Chapter 13

1. Chapter 13 Tax Issues in Investing

2. Income Tax Formula Total income – Adjustments to gross income = Adjusted gross income or AGI – Standard deduction or itemized deductions (whichever is larger) – Personal exemptions = Taxable income (continued)

3. Income Tax Formula (continued) Tax liability (based on taxable income and filing status) – Credits + Other taxes owed = Total taxes for the year – Taxes paid to date = Tax refund to be received or tax due

4. Adjustments to Gross Income • IRA contribution • self-employed SEP, SIMPLE, and qualified plans • penalty on early withdrawal of savings

5. Interest Expense Deduction • Mortgages (with limits) • Margin loans • Interest payments on nonbusiness loan incurred in course of investment activity are referred to as investment interest. • Deductions for investment interest expenses allowed but limited to taxpayer’s “net investment income” for year

6. Net Investment Income • Investment income after deduction of investment expenses • Ordinary dividends clearly count • Qualified dividends do not (those subject to special marginal tax rates) • Unused investment interest can be carried forward to next year

7. Average tax rate • Total amount of income tax paid divided by total income • Person’s average tax rate always lower than his or her marginal tax rate • Marginal tax rate (MTR) • Rate at which incremental income is taxed • Only relevant rate for investment decision making purposes

8. Alternative Minimum Tax • AMT rate = 26% on first $175,000, then 28% (for MFJ) • Few people affected by it at first • With inflation, more taxpayers included each year • Some income that would otherwise be tax exempt is now be taxable

9. Tax Credits • Foreign tax credit • If less than $600 on joint return ($300 on single) can deduct automatically. • If exceed this amount, must prorate using Form 1116 • Retirement savings contributions credit • Only for people with income less than $50,000 joint ($25,000 single) • Up to 50% tax credit for contributions

10. Other Taxes • Premature distribution from a tax-qualified account (10%) • Excess contributions to IRAs & others • Distribution taken from a Coverdell ESA or qualified tuition program not spent appropriately • Shortfall in MRD

11. People with Substantive Nonwage Income • Make estimated payments during the year. • Adjust the amounts withheld by employers on wage income. • Elect to have 20 percent of their investment income withheld for taxes.

12. Comparison of Pre- and After-tax Returns rpost-tax = rpre-tax x (1 – marginal tax rate) rpre-tax = rpost-tax  (1 – marginal tax rate)

13. Combined Marginal Tax Rates If state taxes not itemized on federal returns: MTRcombined = MTRfederal + MTRstate If state taxes are itemized: MTRcombined = MTRfederal+ MTRstate x (1– MTRfederal)

14. Taxation of Dividend Income • Qualified dividends • Special treatment from 2003 till 2010 • Taxed at 15% rate (or 10% if have 15% MTR) • MTR goes to 0% in 2008-10 if in lowest two brackets • Minimum 60-day holding period • Ordinary dividends • Continue to be taxed as ordinary income

15. Capital Distributions • Dividend paid out of capital rather than from earnings • Not taxed when received but do reduce the investment’s basis • Also called liquidating dividend

16. Capital Gains and Losses • Realized vs. Unrealized • Holding Period • Short Term: One-year or less • Long Term: More than one year

17. Cost Basis • Purchase price of asset, plus any commissions paid to acquire it. • Selling Price • Proceeds from sale of asset, less commissions paid to sell it.

18. Tax Treatment of Each Category • Short-Term Capital Gains (STCG): Ordinary Income • Long-Term Capital Gains (LTCG):15% MTR • Unless MTR is 15%, then LTCG is 10% • STCL and LTCL: First, offset Capital gains, then can deduct $3,000 per year and carry unused portion forward

19. Tax-Loss Harvesting • Recognize at least up to $3,000 in capital losses each year if have them • Savings on income taxes • Allows recognition of some capital gains without a tax bill, and/or • Opportunity to rebalance portfolio

20. Tax-Efficient Investing • Avoidance of taking of capital gains on which one would have to pay capital gains tax • Can eventually lead to a concentrated portfolio • Gives appearance of failure to manage portfolio

21. Wash Sale Rule • Loss sustained on sale of security not allowed if investor purchases “substantially identical” security within period beginning 30 days before sale and ending 30 days after sale. • Cannot substitute options for stock • Cannot move to substantially identical convertibles

22. Substantially Identical Convertibles 1. Convertible into common stock 2. Has same voting rights as common stock 3. Subject to same dividend restrictions 4. Trades at prices that do not vary significantly from conversion ratio 5. Unrestricted as to convertibility

23. Restricted Stock • Compensation package for top management • Limitations on tax-deduction of salaries over $1,000,000 • Sell the employee restricted stock • Lend the money to purchase the stock • Later, forgive the loan • If company bought out, employee gets LTCG

24. Stock Splits/Dividends • Nontaxable event • Prorate old cost basis to new shares

25. Warrants • Selling stock and buying warrants on same subject to wash rule • Selling warrants and buying stock NOT subject to wash rule as long as not substantially identical • Cost basis of stock bought through exercise • Cost of warrants plus exercise price

26. Rights and Taxes • Must allocate part of cost basis of stock to rights if value of rights at least 15% of value of stock holding • Cost basis of stock bought through exercise • Cost of rights plus exercise price

27. Short Sales and Taxes • Normal tax rules, except sale date precedes the purchase date • Must be short at least one year to obtain long-term tax treatment

28. Liquidations • Partial liquidation treated as capital distribution • If liquidation in multiple payments and purchases were in multiple batches, then must prorate sales over each batch.

