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Chapter 11 - Investments

Chapter 11 Investments SOLUTIONS MANUAL


Discussion Questions: 1. [LO 1] Describe how interest income and dividend income are taxed. What are the similarities and differences in their tax treatment? Because they are cash method taxpayers, individual investors typically are taxed on interest and dividends when they receive them. However, interest income is taxed using ordinary rates while qualified dividends are taxed at lower capital gains rates. 2. [LO 1] What is the underlying policy rationale for the current tax rules applicable to interest income and dividend income? Interest and dividends are typically taxed annually when received because taxpayers have the wherewithal to pay the tax at that time. Interest income is taxed at ordinary rates because it is viewed as a less risky type of income compared to other more risky forms of income such as the expected appreciation in capital assets. Qualified dividends are taxed at capital gains rates to mitigate the effect of double taxation on corporate earnings. 3. [LO 1] Compare and contrast the tax treatment of interest from a Treasury bond and qualified dividends from corporate stock. Both the interest from Treasury bonds and dividends are taxed by cash method taxpayers in the year they are received. However, interest is taxed using ordinary rates while qualified dividends are taxed at lower capital gains rates. An additional difference between these types of income relates to their state income tax treatment. The interest from Treasury bonds is exempt from state income taxes while dividends are subject to state income taxes. 4. [LO 1] How are Treasury notes and Treasury bonds treated for federal and state income tax purposes? Generally, interest from Treasury bonds and notes is taxed annually as it is received at ordinary rates for federal income tax purposes. However, interest from Treasury bonds and notes is exempt from state income taxes. Treasury bonds and Treasury notes are issued at maturity value, at a discount, or at a premium, depending on prevailing interest rates. Treasury bonds and Treasury notes pay a stated rate of interest semiannually. When Treasury bonds and notes are either issued or subsequently purchased at either a premium or discount, special rules apply. Specifically, taxpayers may elect to amortize the premium to reduce the amount of interest currently reported. To the extent taxpayers amortize the premium,

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they reduce the tax basis in the related bond or note. If a portion of the premium is unamortized (either because the election to amortize the premium was not made or because the bond is sold prior to maturity), the unamortized premium remains part of the tax basis of the bond or note and affects the amount of capital gain or loss taxpayers recognize when the bond or note is sold or when it matures. Original issue discount must be amortized and included in gross income in addition to any interest payments taxpayers actually receive. Also, the tax basis of a bond or note is increased by the amount of original issue discount amortized into income. In contrast, market discount is not amortized into income unless taxpayers elect to do so. Rather, the market discount that would have been amortized into income (on an annual basis using a straight line method) if the taxpayer had elected to amortize the market discount into income is treated as ordinary income when the bond or note is sold or when it matures. 5. [LO 1] Why would taxpayers generally prefer the tax treatment of market discount to the treatment of original issue discount on corporate bonds? Taxpayers generally would prefer market discount to original issue discount on bonds because the ordinary income related to market discount is deferred until bonds are sold or until they mature. In contrast, taxpayers must report ordinary income from the amortization of original issue discount yearly until the bonds are sold or until they mature. 6. [LO 1] In what ways are U.S. savings bonds treated more favorably for tax purposes than corporate bonds? U.S. Savings Bonds compare favorably with corporate bonds because any interest related to the original issue discount on savings bonds is deferred until the savings bonds are cashed in. In comparison, any original issue discount on corporate bonds must be amortized and included in the investors annual tax returns. Also, interest from savings bonds used to pay for qualifying educational expenses may be excluded entirely from income whereas interest from corporate bonds must eventually be reported. 7. [LO 1] {Research, Planning} When should investors consider making an election to amortize market discount on a bond into income annually? [Hint: see 1278(b)] A taxpayer may elect under 1278(b) to amortize market discount on a bond into income currently (as ordinary income) rather than wait to recognize the accrued market discount as ordinary income when the bond is sold or matures. Generally, this election makes sense when the taxpayers current marginal tax rate is expected to be significantly lower than the future marginal rate when the bond is sold or matures.

