Tax Issues in Investing

1
Chapter 13

• Tax Issues in Investing

2

• Overview of Taxation

3
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)

4
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 or tax due

5
Adjustments to Gross Income

• IRA deduction
• Self-employed SEP, SIMPLE, and qualified plans
  contributions
• Penalty on early withdrawal of savings

6
Itemized Deductions (1 of 2)

• medical and dental expenses (to the extent they
  exceed 7.5 percent of AGI)
• taxes (state and local income taxes, real estate
  taxes, and personal property taxes)
• interest expenses

7
Itemized Deductions (2 of 2)

• gifts to charity (not to exceed 50 percent of
  AGI)
• casualty and theft losses (reduced by 100 per
  event, and only to the extent they exceed 10
  percent of AGI)
• job related expenses and most miscellaneous
  deductions (only to the extent they exceed 2
  percent of your AGI)
• miscellaneous Deductions

8
Interest Expense Deduction

• Mortgages (1m in principal for first mortgages,
  100K in principal for seconds)
• 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 taxpayers net investment
  income for year

9
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

10

• Average tax rate
• Total amount of income tax paid divided by total
  income
• Persons 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

11
Alternative Minimum Tax

• AMT rates two-step 26 28
• Few people affected by it at first
• With inflation, more included each year
• Some income that would otherwise be tax exempt is
  now be taxable

12
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 runs through 2006
• Only for people with income less than 50,000
  joint (25,000 single)

13
Payments

• For people with substantial investment income
• make estimated payments during the year
• adjust the amounts withheld by employers on wage
  income
• elect to have 20 percent of the investment income
  withheld for taxes

14
Comparison of Pre- and After-tax Returns

• rpost-tax rpre-tax x (1 marginal tax rate)
• rpre-tax rpost-tax ? (1 marginal tax rate)

15
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)

16

• Taxation of Equities

17
Taxation of Dividend Income

• Qualified dividends
• Special treatment established in 2003
• Taxed at 15 rate (or 5 if have 10 or 15 MTR)
• Minimum 60-day holding period
• Ordinary dividends
• Continue to be taxed as ordinary income

18

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

19

• Capital Gains and Losses
• Increase (or decrease) in market value of asset
• Realized vs. Unrealized
• Holding Period
• Short-term one year or less
• Long-term more than one year

20

• 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.

21
Tax Treatment of Each Category

• Short-Term Capital Gains (STCG) Ordinary Income
• Long-Term Capital Gains (LTCG) 15 MTR
• Unless MTR is 10 or 15, then LTCG is 5
• STCL and LTCL Deduct 3,000 per year and carry
  unused portion forward

22
Multiple Gains Losses (1 of 2)

• Combine all STCG STCL
• Combine all LTCG LTCL
• If have STCG LTCL, or STCL LTCG, combine
  again to get one net figure

23
Multiple Gains Losses (2 of 2)

• If reduces to one figure, apply that one rule
• If have both STCG LTCG, tax each as per its
  rules
• If have both STCL LTCL, deduct 3,000 total
  carry the rest forward.

24
Tax-Loss Harvesting

• Recognize 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

25
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

26
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

27
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

28
Stock Splits/Stock (Share) Dividends

• Nontaxable event
• Prorate old cost basis to new shares
• Example
• Buy 100 shares for 1020 (10 per share plus 20
  commission)
• Stock has 2 x 1 split, so now hold 200 shares
• Cost basis is 5.10 per share (1,020 / 200)

29
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

30
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 (if any) plus exercise price

31
Short Sales and Taxes

• Normal tax rules, except sale date precedes the
  purchase date
• Must be short more than one year to obtain
  long-term tax treatment

32
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.

33

• Taxation of Bonds

34
Cost Basis of Bonds

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

35
Tax Equivalent Yield

• Yield on state and local debt after adjustment
  for fact that the interest is not subject to
  federal taxation
• rt rsl/(1t)
• where rt tax-equivalent yield
• rsl nominal yield on state and
  local debt
• t investors marginal federal tax rate

36
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

37
Zero-Coupon Bonds

• Imputed interest based on YTM at time bonds were
  initially sold
• Best held in tax qualified account so that dont
  have to declare income

38
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
• With EE I, can report interest income each year
  on accrued value basis, or postpone until
  declaration until maturity

39
Federal Municipal Bonds

• Federal bonds exempt from state taxation
• Coupon payments on municipal bonds normally
  exempt from federal taxation and same state
  taxation
• Any state can tax anothers interest
• CG or CL on either is taxable on federal and
  state returns

40
Wash Rule for Bonds

• Easier to apply
• Only one characteristic has to be different to
  avoid wash rule
• Example maturity

41

• Taxation of Investment Companies

42
Investment Companies

• Capital gain distributions paid after 12/31
• ST LT nature of gains holds
• In down markets, investors cannot benefit from
  capital losses
• In up markets, new purchases usually involve
  buying taxes
• Tax-friendly (i.e., tax efficient) funds

43
Determination of Cost Basis for Investment
Companies

• Can be extremely complex
• Specific share identification
• First-in, first-out (Default treatment)
• Average cost basis
• Single category method
• Double category method

44
Wash Rule and Investment Companies

• Can be judgment call when selling one index fund
  and buying another index fund
• Best if index is not the same
• Otherwise, little chance of a wash rule problem
  as long as exact same fund not repurchased

45

• Miscellaneous Tax Treatments Issues

46
Taxes and Options

• Capital transaction
• If option expires as worthless CG to writer and
  CL to buyer
• If option exercised, premium becomes part of cost
  basis for a call option and sale price for a put
  option

47
Annuities Taxes

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

48
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
• Passive income issues for limited partners

49
Investment Strategies

• Hold securities with high current income such as
  bondsin tax-qualified accounts
• Hold securities that produce capital gains (and
  thus allow deferral in tax recognition) in
  taxable accounts
• Rules should not override desired asset
  allocation decision

50
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
• (continued)

51
Net Unrealized Appreciation (NUA) (continued)

• If take cash
• Cash can be rolled into an IRA becomes fully
  taxable as ordinary income upon withdrawal

52
Net Unrealized Appreciation (NUA) (continued)

• If take securities
• must treat cost basis of stock as ordinary income
  at time of distribution
• Can then treat NUA as LTCG when stock eventually
  sold
• Subsequent price appreciation is then treated as
  CG

53
Deduction of Losses on an IRA Account

• Must liquidate all IRA accounts of the same type
• Loss defined as Cost Basis less Liquidation Value
  of the accounts
• Subject to 2 deduction rule

54
Summary of Tax Treatment of Investment Income

• Capital distributions on stock
• Interest on state and local (municipal) bonds

• Not generally subject to federal income tax
• (continued)

55
Summary of Tax Treatment of Investment
Income(continued)

• Unrealized capital gains

• Tax deferred until realized
• (continued)

56
Summary of Tax Treatment of Investment
Income(continued)

• Nonqualified dividend and interest income (other
  than municipal bond interest)
• Rents, royalties, and any other investment income
  payments
• Short-term capital gains and short-term capital
  gain distributions (from mutual funds)
• Payments from deferred income plans, 401(k)
  plans, IRAs, and so forth

• Taxed at ordinary income tax rate
• (continued)

57
Summary of Tax Treatment of Investment
Income(continued)

• Qualified dividends, long-term capital gains, and
  long-term capital gain distributions (from
  investment companies)

• Taxed at 15 or 5