Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard...
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Transcript of Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard...
Chapter 11 Investments
Howard Godfrey, Ph.D., CPAUNC Charlotte
Copyright © 2012, Dr. Howard Godfrey
11. Investments1. How interest income and dividend income are taxed.2. Compute the tax consequences associated with the
disposition of capital assets, including the netting process for calculating gains and losses.
3. Common sources of tax-exempt investment income and explain the rationale for exempting some investments from taxation.
4. Calculate the deduction for portfolio investment-related expenses, including investment expenses and investment interest expense.
5. Understand the distinction between portfolio investments and passive investments and apply tax basis, at-risk, and passive activity loss limits to losses from passive investments.
1. How interest income and dividend income are taxed.
2. Compute the tax consequences associated with the disposition of capital assets, including the netting process for calculating gains and losses.
3. Calculate the deduction for portfolio investment-related expenses, including investment expenses and investment interest expense.
4. Understand the distinction between portfolio investments and passive investments.
5. Apply tax basis, at-risk, and passive activity loss limits to losses from passive investments.
Textbook page 11-4Discount or Premium. How is the bond price computed? How is the amount of the periodic interest payment determined? The amount of interest expense, and amortization? Please study illustration on next few pages.
HK Co. Bond IIlustration – Slide 1 of 19Great Corporation issues bonds with a face value of $100,000 on 1-1-09. The bonds mature 2 years later on 12-31-11.The bonds pay interest of 10% per year, payable twice per year ($5,000 each 6 months).HK Co. buys the bonds, at a price based on a 12% yield.
Bond IIlustration – Slide 2 of 19
If the market rate for companies with similar credit standing is 10%, the bonds will sell for $100,000 (plus any accrued interest if sold between interest dates).
Bond IIlustration – Slide 3 of 19Assume the market rate of interest is 12% compounded semiannually, the bonds will sell for less than $100,000. The bonds will sell at a discount to provide additional earnings for the investor beyond the $5,000 interest payments.
Bond IIlustration – Slide 4 of 19
Both the borrower and the investor (if held to maturity) must amortize bond discount using the constant interest rate method (withsemiannual compounding).
Bond IIlustration – Slide 5 of 19
How would you compute the amount to be paid for these bonds, if yield is 12%, compounded semiannually?
Bond IIlustration – Slide 6 of 19
Discount the interest payments and principal payment, at 12%, compounded semiannually.
HK Co. Bond IIlustration – Slide 7 of 19On 1-1-11, issue $100,000 of bonds.On 12-31-12 the bonds will mature.Bonds have stated interest of 10%. Bonds pay interest of $5,000 each 6 months. HK Co. buys bonds at price to yield 12%, with semi-annual compounding. Compute price paid by HK Co. by discounting cash flows at 6% per interest period.
June Dec. June Dec
PV $5,000
PV $5,000
PV $5,000
PV $5,000
PV $100,000
Price
HK Co. Bond IIlustration – Slide 8 of 19
2011 2012
Interest Payments $5,000.00PV Factor [Pg. 682]=PV(0.06,4,-5000,,0)
PV of annuity of $5,000 $17,325.53
PV of $100,000(4 periods, 6% per period)
Principal Payment $100,000.00Factor =1/(1+0.06)^4 0.792093663PV of $100,000 payment $79,209.37
Price of Bond $96,534.89
Bonds – Slide 9 of 19.PV of 4 interest payments
Bond IIlustration – Slide 10 of 19Prepare amortization table.Note: The PV factors on preceding page were computed with Excel. These factors are a little more accurate than those taken from tables in your book (because of rounding in the textbook).
HK Co. Bond IIlustration – Slide 7 of 19On 1-1-11, issue $100,000 of bonds.On 12-31-12 the bonds will mature.Bonds have stated interest of 10%. Bonds pay interest of $5,000 each 6 months. HK Co. buys bonds at price to yield 12%, with semi-annual compounding. Compute price paid by HK Co. by discounting cash flows at 6% per interest period.
Book Interest Interest Unamort Book
Yr Value Received Income Amort. Disc/Prm Value
2011 96,535
2011
2012
2012 -
Bond IIlustration – Slide 12 of 19 On Jan. 1, 2011, issued $100,000, 10%, 2 year bonds.
