the holding period of publicly traded securities.

Question 2

Capital Gains and Losses

Property acquired by gift. In a situation where the donee (the recipient of a gift) assumes the donor’s adjusted basis, the donor’s holding period is “_____.” In other words, the donee’s holding period begins on the date that the donor acquired the property. Thus, if the fair market value on the date of the gift is greater that the donor’s adjusted basis, the recipient of the gift is treated as holding the property beginning with the date that the donor acquired the property.

(6-5,6, pg 24)

Answer 2

“tacked.”

Alternatively, if the fair market value on the date of the gift is used as the donee’s basis, the holding period starts on the date of the gift.

Question 3

Capital Gains and Losses

Assume that Uncle Frank bought stock for $10/share on January 1, 2007. He gifted the stock to his son Larry on March 15, 2016, when the fair market value was $5/share.

Donor’s adjusted basis: $10
FMV on date of gift: $5

Sale at $3 generates a…

(6-5,6, pg 24)

Answer 3

$2 loss using the FMV on date of gift—Larry’s holding period begins on March 15, 2016.

Question 4

Capital Gains and Losses

Assume that Uncle Frank bought stock for $10/share on January 1, 2007. He gifted the stock to his son Larry on March 15, 2016, when the fair market value was $5/share.

Donor’s adjusted basis: $10
FMV on date of gift: $5

Sale at $14 generates a…

(6-5,6, pg 24)

Answer 4

$4 gain using donor’s basis—Larry’s holding period begins on January 1, 2007.

Question 5

Capital Gains and Losses

Assume that Uncle Frank bought stock for $10/share on January 1, 2007. He gifted the stock to his son Larry on March 15, 2016, when the fair market value was $5/share.

Donor’s adjusted basis: $10
FMV on date of gift: $5

Sale at $6, $7, $8, or $9 generates

(6-5,6, pg 24)

Answer 5

no gain or loss—the basis of the property is equal to the sales price of that security

Question 6

Capital Gains and Losses

Property acquired from a decedent. The holding period of property inherited from a decedent is deemed to be _____ term capital gains. Assume that Susan inherits 100 shares of stock from Aunt Martha on April 15, 2016. The fair market value of the stock on the date of Martha’s death was $1,000. If Susan sells the stock three months later for $1,200, she has a long term capital gain of $200.

Short or Long

(6-5,6, pg 23)

Answer 6

long

Question 7

Capital Gains and Losses

Capital Assets

A capital gain or loss is the result of a sale or exchange of a capital asset. A capital asset is defined to be any asset held by the taxpayer (whether or not connected with his or her trade or business) other than one that falls under one of the excluded classes.

The excluded classes are as follows:

(6-5,6, pg 25)

Answer 7

1. inventory or property held primarily for sale to customers in the ordinary course of business
2. property subject to depreciation and real property used in a trade or business
3. a copyright; a literary or artistic composition; a letter, memorandum, or similar property held by the author or creator, or by donee of the author or creator
4. accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of inventory
5. United States government publications (received from the government without charge, or below the price sold to the public)
6. supplies of a type regularly used or consumed by the taxpayer in the ordinary course of a trade or business

Question 8

Capital Assets

Stocks and bonds (including municipal bonds) held for investment are common examples of capital assets. _____-use assets, such as jewelry, boats, and automobiles are capital assets. A principal residence is also a capital asset.

(6-5,6, pg 23)

Answer 8

Personal

Even though depreciable property and real estate used in a trade or business are not capital assets, they are Section 1231 assets. Thus, those assets may be entitled to long-term capital gain treatment under Section 1231.

Question 9

Capital Assets

The fact that a taxpayer incurs a loss on a capital asset does not make that loss deductible. Generally, a capital loss is allowed only on the sale of an asset held for investment purposes. For example, if a taxpayer sells a personal use automobile for a gain, that gain is treated as a taxable capital gain. However, the same automobile sold at a loss does not generate a DEDUCTIBLE OR NON DEDUCTIBLE capital loss.

(6-5,6, pg 25)

Answer 9

Deductible

Note that the loss on the personal use asset is simply nondeductible—the capital loss does not enter into the capital gain and loss netting process.

Question 10

Capital Gain Rates

The tax rate that applies to long-term capital gains is generally determined by the _____ tax bracket into which the gains fall. For taxpayers with a combination of ordinary income (wages, interest, etc.) and long-term capital gains, the Code provides for a very favorable approach to determining the tax rate applicable to the long-term capital gains.

(6-5,6, pg 23)

Answer 10

marginal

The taxpayer’s deductions for personal and dependency exemptions, and standard or itemized deductions are applied first against the ordinary income. We then look at the marginal bracket that the remaining income falls into.

Question 11

Capital Gain Rates

Assume that, for 2016, Jim and Patty are married taxpayers filing jointly. They have $40,000 of ordinary income and $30,000 of net long-term capital gains from the sale of securities. They have only their two exemptions, and they claim the standard deduction. These deductions total $20,700, leaving $19,300 of ordinary income and $30,000 of LTCG. Their taxable income, therefore, is $_ _, _ _ _

(6-5,6, pg 27)

Answer 11

$49,300

$40,000	Ordinary Income 
\+ $30,000 Capital Gain 
= $70,000 Total Income 
- $8,100 Exemptions
- $12,600 Standard Deduction
= $49,300 Taxable Income 

Placing them in the 15% bracket. As a result, the entire $30,000 is subject to the 0% tax rate.