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[LO 1] Why might investors purchase interest-paying securities rather than dividendpaying stocks? Non-tax considerations may play a role. For example, investors may be willing to give up the tax rate benefit from receiving qualified dividend income in exchange for the certainty of receiving predicable interest payments. 8. [LO 1] Compare and contrast the tax treatment of dividend-paying stocks and growth stocks. Qualified dividends from dividend paying stocks and long-term capital gains from growth stocks are both taxed at favorable capital gains rates. However, dividends are taxed when received in contrast to the appreciation in growth stocks which is taxed only when growth stocks are sold. 9. [LO 1] Do after-tax rates of return for investments in either interest or dividend paying securities increase with the length of the investment? Why or why not? After-tax rates of return do not increase for interest or dividend paying securities with the length of the investment period because they are both taxed annually. 10. [LO 2] What is the definition of a capital asset? Give three examples of capital assets. In general, a capital asset is any asset other than an asset used in a trade or business (i.e., equipment, buildings, inventory, etc.), or accounts or notes receivable generated from the sale of services or property by a trade or business. Also, any property that is used for personal rather than business purposes is a capital asset. Examples of capital assets include investment assets such as corporate or governmental bonds, corporate stock, stocks in mutual funds, and land held for investment. Personal assets such as automobiles, personal residences, golf clubs, book collections, and televisions are also capital assets. 11. [LO 2] Why does the tax law allow a taxpayer to defer gains accrued on a capital asset until the taxpayer actually sells the asset? Taxpayers are allowed to defer accrued gains on capital assets until the date of sale because the investment doesnt provide the wherewithal (i.e., cash) to pay the tax on the accrued gains until after it is sold. When the taxpayer sells the asset, the investment should provide the cash necessary to pay the taxes due on the gain. 12. [LO 2] Why does the tax law provide preferential rates on certain capital gains? Preferential tax rates apply to gains on the sale of certain capital assets (e.g., capital assets held for more than a year). Among other things, these preferential rates are

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meant to encourage taxpayers to invest in those assets and to hold those assets for the

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long term. The government believes this will help the national economy by stimulating the demand for risky investments. 13. [LO 2] Cameron purchases stock in Corporation X and in Corporation Y. Neither corporation pays dividends. The stocks both earn an identical before-tax rate of return. Cameron sells stock in Corporation X after three years and he sells the stock in Corporation Y after five years. Which investment likely earned a greater after-tax return? Why? The gain from the sale of the Corporation Y stock should earn a greater after-tax return because the tax was deferred for 5 years while the tax on the gain from the sale of Corporation X stock was deferred for 3 years. The longer the tax is deferred, the less it costs on an after-tax basis. The lower the tax cost, the higher the after-tax return, all else equal. 14. [LO 2] What is the deciding factor in determining whether a capital gain is a short-term or long-term capital gain? When a capital asset that has been held for more than a year is sold, it generates a long-term capital gain. When it has been held for a year or less it generates a short term capital gain when sold. 15. [LO 2] What methods may taxpayers use to determine the adjusted basis of stock they have sold? Taxpayers can use the FIFO method to determine basis in the stock. That is, the first stock purchased (i.e., the stock the taxpayer has held for the longest time) is treated as though it is the first stock sold. Taxpayers can also use the specific identification method of determining the basis of the stock sold. 16. [LO 2] What tax rate applies to net short-term capital gains? Net short-term capital gains are taxed at the taxpayers ordinary tax rates. 17. [LO 2] What limitations are placed on the deductibility of capital losses for individual taxpayers? Individual taxpayers with a net capital loss for the year may deduct up to $3,000 of the capital loss against ordinary income. Taxpayers can deduct up to $3,000 ($1,500 if married filing separately) of net capital losses against ordinary income. Net capital losses in excess of $3,000 ($1,500 if married filing separately) retain their short or long-term character and are carried forward. 18. [LO 2] What happens to capital losses that are not deductible in the current year?