Interest is paid on 6-30 and 12- 31. Mature 12-31-12.
Bonds were sold at a price to yield 12% per year.
Book Interest Interest Unamort Book
Yr Value Received Income Amort. Disc/Prm Value
2011 96,535 5,000 5,792 792 2,673 97,326.99
2011 97,327 5,000 5,840 840 1,833 98,166.61
2012 98,167 5,000 5,890 890 943 99,056.61
2012 99,057 5,000 5,943 943 (0) 100,000
Bond IIlustration – Slide 12 of 19 On Jan. 1, 2011, issued $100,000, 10%, 2 year bonds.
Interest is paid on 6-30 and 12- 31. Mature 12-31-12.
Bonds were sold at a price to yield 12% per year.
Income(DR) (DR) (CR) (DR)
Bond Bonds InterestTransaction Cash Discount Payable Expense
IssueBonds 96,535 3,465 (100,000)
PayInterest (5,000) 5,000
AmortizeDiscount (792) 792
Totals 2,673 (100,000) 5,792Book Value - bonds - 6-30-06 ($97,327)
Balance Sheet
Bond Illustration. [13 of 19]
Begin Bal. Int. 6% W/draw End. Bal. 1 96,535.00 5,792.10 (5,000) 97,327.10 2 97,327.10 5,839.63 (5,000) 98,166.73 3 98,166.73 5,890.00 (5,000) 99,056.73 4 99,056.73 5,943.40 (5,000) 100,000.13
Cash 96,535 Discount 3,465
Bonds Payable 100,000
Interest Expense 5,000 Cash 5,000
Interest Expense 792 Discount 792
Great Co. Issues Bonds -14 of 19
Issues Bonds 1-1-07
Adjusting Entry 6-30-07
Interest Payment 6-30-07
Bond Investment 96,535 Cash 96,535
Cash 5,000 Interest Revenue 5,000
Bond Investment 792 Interest Revenue 792
HK Co. Buys Bonds -15 of 19
HK Co. Buys Bonds 1-1-07
Adjusting Entry 6-30-07
Interest Received 6-30-07
Bond IIlustration – Slide 16 of 19
How much income is recognized by HK in first year?
Bond IIlustration – Slide 17 of 19
How much income is recognized by HK in first year?$5,792.09 plus $5,839.62.
Cash Other Current AssetsBuilding and LandAccumulated Deprec.Net Fixed Assets
Total AssetsCurrent LiabilitiesLong-Term Debt
Bonds Payable 100,000Less Discount
Common StockRetained EarningsTotal Debt & Equity
Bond IIlustration – Slide 18 of 19
Bond IIlustration – Slide 19 of 19
How much would the bonds sell for if they pay zero interest?Answer:$79,209.37 (Slide 9 of 19)
On Jan. 1, 2007, Carr Corp purchased Fay Corp. 9%. 10-year bonds with a face amount of $400,000 for $375,600, to yield 10%. The bonds are dated January 1, 2007, mature on December 31, 2017, and pay interest annually on Dec. 31. Carr uses the interest method of amortizing discount. What is Carr’s interest revenue for 2007?$40,000 b. $37,560 c. $36,000 d. $34,440(Source: CPA)Ignore some rounding in the price computation
Carr CorporationAnswer is BFace value of investment $400,000Book value of investment $375,600Yield rate 10%Interest earned (revenue) $37,560Interest received
(9% of face value) $36,000Amortization of discount $1,560
2. Compute the tax consequences associated with the disposition of capital assets, including the netting process for calculating gains and losses.
Capital Gains and LossesA capital asset is “any asset other than inventory, receivables, copyrights, assets created by the taxpayer, and depreciable or real property used in a trade or business.”A collectible gain or loss results from the sale or exchange of works of art, gems, metals, antiques, rugs, stamps, wine, etc. held more than 12 months.
Four One Buckets Bucket
Net Net NetShort-T. Long-T. Gain (Loss) Return
Yr 1 STCG $4,000
Yr 1 STCL ($2,400)
Yr 1 LTCG $4,000
Yr 1 LTCL ($3,500)
Net Gain
Gain taxed at ordinary rates
Gain taxed at capital gains rates
Stock Trans.