Question 12

Capital Gain Rates

Assume that, for 2016, Sam and Sally are married taxpayers filing jointly. They have $40,000 of ordinary income and $60,000 of net long-term capital gains from the sale of securities. They have only their two exemptions, and they claim the standard deduction. These deductions total $20,700, leaving $19,300 of ordinary income and $60,000 of LTCG, giving them taxable income of $79,300. The top of the 15% marginal income tax bracket is $75,300. The $19,300 “fills up” the 10% bracket and part of the 15% bracket. It takes another $56,000 in capital gain income to fill the 15% bracket ($75,300 top of the 15% bracket minus the $19,300 of ordinary income). The $56,000 of long term capital gain is taxed at the __% rate, and the remaining $4,000 capital gain is taxed at _ _%.

(6-5,6, pg 27)

Answer 12

0%

15%

Question 13

Capital Gain Rates

When taxpayers have long-term capital gains (and/or qualified dividends), the income tax is computed on a worksheet for Schedule _. Remember that the capital gains and qualified dividends are included in the total income, the AGI, and the taxable income. The worksheet is where the preferential rates are calculated for these income items.

(6-5,6, pg 29)

Answer 13

Schedule D

On the worksheet, the capital gains and qualified dividends are subtracted from the taxable income. The tax is computed on the income that is not subject to the preferential rates, then the tax is computed on the income that is subject to the preferential rates, and the two amounts are added.

Question 14

Capital Gain Rates

There is also a maximum _ _% rate that is applicable to certain long-term capital gains. This rate applies to net gains on collectibles, if held for more than one year. Collectibles include coins, works of art, rugs, antiques, metals, gems, stamps, alcoholic beverages, etc. Also, gold and silver exchange traded funds (ETFs) are generally not taxed as securities but as collectibles, which means long-term capital gains on the funds are taxed at a maximum rate of 28% rather than the lower 15% or 20% rates that would apply to long-term capital gains on the sale of most securities.

(6-5,6, pg 30)

Answer 14

28%

Rule of 28%: This 28% rate is a ceiling on the rate that the taxpayer must pay on the gain from collectibles held long term. In other words, if the taxpayer is a marginal income tax bracket higher than 28%, the long-term collectibles gain will be taxed at 28%. If the taxpayer is in a marginal income tax bracket lower than 28%, the gain will be taxed at the marginal rate.

Note: The 28% rate also applies to the taxable portion of the gain from the disposition of qualified small business stock

Question 15

Capital Gain Rates

On the sale of Section 1250 property (depreciable real estate) held for more than one year, the portion of the gain attributable to depreciation is subject to a maximum _ _% tax rate.

20%

25%

28%

(6-5,6, pg 29)

Answer 15

25%

Rule of 25%: In other words, the gain attributable to the straight-line depreciation is subject to a maximum 25% tax rate. This 25% gain is technically known as “unrecaptured Section 1250 income.” This 25% rate is a ceiling on the rate that the taxpayer must pay on the gain. In other words, if the taxpayer is a marginal income tax bracket higher than 25%, the gain will be taxed at 25%. If the taxpayer is in a marginal income tax bracket lower than 25%, the gain will be taxed at the marginal rate.

Question 16

Capital Gain Rates

During the current tax year, Kristen Benson sold several securities that resulted in the following types of gains and losses:

long-term capital gain—$7,600
short-term capital gain—$8,100

long-term capital loss— $2,100
short-term capital loss—$9,600

Calculate the net capital gain or loss:

(6-5,6, pg 31)

Answer 16

$7,600 Long Term Capital Gain
- $2,100 Long Term Capital Loss
= $5,500 Long Term Capital Gain

$8,100 Short Term Capital Gain
- $9,600 Short Term Capital Loss
= -$1,500 Short Term Capital loss

$4,000 Net Long Term Capital Gain

To calculate the net capital gain or loss, the long-term items are netted, leaving a long-term capital gain of $5,500. The short-term items are netted, leaving a short-term capital loss of $1,500. The long-term capital gain is netted with the short-term capital loss to result in a net long-term capital gain of $4,000. This net long-term capital gain is subject to a preferential tax rate of 15% or 20%, assuming that the taxpayer is in a marginal income tax bracket greater than 15%.

Question 17

Capital Gain Rates

Assume that, during the current tax year, Jeannette has a short-term capital loss of $5,000 from the sale of securities. She also has a long-term capital gain from the sale of a stamp collection of $2,200 and has unrecaptured Section 1250 income of $10,000. Her short-term capital loss is first used to offset the collectibles gain of $2,200. This leaves a short-term capital loss of:

(6-5,6, pg 31)

Answer 17

Capital Loss and Section 1250 income

-$5,000 Short Term Capital Loss
+ $2,200 Long Term Capital Gain
= -$2,800 Short Term Capital Loss

$10,000 Unrecaptured Section 1250 income
+ -$2,800 Short Term Capital Loss
= $7,200 Unrecaptured Section 1250 income taxed at a maximum of 25%

Question 18

Capital Gain Rates

Excess losses, to the extent that they exceed capital gains in any one year, can be deducted only against up to $3,000 of _____ income. In other words, net capital losses are only deductible up to the lesser of the net capital loss or $3,000.

(6-5,6, pg 29)

Answer 18

ordinary

Question 19

Capital Gain Rates

If the taxpayer has net short-term and net long-term losses in the same year, the _____-term losses are used first. Obviously, capital losses are not as beneficial as ordinary losses in offsetting taxable income. Net capital losses that cannot be deducted against the current year’s ordinary income may be carried forward to later years.

short or long

(6-5,6, pg 32)

Answer 19

short-term losses

Any amounts carried forward to the following tax year retain their original character (short-term or long-term) and are involved in the netting process as if they had occurred in such tax year. An effective planner will continue to segregate property into the categories of ordinary income and long and short-term capital gains and losses to take full advantage of these offset rules.