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Individual capital losses that are not deducted in the current year are carried forward indefinitely and treated as though they were incurred in the subsequent year. 19. [LO 2] Are all long-term capital gains taxable at the same maximum rate? If not, what rates may apply to long-term capital gains? Long-term capital gains are generally taxed at a 15% maximum rate. However, unrecaptured 1250 gains from the sale of depreciable real estate investments are taxed at a 25% maximum rate, gains from collectibles held for more than one year are taxed at a 28% maximum rate, and recognized gains from the sale of qualified small business stock held for more than five years is taxable at a 28% maximum rate. 20. [LO 2] {Planning} David, a taxpayer currently in the highest tax rate bracket, has the option to purchase either stock in a Fortune 500 company or qualified small business stock in his friends corporation. All else equal, which of the two will he prefer from a tax perspective if he intends to hold the stock for six years? Which would he prefer if he only plans to hold the stock for two years? If David holds the stock in his friends corporation for more than five years, half his gain will be excluded and the other half will be taxed at a maximum 28% rate yielding an effective tax rate of 14% on his gains. In contrast, gains from the sale of stock in the Fortune 500 Company would be taxed at a 15% maximum rate. Thus, David would prefer to purchase stock in his friends corporation if taxes are the only consideration. If the stocks are only held for two years, the stock in his friends corporation would not be treated as qualified small business stock and he would be indifferent, from a tax perspective, between purchasing the two stocks. 21. [LO 2] What is a wash sale? What is the purpose of the wash sale tax rules? A wash sale is a tax term that applies to transactions in which a taxpayer purchases the same stock or substantially identical stock to the stock they sold at a loss within a 61-day period centered on the date of the sale. A wash sale occurs when an investor sells or trades stock or securities at a loss and within 30 days either before or after the day of sale buys substantially identical stocks or securities. Because the day of sale is included, the 30 days before and after period creates a 61-day window during which the wash sale provisions may apply. The purpose of the wash sale tax rules is to prevent taxpayers from accelerating losses on securities that have declined in value without actually changing their investment in the securities. The 61-day period ensures that taxpayers cannot deduct losses from stock sales while essentially continuing their investment in the stock.

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22. [LO 2] Nick does not use his car for business purposes. If he sells his car for less than he paid for it, does he get to deduct the loss for tax purposes? Why or why not? Personal-use of assets fall within the category of capital assets. When a taxpayer sells a personal-use asset, the gain from the sale of the personal-use asset is taxable even though it was not purchased for its appreciation potential. If a taxpayer sells a car for less than he paid for it, the loss from the sale of the personal-use asset is not deductible, and therefore never becomes part of the netting process. Hence losses recognized on assets used for personal purposes are not deductible. However, if Nick sold the car for more than he purchased it, he would be taxed on the capital gain. 23. [LO 2] Describe three basic tax planning strategies available to taxpayers investing in capital assets. When a taxpayer holds capital assets for more than one year before selling, she is actually utilizing two basis strategies. First, she defers recognizing capital gains thereby reducing the present value of the capital gains tax due when the asset is sold. Second, by converting the capital gain into a long-term capital gain, the gain is taxed at a preferential tax rate of 15% instead of her ordinary rate. A third strategy is to sell investments with built-in losses. Selling loss assets reduces taxes by providing up to a $3,000 deduction against ordinary income and by reducing the amount of capital gains that would otherwise be subject to tax during the year. This is particularly beneficial for a taxpayer with short-term capital gains that would be taxed at high ordinary rates absent offsetting capital losses. 24. [LO 2] {Planning} Clark owns stock in BCS Corporation that he purchased in January of the current year. The stock has appreciated significantly during the year. It is now December of the current year, and Clark is deciding whether or not he should sell the stock. What tax and nontax factors should Clark consider before making the decision on whether to sell the stock now? Tax factors: Clark should consider that rate of tax at which the gain will be taxed. If he sells the stock in December of the current year, the gain is a short-term gain that will likely be taxed at his marginal ordinary income rate. If he waits until he has held the stock for more than a year, the gain will likely be taxed at 15%. Clark should also assess his other capital gains and losses incurred during the year. The gain he recognizes on the sale will enter the netting process. Thus, if he has a large short term capital loss, he may want to sell the stock this year to absorb the loss.