Barb-1 TwoBuckets
Four One Buckets Bucket
Net Net NetShort-T. Long-T. Gain (Loss) Return
Yr 1 STCG $4,000
Yr 1 STCL ($2,400) $1,600
Yr 1 LTCG $4,000
Yr 1 LTCL ($3,500) $500
$2,100
$2,100
$1,600
$500
Net Gain
Gain taxed at ordinary rates
Gain taxed at capital gains rates
Stock Trans.
Barb-2 TwoBuckets
Tax Treatment for Net Long-term GainIndividual Taxpayers
– Collectibles held more than 12 months are taxed at a maximum rate of 28%.
– 50% of the gain on qualified small business stock is excluded, the remainder taxed at a maximum rate of 28%.
– Unrecaptured Section 1250 gain is taxed at a maximum rate of 25%.
Short-term capital loss ($2,000)
Long-term capital gain $12,000
Long-term capital
loss carryover ($5,000)
Collectibles gain $10,000
Juan has these capital gains and losses in the current year:
Example Short-term:S.T. capital loss ($2,000)
Long-term:Collectibles gain $10,000L.T. capital gain $12,000L.T. capital loss c/o ($5,000)
L.T. capital gain $17,000Net L.T. capital gain $15,000
ExampleResults:“28% rate gain” = ($10,000 -$5,000 - $2,000)
= $3,000
ANCG = $15,000 - $3,000 = $12,000
NLTCG is added to taxable incomeNet capital gain, taxed at 15% = $12,000Collectibles gain, taxed at 28% = $3,000
Tax Treatment for Net Short-term Gain
Individual Taxpayers • Net short-term capital gain
is taxed as ordinary income (i.e., taxpayer’s marginal tax rate).
Gain Treatment for Corporations
•Corporations do not receive special treatment for capital gains.
Tax Treatment for Net Loss• Net Capital Loss– Individuals may use only $3,000 to offset
other income• Excess loss is carried forward indefinitely
and retains its short term or long term class for netting purposes
–Corporations cannot deduct a net capital loss• Excess loss carried back 3 then forward 5
years to offset capital gains
Four One Buckets Bucket
Net Net NetShort-T. Long-T. Gain (Loss) Return
Yr 1 STCG $0
Yr 1 STCL ($2,400)
Yr 1 LTCG $400
Yr 1 LTCL ($3,500)
Deduct STCL
Deduct LTCL
Carry over to next year
Deduction limit this year
Bob-1
TwoBuckets
Four One Buckets Bucket
Net Net NetShort-T. Long-T. Gain (Loss) Return
Yr 1 STCG $0
Yr 1 STCL ($2,400) ($2,400)
Yr 1 LTCG $400
Yr 1 LTCL ($3,500) ($3,100)
($5,500)
($2,400)
($600)
($3,000)
($2,500)
Deduct STCL
Deduct LTCL
Carry over to next year
Deduction limit this year
Bob-2
TwoBuckets
Sharon’s Capital Asset Sales-1Sharon has salary income of $68,000, a net short-term capital gain of $15,000, and a net long-term capital loss of $24,000. What is Sharon’s adjusted gross income if she has no other income items?
Sharon-Cap. Asset Sale Details Capital Ordinary Return
Other Income (Other AGI) $68,000 $68,000
Net L.T. capital gain or loss
Net S.T. capital loss or loss
Gain (loss) non-cap. asset:
Gain (Loss)-bus. use asset
Sec. 1231 gain (Cap. Gain.)
Net capital gain or loss
Cap. Loss limited to $3,000
Net capital gain or loss in AGI
Adjusted Gross Income
Carryforward
Sharon-Cap. Asset Sale Details Capital Ordinary Return
Other Income (Other AGI) $68,000 $68,000
Net L.T. capital gain or loss $15,000
Net S.T. capital loss or loss (24,000) (9,000)
Gain (loss) non-cap. asset:
Gain (Loss)-bus. use asset
Sec. 1231 gain (Cap. Gain.)