Question 20

Capital Gain Rates

Last year, Jake Cutler had a $10,000 short-term capital loss carry forward. During the current tax year, he sold several securities that resulted in the following types of gains and losses: long-term capital gain— $9,600; short-term capital gain—$7,900; long-term capital loss—$2,500; and short-term capital loss—$600. The result is as follows:

(6-5,6, pg 22)

Answer 20

$9,600 Long Term Capital Gain
-$2,500 Long Term Capital Loss (-)
= $7,100 Long Term Capital Gain/Loss

$7,900 Short Term Capital Gain
-$10,600 Short Term Capital Loss (-)
= -$2,700 Short Term Capital Gain/loss

$4,400 Net Long/Short Term Capital Gain/Loss

Note that the short-term capital loss carry forward is combined with the current year short-term capital loss. The calculation is then handled in the same manner as in the previous example. To calculate the net capital gain or loss, the long-term items are netted, leaving a long-term capital gain of $7,100. The short-term items are netted, leaving a short-term capital loss of $2,700. The long-term capital gain is netted with the short-term capital loss to result in a net long-term capital gain of $4,400. This net long-term capital gain is subject to a preferential tax rate of 15% or 20%, assuming that the taxpayer is in a marginal income tax bracket greater than 15%.

Question 21

Capital Gain Rates

The capital gain or loss resulting from various security transactions is categorized as _____ income. Remember that losses from passive activities generally can offset only passive income and cannot shelter portfolio investment income until the individual disposes of his or her interest in the passive activity.

active
passive
portfolio
investment

(6-5,6, pg 33)

Answer 21

portfolio

Question 22

Mutual Funds

One of the most frequently overlooked aspects of investing in mutual funds is the tax consideration arising from the sale of mutual fund shares. If an investor sells shares of a mutual fund, there is a tax owed on any gain. This gain is measured by the difference between the sales proceeds and the investor’s _____ (adjusted cost) in the shares.

(6-5,6, pg 33)

Answer 22

basis

Question 23

Mutual Funds

The calculation of basis can be complicated, particularly if the investor has bought a number of shares at different times over a period of years. In this situation, there are three methods the investor may use in calculating basis:

(6-5,6, pg 33)

Answer 23

(1) specific identification,
(2) average cost, and
(3) first-in, first-out (FIFO).

Question 24

Mutual Funds

The _____ identification method requires the seller of the shares to identify the shares of the fund that are sold. Detailed records must be kept to enable proper identification of shares. To accomplish this method, the investor indicates to the mutual fund company which shares, based on purchase date, are being sold. The gain, if any, on these shares is then computed as the excess of the total sales price over the basis of the shares sold.

(6-5,6, pg 33)

Answer 24

specific

Question 25

Mutual Funds

With the _____ cost method, the investor pools all purchased shares into one account and then divides the total cost of all his or her shares by the number of shares held. Therefore, all mutual fund shares in this method have the same cost or basis. The gain is then computed from the sales proceeds of the number of shares sold less this average cost times the same number of shares. Under the single-category method, the investor is allowed to group all shares together to determine the average cost.

(6-5,6, pg 33)

Answer 25

average

This method treats shares sold on a first-in-first-out (FIFO) basis so that shares that qualify for long-term capital gain or loss treatment are treated as sold before shares that would get short-term treatment.

Note: The average cost method is available only for mutual fund shares. Stock sales must use the specific identification method or the IRS will assume FIFO for the basis of the shares sold.

Question 26

Mutual Funds

The FIFO OR LIFO method is the method used by the IRS in the event that the investor does not prove specific identification or chooses the average cost method. This method is generally the method least advantageous to the investor in calculating the cost of mutual fund shares and any gain that may result from their sale.

(6-5,6, pg 33)

Answer 26

FIFO

This is the case if the shares in the fund purchased later were more expensive than earlier purchases. Under this method, the IRS uses the (presumably lower cost) first-purchased mutual fund shares to determine which shares are sold for purposes of computing gain or loss.

Question 27

Mutual Funds

The investor should be aware that the occurrence of a taxable event in mutual fund transactions is not limited just to sales of the shares. Sometimes a mutual fund sponsor (particularly of those funds that are part of a mutual fund family) allows the investor to switch from one type of fund to another without paying a fee. This often is referred to as a _____ transfer.

(6-5,6, pg 34)

Answer 27

telephone

However, the investor should note that this transfer between funds—even if only from one growth or one income fund to another—is a taxable event. If a gain is shown on the shares transferred between funds, it must be reported on the investor’s tax return.

Question 28

Mutual Funds

When a mutual fund earns dividends from stock and passes them on to the investor—whether in cash or in the form of an additional purchase of shares—the distribution is taxed, potentially subject to preferential rates, as discussed below. The distribution of long-term capital gains from security sales within the fund is treated as long-term capital gains to the shareholder. The distribution of short term capital gains from within the fund is treated as _____ income to the shareholder.

(6-5,6, pg 34)

Answer 28

ordinary

The investor should note that reinvested distributions (i.e., those used to purchase additional mutual fund shares) increase the number of shares and the aggregate basis in one’s holdings in the fund.

Question 29

Mutual Funds

When buying mutual fund shares, an investor generally should not buy into the fund _____ prior to a distribution. In such a case, the investor is, in effect, buying a tax liability, since income tax will be due on the distribution even if the value of the shares drops after the distribution.

(6-5,6, pg 35)

Answer 29

immediately

Rather, the investor should generally wait until after the distribution is made—in fact, it is probably a good idea to ask the fund if it expects to make a distribution in the very near future before buying any of its shares.