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Nontax factors: If Clark decides to hold the stock there is risk that the value will decline. Likewise, the stock may appreciate in value if Clark decides to wait to sell. Clark should assess his risk of loss and appreciation potential of the stock before selling. 25. [LO 2] Under what circumstances would you expect the after-tax return from an investment in a capital asset to approach that of tax-exempt assets assuming equal before-tax rates of return? The after-tax return from capital assets approaches the after-tax return of tax exempt assets (assuming equal pre-tax rates of return) the longer the taxpayer holds the capital asset. The longer the taxpayer holds the capital asset before selling, the less the tax costs in present value terms. In the extreme, a taxpayer who holds an appreciated capital asset until death escapes income tax on the gain entirely. In this circumstance, the pretax and after tax return on the capital assets would be the same just as it is with tax exempt assets. 26. [LO 3] Why does the federal government exempt municipal bond interest from federal income tax? The federal government exempts municipal bond interest income from tax to subsidize state and local governments. The tax benefits associated with municipal bonds allows state and local governments to borrow at lower rates than they would otherwise have to pay. 27. [LO 3] Why do taxpayers have an incentive to purchase municipal bonds from within their own states? The states typically exempt municipal bond interest from bonds issued within the state from state income tax. As a result, taxpayers should prefer to purchase municipal bonds issued by governmental entities within their own state holding other factors constant. 28. [LO 3] What is an implicit tax and how does it affect a taxpayers decision to purchase municipal bonds? The price of tax-advantaged assets like municipal bonds is bid up in competitive markets relative to the price of similar assets, like corporate bonds, without tax advantages. The higher price paid for tax-advantaged assets reduces the rate of return on these assets relative to other similar assets without tax advantages. This difference in rates of return represents an implicit tax on tax-advantaged assets. A taxpayer would have to calculate weather her implicit tax rate is greater than or less than her individual marginal tax rate (explicit rate) before deciding to purchase municipal bonds. If her explicit tax rate exceeds her implicit tax rate on municipal bonds, she will prefer municipal bonds over taxable bonds all else being equal.

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29. [LO 3] How do taxpayers explicit marginal tax rates affect their decision to purchase municipal bonds? When deciding whether to purchase municipal bonds, taxpayers often must compare the rate of return from municipal bonds with the after-tax rate of return from similar taxable bonds. Taxpayers must factor in their own explicit marginal tax rates when computing their after-tax rate of returns for taxable bonds. Taxpayers with low marginal tax rates prefer explicitly taxed investments like corporate bonds because the explicit taxes they actually pay are less than the implicit taxes they avoid on taxfavored assets like municipal bonds. 30. [LO 3] Is there a natural clientele for municipal bonds? Why or why not? Yes there is. Taxpayers with high marginal rates are the natural clientele for municipal bonds. Although they pay implicit taxes due to lower returns on municipal bonds, the explicit taxes they save by avoiding taxable bonds are greater than the implicit taxes they pay. 31. [LO 3] In what sense can life insurance be viewed as an investment? Some life insurance policies allow for a build-up in the cash surrender value of the policy over time. Policy holders are frequently permitted to borrow against the cash surrender value of the policy or may receive the cash surrender value if they choose to terminate the policy. 32. [LO 3] How are life insurance proceeds taxed when paid after the insured individuals death? Life insurance proceeds distributed after the death of the insured individual are tax exempt. 33. [LO 3] How are life insurance proceeds taxed if a policy is cashed out early? In this instance, the policy holder is taxed at ordinary rates on the difference between their investment in the policy and the amount they receive. 34. [LO 3] List the important nontax issues to consider when purchasing life insurance as an investment. Life insurance products, when compared to other investment alternatives, tend to be weighed down by high fees and commissions. In addition, beneficiaries may find it difficult to plan for cashing in their investments if they decide to wait until the insured party dies.

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35. [LO 3] How are state-sponsored 529 educational savings plans taxed if investment returns are used for educational purposes? Are the returns taxed differently if they are not ultimately used to pay for education costs? Investment returns from state sponsored 529 plans are never taxed if used to pay for qualified higher education expenses. If distributed investment returns are used for any other purpose, the distributee will pay tax on the investment returns in the year received at ordinary rates. In many instances, the distributee will also be required to pay an additional 10% penalty tax in addition to the normal tax on the investment returns. 36. [LO 3] {Planning} Why would someone saving for college consider investing in something other than a 529 plan? 529 plans offer a fixed menu of investments choices. An individual saving for education costs with a desire for greater investment options may decide to invest elsewhere. 37. [LO 4] Are dividends and capital gains considered to be investment income for purposes of determining the amount of a taxpayers deductible investment interest expense for the year? Long term capital gains and dividends that qualify for the preferential 15% (or lower) tax rate are not considered to be investment income for purposes of determining the investment interest expense deduction unless the taxpayer makes an election to tax this income at ordinary rates. If the taxpayer makes this election, the dividends and long-term capital gains count as investment income for this purpose. Dividends and capital gains that are not eligible for the preferential rate are included in investment income in determining the deductibility of investment interest expense. 38. [LO 4] How is the amount of net investment income determined for a taxpayer with investment expenses and other noninvestment miscellaneous itemized deductions? Investment expenses and miscellaneous itemized deductions are subject to the 2% of AGI limitation. So, when the two types of expenses are added together, only the amount in excess of 2% of AGI is deductible. The amount in excess of 2% of AGI is first considered to be the investment expenses. If these expenses are fully deductible, the remaining miscellaneous itemized deduction consists of the non-investment expenses. This sequence maximizes the deductibility of the investment expenses. The sequence is unfavorable for the taxpayer because maximizing the deductible investment expenses minimizes net investment income which minimizes the investment interest expense deduction.