Net capital gain or loss (9,000)
Cap. Loss limited to $3,000 (3,000)
Net capital gain or loss in AGI (3,000)
Adjusted Gross Income $65,000
Carryforward ($6,000)
Qualified Small Business Stock• Qualified stock –Held for more than 5 years–Purchased directly from corporation• Corporation with gross assets < $50 million
–Purchased after 8/10/93• Up to 50% of gain may be excluded– Limited to the greater of• 10 times basis in the stock, or• $10 million for each small business
– Exclusion is based on a 28% rate
Planning Strategies• Net Capital Gain position– Sell assets with unrealized losses
• Net Capital Loss position– Sell assets with unrealized gains – Optimize at $3,000 (deduct $3,000 from Ord. Inc.)
• Worthless Securities– Worthlessness deemed to occur on the last day of
the year– Realized loss = basis in the worthless security
• Basis determination– FIFO– Specific identification
Section 1231
1231 Property
1231 Netting
Section 1231•Net Section 1231 gains may
be allowed capital gain treatment even though they arise from “ordinary” assets.•Net Sec. 1231 losses are
ordinary.
$2,000
($8,000)
($4,000)auto (owned 2 years)
Adjusted gross income?
Jill had AGI of $100,000, before these transactions.
Long-term capital gain
Short-term capital loss
Loss on sale of business
$2,000
($8,000)
($4,000)
$93,000
auto (owned 2 years)
Adjusted gross income?
Jill had AGI of $100,000, before these transactions.
Long-term capital gain
Short-term capital loss
Loss on sale of business
$2,000
($8,000)
$4,000 land (owned 2 years)
Adjusted gross income?
Jack had AGI of $100,000, before these transactions.
Long-term capital gain
Short-term capital loss
Gain on sale of business
$2,000
($8,000)
$4,000
$98,000
land (owned 2 years)
Adjusted gross income?
Jack had AGI of $100,000, before these transactions.
Long-term capital gain
Short-term capital loss
Gain on sale of business
Section 1231 Netting Results• Net Section 1231 gain is classified as
long-term capital gain–Lookback rule may reclaim some gains
as ordinary• to the extent of Section 1231 loss
reported in the previous 5 years• Net Section 1231 loss is classified as
ordinary loss
Section 1231Disposition of Rental Activities
• Disposition of rental property held for the production of income (investment) yields capital gain or loss• Disposition of rental property used
in a trade or business yields Section 1231 gain or loss
Deprec. Recapture
Section 1245 Recapture
Section 1250 Recapture
Section 1245 Property
Section 1250 Property
Unrecaptured 1250 Gain
Depreciation RecapturePrevents taxpayers from receiving the dual benefits of a depreciation deduction and special Section 1231 gain treatment.Applies to Sec. 1231 gain property onlyRequires gains to be treated as ordinary
to the extent of prior depreciation deductions
Depreciation Recapture-Section 1245• Requires full recapture of all
depreciation–Gains are treated as ordinary
income to the extent of any depreciation taken
• Any gain in excess of depreciation is netted under Section 1231
Depreciation Recapture-Section 1245
• Applies to –Depreciable personal property
and–Nonresidential real estate placed
in service between 1981 and 1986 and depreciated under ACRS
Depreciation Recapture• Depreciation recapture converts part or
all of the gain on the sale of depreciable assets to ordinary income to the extent of the reduction in basis attributable to depreciation expense previously claimed
• The amount of income recaptured as ordinary income can never exceed either the realized gain or prior depreciation deductions
• Recapture rules cannot apply to assets on which there is a realized loss
Section 1245 Full Recapture• Applies to machinery, equipment,
furniture, and fixtures (but not to buildings or structural components)
• Any gain on the sale of section 1245 property is ordinary income to the extent of all depreciation allowed or allowable for the property– Any amount expensed under section 179 is
included in the depreciation allowed– The income recaptured is the lesser of all
depreciation taken or the realized gain
Asset - Section 1245 Machine
Owner Individual
Selling Price $290,000Cost 300,000Accum. Deprec. (S/L) (60,000) Additional Dep. DDB -
Adjusted Basis
Gain
Section 1245 GainSection 1231 gain (CG?)
Asset - Section 1245 Machine
Owner Individual
Selling Price $290,000Cost 300,000Accum. Deprec. (S/L) (60,000) Additional Dep. DDB
Adjusted Basis 240,000
Gain 50,000
Section 1245 Gain 50,000 Section 1231 gain (CG?)