Question 30

Wash Sale Rule

The so-called wash sale rule disallows a loss on the sale or disposition of stock or other securities (including options or contracts to sell or acquire) if the taxpayer purchases “_____ identical” stock or securities within either 30 days before or 30 days after the date of the sale or disposition. The definition of substantially identical is less than precise.

(6-5,6, pg 35)

Answer 30

“substantially “

A stock or security is substantially identical if it is not different in any material or essential way. Factors to be considered include interest rates, dividend rights, maturity dates, and conditions of retirement. Stocks or securities are not substantially identical if they have a different issuer or obligor.

Question 31

Wash Sale Rule

Although the IRS has not ruled on the issue, many experts agree that the sale of an index fund, and subsequent purchase of a different fund investing in the same index, is subject to the wash sale rule. Experts are divided on the issue of the sale of an index fund and the subsequent repurchase of an _____ in the same index.

(6-5,6, pg 34)

Answer 31

ETF

There is some consensus that the sale of an index fund and subsequent purchase of a narrower or broader index fund is not subject to the wash sale rules. For
example, a sale of an S and P 500 index fund and purchase of a total stock market index fund or an NYSE Composite ETF may not be subject to the wash sale rule.

Question 32

Wash Sale Rule

The basis and holding period of the newly acquired (substantially identical) security are impacted by the wash sale. The basis of the new security is INCREASED OR DECREASED by the amount of loss that was disallowed on the wash sale.

(6-5,6, pg 34)

Answer 32

increased

This basis adjustment essentially postpones the deduction for the loss until the disposition of the new security. In addition, the holding period for the new securities includes the holding period of the old security.

Question 33

Wash Sale Rule

Marcy has owned 100 shares of RST stock since January 5, 2010. Her basis in the 100 shares is $10,000. She sold these shares on January 5, 2016, for $9,000. After hearing an upbeat prediction for the RST stock, she purchases 100 shares on January 27, 2016 for $9,500. The $1,000 loss from the sale of the original shares is not currently deductible due to the wash sale rules. Her basis in the new shares is $_ _, _ _ _

(6-5,6, pg 36)

Answer 33

$10,500

(the $9,500 purchase price increased by the disallowed loss of $1,000).

Her holding period for the 100 shares of RST begins on January 5, 2010. This is because the holding period for the new stock includes the holding period of the stock sold.

Question 34

Wash Sale Rule

More or less stock bought than sold. If the number of shares of substantially identical stock or securities purchased within 30 days before or after the wash sale is either more or less than the number of shares sold, the _____ must determine the particular shares to which the wash sale rules apply.

(6-5,6, pg 36)

Answer 34

taxpayer

This is accomplished by matching the shares bought with an equal number of the shares sold. Match the shares purchased in the same order that they were purchased, beginning with the first shares bought. The shares or securities so matched are subject to the wash sale rules.

Question 35

Wash Sale Rule

Roy purchased 100 shares of LMN stock on September 30, 2015, for $5,000. On December 20, 2015, Roy bought another 75 shares of LMN stock for $3,300. On January 10, 2016, Roy sold the 100 shares purchased in September for $4,000. Roy has a $1,000 loss on the sale. Because Roy purchased 75 shares of substantially identical stock within 30 days before the sale, he cannot deduct the loss ($750) on 75 shares. He CAN OR CANNOT deduct the loss ($250) on the other 25 shares.

(6-5,6, pg 37)

Answer 35

can

The basis of the 75 shares purchased on December 20 is increased by the $750 disallowed loss. The new basis of those shares is $4,050 ($3,300 + $750). The holding period of the remaining 75 shares begins on September 30, 2015, because the holding period is determined by reference to the shares sold in the wash sale.

Question 36

Wash Sale Rule

One investment strategy that may be explored is known as “_____ up.” An investor may buy additional securities equal in number to those already held, wait at least 31 days, and then sell the original securities.

(6-5,6, pg 37)

Answer 36

“doubling”

In this manner, the investor can maintain his or her position but may take advantage of the loss on the sale of the original securities.

Question 37

Wash Sale Rule

At one time, it was thought that an investor could use an IRA to get around the wash sale rules. However, the IRS has now officially ruled that it is not possible. If an investor sells an investment at a loss, and has his IRA buy a substantially identical security within 30 days before or 30 days after the date of the sale, the wash sale rule applies and the loss is disallowed. Also, the basis of the security within the IRA IS OR IS NOT INCREASED by the disallowed loss (Rev Rul. 2008-5).

(6-5,6, pg 37)

Answer 37

not increased

Question 38

Short Sales

A short sale occurs when an investor borrows a security from a broker and then sells it, with the understanding that the security must later be bought back (hopefully at a lower price) and returned to the broker. This transaction is still governed by the capital gain and loss rules, so long as the short sale property constitutes a capital asset in the hands of the taxpayer. Generally, the gain or loss is not recognized until the short sale is _____.

(6-5,6, pg 38)

Answer 38

closed

A capital gain from a short sale generally will be considered short term (unless the investor closes the short sale with securities held for the long-term holding period). A loss generally will be treated as a short-term capital loss. The loss may be treated as a long-term capital loss if the investor closes the sale with substantially identical securities held for the long-term holding period prior to the sale date.

Question 39

Related Party Sales

No loss deduction is allowed from a sale or exchange between certain related taxpayers. Related taxpayers include:

(6-5,6, pg 38)

Answer 39

• members of the seller’s family—brothers and sisters, parents, grandparents, etc., and children (in-laws are NOT included);
• controlled corporations;
• certain business organizations, if one person owns more than 50% of each;
• an estate and beneficiary; and
• certain trustees, grantors, and beneficiaries.

The disallowed loss generally increases the basis of the acquired property, such that a later resale of the property results in a smaller gain.