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39. [LO 4] What limitations are placed on the deductibility of investment interest expense? What happens to investment interest expense that is not deductible because of the limitations?

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Investment interest expense is deductible, as an itemized deduction, to the extent of net investment income. Net investment income is investment income minus deductible investment expenses. Investment interest expense that is not deductible because of the net investment income limitation is carried forward and treated as though it is incurred in the next year. Unused investment interest expense can be carried forward indefinitely. 40. [LO 4] When taxpayers borrow money to buy municipal bonds, are they allowed to deduct interest expense on the loan? Why or why not? Interest expense incurred on loans used to purchase municipal bonds is not deductible. The interest income from the municipal bonds is not included in income; therefore, the interest expense incurred to produce the tax exempt income is not deductible. 41. [LO 5] What types of losses may potentially be characterized as passive losses? Losses from limited partnerships, and from rental activities, including rental real estate, are generally considered passive losses. In addition, losses from any other activity involving the conduct of a trade or business in which the taxpayer does not materially participate are also treated as passive losses. Material participation is defined as regular, continuous, and substantial. 42. [LO 5] What are the implications of treating losses as passive? Passive losses may not be used to offset in portfolio or active income. Rather, they are suspended until taxpayers have passive income or until the activity producing the passive loss is sold. 43. [LO 5] What tests are applied to determine if losses should be characterized as passive? In general, losses are from trade or business activities are passive unless individuals are material participants in the activity. Regulations provide seven separate tests for material participation, and individuals can be classified as material participants by meeting any one of the seven tests. The seven tests are as follows: 1. The individual participates in the activity more than 500 hours during the year. 2. The individuals activity constitutes substantially all of the participation in such activity by the individuals including non-owners. 3. The individual participates more than 100 hours during the year and the individuals participation is not less than any other individuals participation in the activity.

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4. The activity qualifies as a significant participation activity (more than 100 hours spent during the year) and the aggregate of all significant participation activities is greater than 500 hours for the year. 5. The individual materially participated in the activity for any five of the preceding 10 taxable years. 6. The individual materially participated for any three preceding years in any personal service activity (personal services in health, law, accounting, architecture, etc.) 7. Taking into account all the facts and circumstances, the individual participates on a regular, continuous, and substantial basis during the year. 44. [LO 5] {Planning} All else being equal, would a taxpayer with passive losses rather have wage income or passive income? A taxpayer in this situation would prefer passive income because the taxpayers passive losses could be applied currently against the passive income to reduce the amount of tax paid currently. If the taxpayer had received wage income, the passive losses would have been suspended and the tax benefits associated with the passive losses would be deferred. 45. [LO 1,2,3] {Planning} Laurie is thinking about investing in one or several of the following investment options: Corporate bonds 529 plan Dividend-paying stock Life insurance Savings account Treasury bonds Growth stock a. Assuming all seven options earn similar returns before taxes, rank the Lauries investment options from highest to lowest according to their after-tax returns. b. Which of the investments employ the deferral and/or conversion tax planning strategies? c. How does the time period of the investment affect the returns from these alternatives? d. How do these alternative investments differ in terms of their nontax characteristics?

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Investmen t Corporate Bonds 529 plan 5

Part a AT RoR Rank

Part b Tax planning strategy None Conversion Deferral if proceeds not used for education.

Part c Time period No effect No effect if proceeds used for education. Returns increase with holding period if proceeds not used for education. No effect

1 (used for education)

Part d Nontax characteristics Rate higher than savings but may be more risky. Limited choices of investments. Not asset of student for financial aid purposes.

Dividend Paying Stock Life Insurance

Conversion

1 (if held until death)

Conversion

No effect if policy held until death of insured. Otherwise returns increase with holding period. No effect

Consistent income stream. Equity investment subject to market risk. High commissions and fees.

Savings Account

6 (likely wouldnt earn same return as other investments) 4 (but no state taxes)

None

Safe investment; likely low beforetax return.

Treasury Bonds

None for federal/conversio n for state.

No effect

Safe investment.

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Growth Stock

Deferral and conversion.

Returns increase with holding period.