Asset - Section 1245 Machine
Owner Individual
Selling Price $320,000Cost 300,000Accum. Deprec. (S/L) (60,000) Additional Dep. DDB
Adjusted Basis
Gain
Section 1245 GainSection 1231 gain (CG?)
Asset - Sec. 1245 Machine
Owner Individual
Selling Price 320,000$ Cost 300,000Accum. Deprec. (S/L) (60,000) Additional Dep. DDB
Adjusted Basis 240,000
Gain 80,000
Section 1245 Gain 60,000 Section 1231 gain (CG?) 20,000
Asset - Section 1250 Apartment
Owner Individual
Selling Price 250,000$ Cost 300,000Accum. Deprec. (S/L) (80,000) Additional Dep. DDB
Adjusted Basis 220,000
Gain 30,000
Section 1245 GainSection 1250 gain - Section 1231 gain (CG?) 30,000
Unrecaptured 1250 gain
The next slide has an illustration of how the tax law worked for accelerated depreciation on residential real estate. However, only the straight-line method has been allowed for buildings acquired in last 25 years.Buildings bought more than 25 years ago would actually already be fully depreciated by now (shorter life used then).But this shows how it worked.
Asset - Section 1250 Apartment
Owner Individual
Selling Price 250,000$ Cost 300,000Accum. Deprec. (S/L) (80,000) Additional Dep. DDB (40,000)
Adjusted Basis 180,000
Gain 70,000
Section 1245 GainSection 1250 gain 40,000 Section 1231 gain (CG?) 30,000
Depreciation Recapture-Section 1250• Requires partial recapture of
depreciation–Gains are treated as ordinary income
to the extent of depreciation taken in excess of straight-line amount
• Any gain in excess of depreciation is netted under Section 1231
Depreciation Recapture-Section 1250• Applies to depreciable real
property –Not covered by Section 1245 and –Not depreciated using the
straight-line method• Eliminates most MACRS realty
Unrecaptured Section 1250 Gain• Requires that the portion of the gain
attributable to depreciation that is not Section 1250 recapture is taxed at a rate of 25%. • Applies to depreciable real property
sold after 5/7/97.• Any gain not attributable to
depreciation (SP in excess of original cost) is a Section 1231 gain taxed at 15%.
Owner GailAsset Apt BldgSelling Price $390,000Cost $400,000Accum. Dep. (S/L) (60,000) Extra depreciationAdjusted Basis 340,000 Gain 50,000 Section 1245 Gain OrdinarySection 1250 Gain OrdinarySection 1231 gain UnRecap.25%Section 1231 gain Cap. Gain-15%
Owner GailAsset Apt BldgSelling Price $390,000Cost $400,000Accum. Dep. (S/L) (60,000) Extra depreciationAdjusted Basis 340,000 Gain 50,000 Section 1245 Gain Ordinary - Section 1250 Gain Ordinary - Section 1231 gain UnRecap.25% 50,000 Section 1231 gain Cap. Gain-15%
Owner GusAsset Apt BldgSelling Price $410,000Cost $400,000Accum. Dep. (S/L) (60,000) Extra depreciation - Adjusted BasisGainSection 1245 Gain OrdinarySection 1250 Gain OrdinarySection 1231 gain UnRecap.25%Section 1231 gain Cap. Gain-15%
Owner GusAsset Apt BldgSelling Price $410,000Cost $400,000Accum. Dep. (S/L) (60,000) Extra depreciationAdjusted Basis 340,000 Gain 70,000 Section 1245 Gain Ordinary - Section 1250 Gain Ordinary - Section 1231 gain UnRecap.25% 60,000 Section 1231 gain Cap. Gain-15% 10,000
Section 1231 Look-Back Rules • Net Section 1231 gains are taxed as ordinary
income to the extent of any unrecaptured net Section 1231 losses in the five preceding years– This prevents taxpayers from generating tax
savings by bunching their Section 1231 gains into one year (to receive tax-favored long-term capital gains treatment) and losses into alternate years (deducting the Section 1231 losses in full against ordinary income)
Year 1 Year 2 Year 3 Year 4
$50,000 ($45,000) $20,000 $15,000
a.
b.
c.
d. $0 $15,000
(loss)Gain or
How will she treat the $15,000 gain in yr 4?