Question 40

Specialized Small Business Investment Companies

Individuals and C corporations may elect to defer recognition of capital gain income on the sale of publicly traded securities if the taxpayers use the sales proceeds within _ _ days to purchase common stock or a partnership interest in a specialized small business investment company (SSBIC).

10

30

60

90

(6-5,6, pg 39)

Answer 40

60

This provision is effective for dispositions on or after August 10, 1993.

Question 41

Specialized Small Business Investment Companies

Individuals may elect to defer gain in a taxable year of up to the GREATER OR LESSER of $50,000 or $500,000 reduced by any gain previously deferred under this provision.

(6-5,6, pg 39)

Answer 41

lesser

These amounts are reduced to $25,000 and $250,000, respectively, for married individuals filing separately. For C corporations, the limits are increased to $250,000 and $1 million, respectively.

Question 42

Exclusion of Gain from Small Business Stock

Taxpayers other than C corporations who hold qualified small business stock (QSBS) for more than five years may exclude a portion, or all of the gain on the sale of the stock. For stock acquired after September 27, 2010, the maximum exclusion is 100%. The maximum amount of gain eligible for the exclusion is limited to the greater of what two amounts?

1. _ _ times the taxpayer’s basis in the stock,

or

2. $_ _ million of gain from the stock in that corporation.

(6-5,6, pg 39)

Answer 42

1. 10 times the taxpayer’s basis in the stock,

or

2. $10 million of gain from the stock in that corporation.

Question 43

Exclusion of Gain from Small Business Stock

The qualified small business corporation must be a C corporation and must not have aggregate gross assets in excess of $_ _ million when the stock is issued. Also, 80% or more of the value of corporate assets must be used in the active conduct of one or more qualified trades or businesses. Qualified trades or businesses are businesses other than those performing services in a personal service field or in the areas of finance, banking, real estate, leasing, mineral extraction, and farming; or hotels, motels, restaurants, or similar businesses.

50

60

75

(6-5,6, pg 40)

Answer 43

50

Question 44

Bond Premium and Discount

Original issue discount (OID). Some new bonds are issued at a discount—an original issue discount (OID). In the case of OID bonds issued after May 27, 1969, the amount of the discount must be treated annually as income for tax purposes, even if the taxpayer is on a cash method basis of reporting. The annual accrual also increases the _____ basis of the bond each year.

(6-5,6, pg 41)

Answer 44

cost

The treatment of OID also applies to tax-exempt bonds. However, in the case of tax-exempt bonds, the OID is also tax-exempt. The accrued OID increases the basis in the bond for purposes of calculating capital gain or loss if the bond is sold prior to maturity. In many instances, the taxpayer (and the IRS) will receive a Form 1099-OID that reports the annual OID amount.

Question 45

Bond Premium and Discount

Market discount bonds. The holder of a bond purchased in the market at a discount may elect to treat the difference between the purchase price and the face value—that is, the discount—as being taxed as current income annually over the remaining term of the bond, or taken in total as _____ income upon the maturity of the bond.

(6-5,6, pg 41)

Answer 45

ordinary

If the taxpayer does not include the market discount in income, gain realized on disposition of the market discount bond is treated as ordinary income to the extent of the accrued market discount on the bond.

The election to include market discount in income is revocable only with consent of the IRS, and applies to all market discount bonds acquired during and after the year of election.

Question 46

Bond Premium and Discount

Bond premium. When a taxpayer purchases a bond at a premium, the interest return on the bond is, in essence, reduced. The Code thus allows the taxpayer to amortize (deduct) the bond premium on taxable bonds over the life of the bond. This deduction is taken as an offset to the interest income as a negative entry on Schedule _.

(6-5,6, pg 41)

Answer 46

Schedule B

The deduction reduces the basis of the bond. The election to amortize bond premium on taxable bonds applies to all future bonds acquired by the taxpayer, and may not be revoked without IRS consent.

In the case of a tax-exempt bond issued at a premium, the bondholder must amortize the premium to reduce the basis of the bond. The premium amortization is not deductible in this situation.

Question 47

Taxation of U.S. Treasury Securities

T-bills. T-bills are short-term versions of zero coupon bonds; that is, they make no interest payments per se but are sold at a discount to face value. An investor might buy a T-bill for $9,530 and receive $10,000 six months later at maturity. The difference between the holder’s tax basis and the face value is the total return, which is treated as _____ income.

(6-5,6, pg 42)

Answer 47

ordinary

That income recognition falls into the year in which the face value is paid over to the investor, not when the T-bill is purchased. State and local governments do not impose their own taxes on U.S. Treasury securities.

Question 48

Taxation of U.S. Treasury Securities

Treasury notes and bonds. Tax treatment of these securities is the same as it is for _____ bonds, except that interest is exempt from state and local income taxation.

(6-5,6, pg 42)

Answer 48

corporate

Question 49

Taxation of U.S. Treasury Securities

Treasury inflation-indexed securities. These Treasury securities combine a fixed interest rate with the principal amount of the securities adjusted for inflation. The interest payments are taxed when _____.

(6-5,6, pg 42)

Answer 49

received

The inflation adjustments to the principal are taxable in the year in which such adjustments occur even though the inflation adjustments are not paid until maturity. The interest is exempt from state and local income taxation.

Question 50

Other Investment Losses

There are other investment losses that may be deducted by an individual taxpayer. While no loss from the sale of assets within an IRA may be deducted, certain losses may still be deductible. If the taxpayer has made nondeductible traditional IRA contributions, and liquidates _____ of her traditional IRAs, a loss is recognized (deducted) if the amounts distributed are less than the remaining unrecovered basis in the traditional IRAs.