Typically involves risk; therefore, should diversify.

Problems 46. [LO 1] Annes marginal income tax rate is 30 percent. She purchases a corporate bond for $10,000 and the maturity, or face value, of the bond is $10,000. If the bond pays 5 percent per year before taxes, what is Annes annual after-tax rate of return from the bond if the bond matures in one year? What is her annual after-tax rate of return if the bond matures in 10 years? Annes after-tax rate of return from the corporate bond is 3.5% or 5% x (1-.3). Because interest from the bond is taxed annually and her rate is assumed to be constant, the after-tax rate of return doesnt depend on her investment horizon. Thus, her annual after-tax rate of return remains at 3.5% if the bond matures in ten years. 47. [LO 1] Matt recently deposited $20,000 in a savings account paying a guaranteed interest rate of 4 percent for the next 10 years. If Matt expects his marginal tax rate to be 20 percent for the next 10 years, how much interest will he earn after-tax for the first year of his investment? How much interest will he earn after-tax for the second year of his investment if he withdraws enough cash every year to pay the tax on the interest he earns? How much will he have in the account after four years? How much will he have in the account after seven years? After one year, Matt will have earned $640 or 20,000 x .04(1-.2) after tax. In the second year, Matt will earn $660 after tax or 20,640 x .04(1-.2) after tax. After four years, Matt will have $22,686 or 20,000 x (1 + .04(1-.2))4 in the savings account. After seven years, Matt will have $24,934 or 20,000 x (1 + .04(1-.2))7 in the savings account. 48. [LO 1] Dana intends to invest $30,000 in either a Treasury bond or a corporate bond. The Treasury bond yields 5 percent before tax and the corporate bond yields 6 percent before tax. Assuming Danas federal marginal rate is 25 percent and her marginal state rate is 5 percent which of the two options should she choose? If she were to move to another state where her marginal state rate would be 10 percent, would her choice be any different? Assume that Dana itemizes deductions. When the state rate is 5 percent, Dana would achieve the following returns from the Treasury bond or the corporate bond:

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The Treasury bond yields $1,125 or 30,000 x [.05 x (1-.25)] after tax. The corporate bond yields $1,282.50 or 30,000 x [.06 x (1 - .25 - .05(1-.25))] after tax. Note that the actual state rate is reduced by 25% to allow for the deductibility of state income taxes on the federal income tax return. Thus, she should choose the corporate bond. When the state rate is 10%, Dana would achieve the following returns from the Treasury bond or the corporate bond: The Treasury bond would still yield $1,125 or 30,000 x [.05 x (1-.25)] after tax because state rates dont affect after- tax returns from Treasury bonds. The corporate bond yields $1,215 or 30,000 x [.06 x (1 - .25 - .10(1-.25))] after tax. Again, note that the actual state rate is reduced by 25% to allow for the deductibility of state income taxes on the federal income tax return. If Danas state tax rate increases to 10%, corporate bonds are still superior to Treasury bonds. 49. [LO 1] At the beginning of his current tax year David invests $12,000 in original issue U.S. Treasury bonds with a $10,000 face value that mature in exactly 10 years. David receives $700 in interest ($350 every six months) from the Treasury bonds during the current year and the yield to maturity on the bonds is 5 percent. a. How much interest income will he report this year if he elects to amortize the bond premium? If David elects to amortize the $2,000 bond premium, he will use the constant yield method (similar to the method used to amortize bond premium under GAAP) to amortize the bond premium semiannually. Ultimately, he will report $599 of interest income from the bond. The amortization table below reflects the required calculations: Column 1 Semiannua l Period Column 2 Adjusted Basis of Bond at Beginning of Semiannual Period $12,000 $11,950 Column 3 Interest Received Column 4 Premium Amortization (Column 3 Column 5) $50 $51 $101 Column 5 Reported Interest (Column 2 x . 05 x .5) $300 $299 $599

1 2 Yearly Total

$350 $350 $700

b. How much interest will he report this year if he does not elect to amortize the bond premium?