$10,000 $5,000
$15,000 $0
Section 1250 Lookback Barbara had these Sec. 1231 gains & losses:
Ordinary Income Capital Gain
$5,000 $10,000
Ori
gin
al C
ost
-
$400
,000
Buy, Use and Sell Business Asset$400,000
SL-$50,000
Sel
lin
g P
rice
$4
00
,00
0
Ori
gin
al C
ost
-
$400
,000
$300,000
$400,000
SL-$50,000
Extra-$50,000
Book
Val
ue
$300
,000
Case 1 Case 2Buy Asset Use Asset
Sel
lin
g P
rice
$4
00
,00
0
Selli
ng P
rice
$200
,000
Ori
gin
al C
ost
-
$400
,000
$300,000
$200,000
Book
Val
ue
$300
,000
$100,000
Wash Sales• Wash sale - identical securities acquired
within 30 days before or after the sale date (a 61-day period)–Wash sale losses are disallowed but gains are
taxed– Loss is deferred by adding disallowed loss to
basis of new shares– If more stock is sold than is purchased within
the 61-day period, only a portion of the loss representing the repurchased stock is deferred
Ms. Rich had these transactions in GM Corp. stock.
No. of Total
Date Event Shares Amount
01/02/01 Bought: 4,000 Cost $20,000
12/31/11 Sold: 4,000 Sell. Price $12,000
01/02/12 Bought: 2,000 Cost $6,000
How much loss may she deduct for 2011?
What is the basis of the stock bought in 2011?
3. Calculate the deduction for portfolio investment-related expenses, including investment expenses and investment interest expense.
Note that business expenses are deductible under Section 162, while non-business expenses of earning income are deductible under Sec. 212.
Investment interest is deductible under 163(d). Note the limits.
Sec. 62, and Sec. 67 determine where to take the deductions.
See Page 11-27+ for discussion of Educational Savings Plans
Text H/W no. 78 [LO 4] Mickey & Jenny file a joint tax return. They itemize deductions. They incur $2,000 in employment-related mis. itemized deductions. They also incur $3,000 of investment interest expense. Their income consists of $150,000 in salary, and $2,500 of interest income.•Investment interest expense deduction?•Investment interest expense deduction, if they also had a ($2,000) long-term capital loss?
a. The $3,000 of investment interest expense is deductible to the extent of net investment income. In this problem, investment income and net investment income are $2,500 because there are no investment expenses. Consequently, $2,500 of the investment interest expense is deductible and $500 is carried forward to next year.
b. If the Porters also have a $2,000 long-term capital loss, their net investment income is reduced to $500 (i.e., $2,500 + ($2,000)). Consequently, only $500 of the investment interest expense is deductible and $2,500 is carried over to next year.
4. Understand the distinction between portfolio investments and passive investments.
Tax Shelter Losses Passive Activity Loss
• Passive Activity Loss Rules disallow the deduction of passive activity losses from other forms of income
A passive activity is any trade or business in which the taxpayer does not materially participate.