(6-5,6, pg 43)

Answer 50

all

If the taxpayer has made only deductible contributions to the IRAs, no loss may be recognized because the taxpayer has no basis in the deductible IRAs. However, if the taxpayer has made deductible and nondeductible traditional IRA contributions, and liquidates all of her traditional IRAs, a loss is recognized if the amounts distributed are less than her remaining unrecovered basis in the traditional IRAs. For purposes of this rule, all traditional IRAs are aggregated; they are not combined with Roth or Coverdell IRAs.

Question 51

Other Investment Losses

Susan has made nondeductible IRA contributions of $45,000 to a single IRA. Due to poor investment performance, the account is now worth $25,000. She liquidates the IRA and withdraws the entire $25,000 in 2016. Susan [is / is not] allowed a deduction for the $20,000 loss in 2016.

(6-5,6, pg 43)

Answer 51

is allowed

According to the IRS, this loss is treated as a Tier-II miscellaneous itemized deduction, deductible only to the extent that the total Tier-II itemized deductions exceed 2% of AGI. Assume that Susan has an AGI of $100,000 and no other Tier-II deductions. She may deduct $18,000 ($20,000 loss reduced by $2,000, 2% of her AGI).

Question 52

Other Investment Losses

While no loss from the sale of assets within the Roth IRA may be deducted, if the taxpayer liquidates _____ of his Roth IRAs, a loss is recognized (deducted) if the amounts distributed are less than the remaining unrecovered basis in the Roth IRAs.

(6-5,6, pg 43)

Answer 52

all

For purposes of this rule, all Roth IRAs are aggregated; they are not combined with traditional or Coverdell IRAs. Again, the loss, according to the IRS, is treated as a Tier-II miscellaneous itemized deduction.

Question 53

Other Investment Losses

A loss also may be allowed upon the surrender of a refund annuity policy. If the taxpayer surrenders an annuity policy and receives less than the _____ basis in the contract, the annuitant has sustained a deductible loss. The basis in the contract is the premiums paid reduced by any amounts previously received from the annuity contract that were excludable from gross income (excludible dividends and the excludible portion of any nonperiodic distributions and prior annuity payments).

(6-5,6, pg 43)

Answer 53

adjusted

In order to qualify for this deduction, the taxpayer must be an annuitant on the policy. If the taxpayer owns a policy that has another individual as the annuitant,
there is no presumption of a profit motive for purchasing the contract, and any ensuing loss is not deductible.

It should be noted that none of these losses are capital losses. They are treated as ordinary losses. Thus, they are not part of the capital gain and loss netting process, nor are they subject to the $3,000 annual net capital loss limitation.

Question 54

Capital Gains and Losses

Module Check

5. Assume that, during the current tax year, Jake has a short-term capital loss of $9,000 from the sale of stocks. He also has a long-term capital gain from the sale of a sports memorabilia collection of $5,500 and has unrecaptured Section 1250 income of $14,000. Jake is in the 33% marginal income tax bracket. What is the tax result from the capital transactions?
6. $3,500 short-term capital loss carryforward and $14,000 unrecaptured Section 1250 income taxed at 25%
7. $5,000 unrecaptured Section 1250 income taxed at 25% and $5,500 collectibles gain taxed at 28%
8. $10,500 unrecaptured Section 1250 income taxed at 25%

(LO 6-5)

Answer 54

3. $10,500 unrecaptured Section 1250 income taxed at 25%

-$9,000 Short Term Capital Loss
+ $5,500 Long Term Capital Gain
= -$3,500 Short Term Capital Loss

$14,000 Unrecaptured Section 1250 income
+ -$3,500 Short Term Capital Loss
= $10,500 Unrecaptured Section 1250 income

taxed at a maximum of 25%

This is the most favorable manner of offsetting the capital losses against the capital gains.

Question 55

Capital Gains and Losses

Module Check

6. Which one of the following is a correct statement regarding the wash sale rules?
   a. The wash sale rules do not apply to dealers.
   b. Small differences in the maturity dates of bonds will not cause them to be classified as substantially identical.
   c. The wash sale rules do not apply to sales and investments in mutual funds.
   d. Basis is generally decreased by the amount of the loss that is disallowed on a wash sale.

(LO 6-6)

Answer 55

a. The wash sale rules do not apply to dealers.

The wash sale rules do not apply to taxpayers who are brokers or dealers of financial instruments.

The wash sale rules do apply to sales and investments in mutual funds and ETFs.

Basis is generally increased by the amount of the loss that is disallowed on a wash sale.

Question 56

Capital Gains and Losses

Module Check

8. How are stock redemptions treated for federal income tax purposes?
9. as dividends
10. as stock dividends
11. as sales of stock to the corporation
12. as distributions of corporate property

(LO 6-6)

Answer 56

3. as sales of stock to the corporation

A stock redemption is normally treated as a sale of stock to the corporation, not as a dividend. Thus, the redemption would generally by entitled to capital gain treatment.

Question 57

Capital Gains and Losses

Module Check

9. To the extent that a distribution to a shareholder exceeds the corporation’s current and accumulated earnings and profits (E and P), how is such a distribution treated?
   a. The distribution is treated as a taxable event, and a shareholder recognizes it as a capital gain.
   b. The distribution is treated as a taxable event, and the shareholder recognizes it as an ordinary gain.
   c. The distribution is treated as a nontaxable distribution of property.
   d. The distribution is treated as a return of capital.

(LO 6-6)

Answer 57

d. The distribution is treated as a return of capital.

Because the corporation has insufficient earnings and profits, the distribution is not treated as a dividend but as a return of capital that reduces the shareholder’s basis in his or her stock.

The shareholder would not recognize the distribution as a capital gain because he or she has received a return of capital.