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If David does not elect to amortize the bond, he will simply report the entire $700 payment he receives as interest income for the year. 50. [LO 1] Seth invested $20,000 in Series EE savings bonds on April 1. By December 31, the published redemption value of the bonds had increased to $20,700. How much interest income will Seth report from the savings bonds in the current year absent any special election? Seth will not report any interest income from the EE savings bonds currently unless he elects to have the increase in redemption value taxed currently. 51. [LO 1] At the beginning of her current tax year, Angela purchased a zero-coupon corporate bond at original issue for $30,000 with a yield to maturity of 6 percent. Given that she will not actually receive any interest payments until the bond matures in 10 years, how much interest income will she report this year assuming annual compounding of interest? Typically, original issue discount must be amortized semiannually for tax purposes using the constant yield method (similar to the approach used to amortize bond discount under GAAP). If, however, the original issue discount (OID) were to be amortized annually Angela would simply report $1,800 of interest from OID or $30,000 x 6%. 52. [LO 1] At the beginning of his current tax year, Eric bought a corporate bond with a maturity value of $50,000 from the secondary market for $45,000. The bond has a stated annual interest rate of 5 percent payable on June 30 and December 31, and it matures in five years on December 31. Absent any special tax elections, how much interest income will Eric report from the bond this year and in the year the bond matures? Accrued market discount on bonds is reported as interest income when the bonds are sold or mature. Therefore, Eric will only report the interest he actually receives or $2,500 [($50,000 x .025) x 2]. In the year the bond matures, he will again report $2,500 of interest income related to the semiannual interest payments received and an additional $5,000 of interest income related to the market discount on the bonds. 53. [LO 1] Hayley recently invested $50,000 in a public utility stock paying a 3 percent annual dividend. If Hayley reinvests the annual dividend she receives net of any taxes owed on the dividend, how much will her investment be worth in four years if the dividends paid are qualified dividends? (Hayleys marginal income tax rate is 28 percent.) What will her investment be worth in four years if the dividends are nonqualified? If Hayley receives qualified dividends, her annual after-tax rate of return will be 2.55% or 3% x (1-.15). On the other hand, if the dividends are nonqualified her

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annual after-tax rate of return will be 2.16% or 3% x (1-.28). As a result, her investment will be worth $55,298 or 50,000 x (1+.0255)4 if the dividends are qualified. Otherwise, her investment will be worth $54,462 or 50,000 x (1+.0216)4. 54. [LO1] {Planning} Five years ago, Kate purchased a dividend-paying stock for $10,000. For all five years, the stock paid an annual dividend of 4 percent before tax and Kates marginal tax rate was 25 percent. Every year Kate reinvested her after-tax dividends in the same stock. For the first two years of her investment, the dividends qualified for the 15 percent capital gains rate; however, for the last three years the 15 percent dividend rate was repealed and dividends were taxed at ordinary rates. a. What is the current value (at the beginning of year 6) of Kates investment assuming the stock has not appreciated in value? The following formula takes into account the change in dividend tax rates in the last three years of Kates investment: $10,000 (1+ (.04 (1-.15))) 2 (1+ (.04 (1-.25))) 3 = $11,683 b. What will Kates investment be worth three years from now (at the beginning of year 9) assuming her marginal tax rate increases to 35 percent for the next three years? $11,683 (1+ (.04 (1-.35))) 3 = $12,618 55. [LO 2] John bought 1,000 shares of Intel stock on October 18, 2007 for $30 per share plus a $750 commission he paid to his broker. On December 12, 2010, he sells the shares for $42.50 per share. He also incurs a $1,000 fee for this transaction. a. What is Johns adjusted basis in the 1,000 shares of Intel stock? Johns basis in the 1,000 shares of Intel stock is $30,750. This is the purchase price of $30,000 (i.e., 30 x $1,000) plus the $750 commission paid to the broker. b. What amount does John realize when he sells the 1,000 shares? On the sale, John realizes $41,500. This is the sales price of $42,500 (i.e., 1,000 x $42.50) minus the transaction fee of $1,000. c. What is the gain/loss for John on the sale of his Intel stock? What is the character of the gain/loss?

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Johns gain on the sale is $10,750 which is the amount realized minus his adjusted basis (i.e., $41,500 30,750). The gain is a long-term capital gain because John held the stock for more than a year before selling. 56. [LO 2] Dahlia is in the 28 percent tax rate bracket and has purchased the following shares of Microsoft common stock over the years: Microsoft common stock Date Purchased Shares 7/10/2002 400 4/20/2003 300 1/29/2004 500 11/02/2006 250 Basis $12,000 $10,750 $12,230 $7,300