Types of Income and Losses• Active: salary and wages of an employee
and income earned from a business in which the owner/recipient materially participates
• Portfolio: interest and dividends• Passive: tax shelter income, income
passed through to limited partners, and income from other businesses in which owner/recipient does not materially participate
Passive Activity Loss• Taxpayers subject to the limitations:–All non-corporate taxable entities–Conduit entity passive losses flow-through
to owners• Taxpayers not subject to the limitations:–Publicly held corporations • PAL can offset active and portfolio income
–Closely held corporations• PAL can offset active income, but not portfolio
Passive Activity LossGeneral Rules for Limitations
• Passive activity losses must be netted against passive activity income–Net passive losses are not
deductible–Net passive gains are reported
with other income
Passive Activity LossException for Rental Real Estate
• By definition, all rental activities and limited partnership interests are passive• But, taxpayers who materially
participate in rental real estate business are allowed to offset any losses against other active or portfolio income
Passive Activity LossDisposition of Passive Activities
• Excess (suspended) losses must be accounted for in the year of disposition
• Disposition by sale frees the suspended loss to offset income of any other activity– First, offsets other passive income– Second, offsets gain from disposal– Third, any remaining PAL offsets ordinary income
Disposition of Passive Activities• Disposition upon death leaves the passive
activity in the decedent’s estate– Passive activity with unrealized gain• Beneficiary takes passive activity with stepped-up
basis• Released excess loss is deductible against other
income, but• Any unrealized gain on activity decreases amount
of suspended loss to release
– Passive activity with unrealized loss• No suspended loss is released
5. Apply tax basis, at-risk, and passive activity loss limits
Building bought on 1/1/Yr 1Cost 1/1/Yr-1 $400,000 RentalMort 10% $400,000 Office Annual Deprec. Expense $10,000 BuildingAnnual insurance & exp. $15,000Value 1/1/Yr-1 $400,000Value 12/31/Yr-1 $500,000
Rental income
Per Year
Individual Taxpayer
$60,000
Study the information given on the building on the preceding page. Assume the owner only pays interest on the mortgage.What is gain or loss on sale of the building, if it is sold on 1-1-Yr2, for $500,000?What happens to the taxable loss from Yr 1? We will also consider what happens if the value of the building declines over the period of ownership. You can lose from operations and from selling the property for less than basis.
T/P buys Rental Building on 1-1-Yr-1Cost 1/1/Yr-1 $400,000Mortgage 10% $400,000Value of Build. 1/1/Yr-1 $400,000Value of Build. 12/31/Yr-1 $500,000Rent RevenueDepreciationInterest ExpenseTaxes,insuranceTaxable Income (loss)Economically - Is there a loss?
T/P buys Rental Building on 1-1-08Cost 1/1/Yr-1 $400,000Mortgage 10% $400,000Value of Build. 1/1/Yr-1 $400,000Value of Build. 12/31/Yr-1 $500,000Rent Revenue $60,000Depreciation (10,000)Interest Expense (40,000)Taxes,insurance (15,000)Taxable Income (loss) ($5,000)Really - Is there a loss?
Assume Taxpayer owns the building for exactly 4 years and in each year the income statement looks like the one on the preceding slide.After 4 years (12-31-Yr-4), Taxpayer sells the building for $350,000.Taxpayer has been paying interest only.What is the gain or loss on the building?What happens to 4 years of losses?
Yr-1 Yr-2 Yr-3 Yr-4
Rent Revenue $60,000 $60,000 $60,000 $60,000
Depreciation (10,000) (10,000) (10,000) (10,000)
Interest Expense (40,000) (40,000) (40,000) (40,000)
Taxes, insurance (15,000) (15,000) (15,000) (15,000)
Loss(Suspended) ($5,000) ($5,000) ($5,000) ($5,000)
Building Basis $390,000 $380,000 $370,000 $360,000
What is total cash inflow (after expenses) in 4 years?
T/P Sells Rental Build. on 12-31-Yr-4
Cost 1/1/Yr-1 $400,000
Accum. Deprec. ($40,000)
Book Value 12/31/Yr-4 $360,000
Selling Price $350,000
Loss on Bldg. 12/31/Yr-4 ($10,000)
Operating loss Year - 4 ($5,000)
Suspended Loss Three yrs. ($15,000)
Total loss ($30,000)
T/P Sells Rental Build. on 12-31-Yr-4
Four Year Cash Flow Analysis
Annual revenueSelling price
Cash inflowsInterest ExpenseTaxes, InsuranceCost of property
Cash outflowsExcess outflow
T/P Sells Rental Build. on 12-31-Yr-4
Four Year Cash Flow AnalysisTotal annual revenue $240,000
Selling price $350,000
Cash inflows $590,000
Interest ExpenseTaxes, InsuranceCost of property
Cash outflowsExcess outflow
T/P Sells Rental Build. on 12-31-Yr-4
Four Year Cash Flow AnalysisAnnual revenue $240,000Selling price $350,000
Cash inflows $590,000Interest Expense ($160,000)Taxes, Insurance ($60,000)Cost of property ($400,000)
Cash outflows ($620,000)Excess outflow ($30,000)
Rental Real Estate Relief• Taxpayers can qualify for up to $25,000
deduction for rental real estate losses• Taxpayer must own at least 10% and
actively participate in management–Set rents, qualify renters, approve
repairs• Deduction phases out for AGIs
between $100,000 and $150,000
Bud is single & received wages of $140,000 from IBM in 2010. Bud is a 50% partner in a partnership engaged in a rental real estate activity which generated a $60,000 loss for the partnership. Bud was an active participant in the rental real estate activity. He had no other income. How much of the partnership rental loss may Bud deduct on his 20 income tax return? (Sec. 469(i))a. $0 b. $5,000 c. $15,000 d. $25,000
Bud - Loss from rental activity.