The shareholder’s basis in his or her shares is reduced by the amount of the distribution, which is treated as a return of capital. It is not a taxable event to the shareholder.

Question 58

Capital Gains and Losses

Module Check

15. Which one of the following statements regarding long-term capital gains rates is not correct?
    a. Net long-term capital gains are generally subject to a maximum rate of 15% or 20%.
    b. The long-term capital gain holding period is more than 18 months.
    c. A 28% maximum capital gains rate applies to the gain on collectibles held for more than one year.

(LO 6-6)

Answer 58

The long-term capital gain holding period is more than 18 months.

The long-term capital gain holding period is more than 12 months, not 18 months.

The net long-term capital gains rate is generally 15% (or 20% for taxpayers in the 39.6% marginal income tax bracket).

Collectibles gain is subject to a maximum 28% long-term capital gains rate.

Question 59

Capital Gains and Losses

Module Check

16. Which of the following rates apply to qualified dividends that fall into the 39.6% marginal income tax bracket?

0%

15%

20%

25%

(LO 6-6)

Answer 59

20%

Qualified dividends (and net long-term capital gains) that fall into the 39.6% bracket are taxed at a 20% rate.

Qualified dividends (and net long-term capital gains) that fall into the 10% or 15% marginal tax bracket are subject to a 0% maximum rate.

Qualified dividends are subject to a 15% tax rate when they fall into the 25% to 35% brackets.

A 25% long-term capital gains rate applies to unrecaptured Section 1250 income (the portion of the gain from the sale of realty that was attributable to depreciation, but was not treated as Section 1250 recapture).

Question 60

Capital Gains and Losses

Module Check

17. Which one of the following statements regarding net short-term capital gains is correct?
    a. Net short-term capital gains are treated as ordinary income.
    b. Net short-term capital gains are subject to a 15% capital gains rate.
    c. Net short-term capital gains are subject to a 25% capital gains rate.
    d. Net short-term capital gains are subject to a 28% capital gains rate.

(LO 6-6)

Answer 60

Net short-term capital gains are treated as ordinary income.

A taxpayer’s net short-term gains are treated as ordinary income and are subject to the taxpayer’s regular marginal tax rate.

Question 61

Capital Gains and Losses

Module Check

23. This year, Irwin West sold several securities that left him with the following types of gains and losses: long-term capital gain—$18,000, short-term capital gain—$11,800, long-term capital loss—$12,200, and short-term capital loss—$12,000. What is the net capital gain or loss on Irwin’s security sales?
    a. net long-term loss of $24,200
    b. net long-term gain of $5,600
    c. net long-term gain of $5,600 and net short-term gain of $80

(LO 6-5)

Answer 61

b. net long-term gain of $5,600

The long-term gain and loss are netted, leaving a long-term gain of $5,800. Short-term gains and losses are netted, leaving a short-term loss of $200. Because there is a positive and a negative, these are netted to leave a net long-term capital gain of $5,600.

Question 62

Capital Gains and Losses

Module Check

24. The basis that is used in determining gains from mutual funds sales may be calculated by using all of the following methods except
    a. the specific identification method.
    b. the average cost method.
    c. the first-in, first-out (FIFO) method.
    d. the last-in, first-out (LIFO) method.

(LO 6-5)

Answer 62

the last-in, first-out (LIFO) method.

The basis of mutual fund shares may not be determined by using the last-in, first-out method.

Question 63

Capital Gains and Losses

Module Check

25. Which one of the following is a true statement regarding the wash sale rules?
26. The wash sale rules allow an investor to switch from one type of fund to another without paying a fee.
27. The wash sale rules apply to mutual fund dispositions as well as those of stocks or other securities.
28. Basis under the wash sale rules is determined by the last-in, first-out method.
29. The wash sale rules operate to allow loss recognition where substantially identical securities are acquired within 30 days of the sale.

(LO 6-6)

Answer 63

2. The wash sale rules apply to mutual fund dispositions as well as those of stocks or other securities.

The wash sale rules apply to both mutual fund dispositions and stock or other security dispositions.

A telephone transfer is a taxable event in which an investor switches from one type of fund to another without paying a fee.

Basis under the wash sale rules is generally determined by increasing the basis in the stock or security by the amount of the loss that was disallowed under the wash sale rules.

The wash sale rules operate to disallow loss recognition where substantially identical securities are acquired within 30 days of the sale.

Question 64

Capital Gains and Losses

Module Check

26. Which one of the following statements is incorrect regarding specialized small business investment companies (SSBICs)?
27. Individuals or C corporations may utilize this provision.
28. The SSBIC classification includes investment companies that finance small business concerns owned by disadvantaged taxpayers.
29. The sale proceeds of publicly traded securities must be used within 30 days to purchase the common stock of, or a partnership interest in, an SSBIC.

(LO 6-6)

Answer 64

3. The sale proceeds of publicly traded securities must be used within 30 days to purchase the common stock of, or a partnership interest in, an SSBIC.

The sale proceeds of publicly traded securities must be used within 60 days to purchase the common stock of, or a partnership interest in, an SSBIC.

Individuals or C corporations may elect to defer recognition of capital gain income for the sale of publicly traded securities by purchasing the common stock of, or a partnership interest in, an SSBIC.

The SSBIC classification does include investment companies that finance small business concerns owned by disadvantaged taxpayers.

Question 65

Capital Gains and Losses

Module Check

30. Sid has owned 100 shares of WordCo Publishing stock since September 15, 2013. His basis in the 100 shares is $15,000. Sid sold these shares on March 15, 2016, for $12,500. After hearing a positive earnings report for the WordCo stock, he purchases 100 more shares on April 11, 2016, for $13,000. What is the basis in the shares purchased on April 11, 2016?