29. Taxation of Bond Interest • Municipals normally exempt from federal taxation • Treasury bonds & federal agency bonds exempt from state & local taxation • Bonds of gov’t sponsored corporations not exempt from state & local taxation • Some states tax only income from dividends and interest

30. Cost Basis of Bonds • Cost of bonds + commission • Accrued interest paid will be an offset to interest income for the year.

31. Tax Equivalent Yield • Yield on state and local debt instruments after adjustment for fact that debt holder is not liable for federal income tax • Calculated as YTE = Ys&l /(1–T) where YTE = tax-equivalent yield Ys&l = nominal yield on state and local debt T = investor’s marginal federal tax rate

32. Tax-Coupon Effect • Deep discount bonds sell at lower YTM than higher coupon bonds of same term to maturity because more of profit is taxed at CG rates rather than ordinary income

33. Convertible Bonds • Conversion is a non-tax event • Exchange of like assets • Cost basis of shares acquired equals the cost basis of the bonds

34. Zero-Coupon Bonds • Imputed interest based on YTM at time bonds were initially sold • Best held in tax qualified account so that don’t have to declare income

35. OIDs • Original-issue discount bonds • Still have some imputed interest

36. TIPS and Savings Bonds • TIPS: taxed on increase in principal, even though this is not received until maturity • Savings bonds: • Exempt from state & local taxes • Exempt if used to pay college tuition (subject to income limits) • With EE & I, can report interest income each year on accrued value basis, or postpone until declaration until maturity

37. Wash Rule for Bonds • Easier to apply • Only one characteristic has to be different to avoid wash rule • Example: maturity

38. Investment Companies • Capital gain distributions paid after 12/31 • ST & LT nature of gains holds • In down markets, investors cannot benefit from capital losses • After a down market, can buy a tax-shelter • In up markets, new purchases usually involve “buying taxes” • Tax-friendly funds (portfolio turnover ratio)

39. Determination of Cost Basis for Investment Companies • Can be extremely complex • Specific share identification • First-in, first-out • Average cost basis • Single category method • Double category method

40. Unit Investment Trusts • For bond UITs, maturing bonds are a return of principal • For equity UITs, pay CG tax even if roll over to another equity UIT • Exception: if the successor portfolio has the same securities as the terminating portfolio, the cost basis of those particular securities may be carried forward

41. Wash Rule and Investment Companies • Can be judgment call when selling one index fund and buying another index fund • Otherwise, little chance of a wash rule problem

42. Taxes and Options • Capital transaction if underlying asset is a capital asset • Ordinary income if asset not cap. asset • If option expires as worthless: CG to writer or CL to buyer • If option exercised, premium becomes part of cost basis or sale price

43. Annuities & Taxes • Part of each payment is return of principal and rest is investment income. • If all principal received, full payment becomes investment income

44. Partnerships and Taxes • Profit or loss of business is passed through to owners as in proprietorships • Schedule K-1 • Major benefit when business incurs loss, the operating loss can reduce ordinary income

45. Futures Contracts • Capital assets • Any positions that are open as of December 31 of each year are treated as if they are closed out on this date • the gains and losses are arbitrarily allocated to being 60 percent long term and 40 percent short term • Exception for a tax straddle

46. Investment Strategies • Hold securites with high current income— such as bonds—in tax-qualified accounts • Hold securities which produce capital gains and ability to defer recognition in taxable accounts • Rules should not override desired asset allocation decision

47. Net Unrealized Appreciation (NUA) • Withdrawals from qualified plans such as ESOPs, 401(k)s, and qualified pensions may be made in one of two ways • Cash • Securities • Cash can be rolled into an IRA & becomes fully taxable as ordinary income upon withdrawal (continued)

48. Net Unrealized Appreciation (NUA) (continued) • If take securities • can treat cost basis of stock as ordinary income at time of distribution • Can treat NUA as LTCG when stock evenually sold • Subsequent price appreciation is then treated as CG

49. Roth IRA Accounts • Maximum contribution is $4,000/year • Extra $500/year (over 50 & qualify) • Contributions never deductible • Full contribution rquires one’s adjusted AGI not exceed $160,000 (MFJ), $110,000 (S) • Principal withdrawal tax-exempt anytime • Profit withdrawal tax-exempt after 5 years & at least age 59 ½

50. Tax Deduction for IRA Losses • All IRAs of same type must be liquidted that year • Deduction based on combined loss • Deduction subject to the 2% AGI rule • Early withdrawal penalty waived