Maximum loss write-off
Threshhold
Phase-out percentage
AGI- above threshhold
Reduction in max loss
Maximum write-off
Bud - Loss from rental activity.
Maximum loss write-off $25,000
Threshhold 100,000
Phase-out percentage 50%
AGI- above threshhold 40,000
Reduction in max loss 20,000
Maximum write-off $5,000
Real PropertyBusiness Exception• Taxpayers must spend more
than half their time in real property businesses in which they materially participate and time spent equals or exceeds 750 hours
A taxpayer has this income (losses) for the current year:Active Income $43,000 Portfolio Income $29,000Passive Income $(27,000)What is the taxpayers taxable income (loss) if:
T/P is single individual & passive income is not from rental?An individual cannot deduct passive losses against active or portfolio income. The individual taxpayer has taxable income of $72,000 ($43,000 + $29,000) and a suspended loss of $27,000.
T/P is single. Passive income results from a rental activity for which the taxpayer qualifies as a real estate professional? A real estate professional can deduct all losses from the activity against active and portfolio income. The taxable income is $45,000 ($43,000 + $29,000 - $27,000).
T/P is a single individual. Passive income results from a rental activity for which the taxpayer fails to qualify as a real estate professional?Individual - active participant in a rental real estate activity - is allowed to deduct up to $25,000 of losses from rental activities against active and portfolio income. The taxable income is $47,000 ($43,000 + $29,000 - $25,000).
Laura owns a commercial office building. She spends more than 500 hours a year managing the building. She also spends 1,700 hours working in her own real estate development firm.
Laura qualifies as a real estate professional. She spends more than 50% of her personal service time in a real property trade or business, the amount of time spent in the real property trade or business is greater than 750 hours, and she materially participates in the rental activity (i.e., spends greater than 500 hours managing the rental activity). Because she qualifies as a real estate professional, office building is not passive activity.
Assume same facts as in preceding slide, except that Laura hires a full-time manager for the commercial office building. She spends 75 hours meeting with manager and reviewing operations.
The office building is a passive activity. Because Laura does not spend more than 500 hours managing the rental property, she does not qualify as a real estate professional.
Sale to Related PartyThe remaining slides cover a topic mentioned on page 11-21, but is covered in Chapter 10.
Sale to Related Party• Losses on sales to related parties are
disallowed– Related parties include brothers, sisters,
spouse, ancestors and lineal descendents, as well as a more-than 50% owned corporation
• If related buyer later sells property at a gain, this gain can be reduced (not below zero) by the seller’s previously disallowed loss
Loss on Sale to Relative - 1In April 2011, Pam sold stock with a cost basis of $17,000, to Lisa, her sister, for $10,000. In September 2011, Lisa sold the same shares of stock to her neighbor, Niki, for $20,000. What is Lisa's gain for 2011?a. $0 b. $3,000 c. $7,000 d. $10,000
Price received by Pam $10,000
Pam's basis in stock 17,000
Loss realized by Pam
Loss Disallowed
on sale by Pam
Loss recognized by Pam
Loss on Sale to Relative - 2
Price received by Pam $10,000
Basis to Pam 17,000
Loss realized by Pam (7,000)
Loss Disallowed
on sale by Pam (7,000)
Loss recognized by Pam $0
Loss on Sale to Relative - 3
Price received by Lisa
Basis to Lisa
Gain realized by Lisa
Less Loss Disallowed
on sale by Pam
Gain recognized by Lisa
Loss on Sale to Relative - 4
Price received by Lisa $20,000
Basis to Lisa 10,000
Gain realized by Lisa 10,000
Less Loss Disallowed
on sale by Pam (7,000)
Gain recognized by Lisa $3,000
Loss on Sale to Relative - 5
The End