$10,500

$13,000

$15,500

(LO 6-6)

Answer 65

$15,500

The basis of the newly acquired security is increased by the amount of the disallowed loss from the wash sale.

Question 66

Practice Test 2

Capital Gains and Losses

45. Edward Coleman had the following capital transactions during the current year:

$3,200 Long term capital gain

$3,600 Long term capital loss

$4,500 Short term capital gain

$3,400 Short term capital loss

Which one of the following describes the net capital gain or loss reportable by Edward for the current tax year?

$700 net short-term capital gain

$1,100 net short-term capital gain, $400 net long-term capital loss

$900 net short-term capital gain, $200 net short-term capital loss

$7,700 net capital gain, $7,000 net capital loss

(LO 6–5)

Answer 66

$700 net short-term capital gain

$3,200 Long Term Capital Gain
- $3,600 Long Term Capital Loss
= -$400 Long Term Capital Loss

$4,500 Short Term Capital Gain
- $3,400 Short Term Capital Loss
= $1,100 Short Term Capital Gain

-$400 Long Term Capital Loss
+ $1,100 Short Term Capital Gain
= $700 Net Short Capital Gain

Therefore, $700 Short Term Capital Gain

Question 67

Practice Test 2

Capital Gains and Losses

46. During the current tax year, Ken Brandt sold several securities that resulted in the following types of gains and losses: long-term capital gain—$6,700; short-term capital gain—$7,000; long-term capital loss—$1,900; and short-term capital loss—$9,200.

What is the net capital gain or loss on Ken’s security sales?

a. net short-term loss of $2,500 and net long-term gain of $5,100
b. net short-term gain of $2,600
c. net long-term gain of $2,600
d. net long-term gain of $4,800 and net short-term loss of $2,200

(LO 6–5)

Answer 67

c. net long-term gain of $2,600

$6,700 Long Term Capital Gain
+ -$1,900 Long Term Capital Loss
= $4,800 Long Term Capital Gain

$7,000 Short Term Capital Gain
+ -$9,200 Short Term Capital Loss
= -$2,200 Short Term Capital loss

$4,800 Long Term Capital Gain
+ -$2,200 Short Term Capital loss
= $2,600 Net Long/Short Capital Gain

Therefore, $2,600 Net Long Term Capital Gain

The long-term items are netted, leaving a long-term capital gain of $4,800. The short-term items are netted, leaving a short-term capital loss of $2,200. The long-term capital gain is netted with the short-term capital loss to result in a net long-term capital gain of $2,600.

Question 68

Practice Test 2

Capital Gains and Losses

47. Ann Hamilton owns 500 shares in the XYZ Growth Mutual Fund. The basis of her investment in this fund is $3,700, while the fair market value is only $1,200. She wants to sell her shares to “lock in” the $2,500 loss, but she is considering buying 500 shares of the same fund the following week because she believes that the value is going to increase significantly over a longer period.

As her planner, what can you accurately tell her about this scenario?

a. The loss would be a fully deductible capital loss.
b. The basis in the newly acquired shares would be the amount paid for those shares, increased by the $2,500 disallowed loss.
c. She should wait a minimum of 60 days after the sale to repurchase the shares so that the loss may be recognized.
d. If she purchased shares in the ABC Growth Mutual Fund within 30 days after the sale of the old shares, the $2,500 loss would be disallowed.

(LO 6–5)

Answer 68

b. The basis in the newly acquired shares would be the amount paid for those shares, increased by the $2,500 disallowed loss.

The wash sale rule disallows a loss if substantially identical securities are purchased prior to 30 days after the sale that resulted in the loss. The basis of the acquired securities is increased by the amount of the disallowed loss. Securities from a different issuer (ABC) are not considered substantially identical.

Question 69

48. Gary Anderson bought 200 shares in a mutual fund for $15 per share. Shortly after this purchase, the mutual fund went ex-distribution and declared a distribution of $.50 per share. Gary elected to have dividend distributions from the fund reinvested to purchase additional shares at $15 per share.

How much taxable gain will Gary incur if he later sells all his shares for $16 per share?

$100

$107

$200

$207

(LO 6–5)

Answer 69

$207

  $15 Sales price of shares
* 200 Number of shares purchased 
= $3,000	Cost Basis
\+ $100 Reinvested Dividends ($.50*200)
= $3,100 Basis

  $100 Reinvested Dividends ($.50*200)
* $15 Sales price of shares
= 6.67 Number of shares owned via dividends
\+ 200 Number of shares purchased 
= 206.67	Total number of shares 
* $16 New sales price 
= $3,307	Current Value 

$3,307 Current Value
- $3,100 Basis
= $207 Total gain on the sale

Question 70

Practice Test 1

26. This year, Ken Bush sold several securities that left him with the following types of gains and losses: long-term capital gain—$8,000; short-term capital gain—$1,800; long-term capital loss—$2,200; and short-term capital loss—$1,000.

What is the net capital gain or loss on Ken’s security sales?

a. net long-term loss of $1,400
b. net long-term gain of $2,320 and net short-term gain of $800
c. net long-term gain of $2,640
d. net long-term gain of $5,800 and net short-term gain of $800
e. net long-term gain of $6,600

(LO 6-5)

Answer 70

net long-term gain of $5,800 and net short-term gain of $800

$8,000 Long Term Capital Gain
+ -$2,200 Long Term Capital Loss
= $5,800 Long Term Capital Gain

$1,800 Short Term Capital Gain
+ -$1,000 Short Term Capital Loss
= $800 Short Term Capital Gain

These are left separate due to the disparate tax treatment of short-term versus long-term gains.