If Dahlia sells 800 shares of Microsoft for $40,000 on December 20, 2010, what is her capital gain or loss in each of the following assumptions? a. She uses the FIFO method. Under the FIFO method, the first 400 shares sold have a $12,000 basis, the next 300 have a $10,750 basis, and the last 100 shares have a basis of $2,446 (100/500 X $12,230) for a total basis of $25,196. The resulting capital gain would be $40,000 less the $25,196 tax basis of the shares sold or $14,804. b. She uses the specific identification method and she wants to minimize her current year capital gain. The shares purchased in 2002 cost $30 per share, the shares purchased in 2003 cost $35.83 per share, the shares purchased in 2004 cost $24.46 per share, and the shares purchased in 2006 cost $29.20 per share. To minimize her capital gain, Dahlia should specifically identify the 300 shares purchased in 2003, then the 400 shares purchased in 2002 and then 100 of the shares purchased in 2006. Under the specific identification method, the 300 shares purchased in 2003 have a $10,750 basis, the 400 shares purchased in 2002 have a $12,000 basis, and the 100 shares purchased in 2006 have a basis of $2,920 (100/250 X $7,300) for a total basis of $25,670. The resulting capital gain would be the $40,000 sales proceeds less the $25,670 tax basis of the shares sold or $14,330. 57. [LO 2] {Research} Karyn loaned $20,000 to her co-worker to begin a new business several years ago. If her co-worker declares bankruptcy on June 22nd of the current year, is Karyn allowed to deduct the bad debt loss this year? If she can deduct the loss, what is the character of the loss?

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Chapter 11 - Investments

According to IRC Section 166 and Publication 550, taxpayers may deduct nonbusiness bad debts in the year the amount of the loss can be determined. Because Karyn will not be able to measure her actual loss until the bankruptcy process is complete, she must wait until to deduct her loss until she knows with certainty the amount of her loss. 58. [LO 2] Sue has 5,000 shares of Sony stock that has an adjusted basis of $27,500. She sold the 5,000 shares of stock for cash of $10,000, and she also received a piece of land as part of the proceeds. The land was valued at $20,000 and had an adjusted basis to the buyer of $12,000. What is Sues gain or loss on the sale of 5,000 shares of Sony stock? Sues gain on the sale is $2,500 which is the amount realized of $30,000 ($10,000+ $20,000) less her adjusted basis of $27,500. Note that the value of the land is included in her amount realized along with the cash she received. 59. [LO 2] Matt and Meg Comer are married. They do not have any children. Matt works as a history professor at a local university and earns a salary of $52,000. Meg works part-time at the same university. She earns $21,000 a year. The couple does not itemize deductions. Other than salary, the Comers only other source of income is from the disposition of various capital assets (mostly stocks). a. What is the Comers tax liability for 2010 if they report the following capital gains and losses for the year? Short-term capital gains $7,000 Short-term capital losses ($2,000) Long-term capital gains $15,000 Long-term capital losses ($6,000) Salary $73,000 Net short-term capital gain 5,000 Net long-term capital gain 9,000 AGI $87,000 Standard deduction (11,400) Personal exemption (7,300) Taxable income $68,300 Less preferentially taxed income (9,000) Income taxed at ordinary rates $59,300 tax $1,675 + $6,382.50 = $8,057.50 Income subject to capital gains rates 9,000 tax ($8,700 x 0%) + ($300 x 15%) = $0 + $45 = $45 Total tax liability = $8,057.50 + $45 = $8,102.50

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Chapter 11 - Investments

b. What is the Comers tax liability for 2010 if they report the following capital gains and losses for the year? Short-term capital gains Short-term capital losses Long-term capital gains Long-term capital losses Short-term capital gains Short-term capital losses Net short-term capital gain $1,500 $0 $15,000 ($10,000) $1,500 $0 $1,500

Long-term capital gains $15,000 Long-term capital losses ($10,000) Net long-term capital gains $5,000 Salary $73,000 Long-term capital gains 5,000 Short-term capital gains 1,500 AGI $79,500 Standard deduction (11,400) Personal exemption (7,300) Taxable income $60,800 Less preferentially taxed income (5,000) Income taxed at ordinary rates $55,800 tax $1,675 + $5,857.50= $7,532.50 Income subject to capital gains rates 5,000 tax ($5,000 x 0%) = $0 Total tax liability = $7,532.50 + $0 = $7,32.50 60. [LO 2] Grayson is in the 25 percent tax rate bracket and has the sold the following stocks in 2009: Stock A Stock B Stock C Stock D Stock E Date Purchased 1/23/1986 4/10/2010 8/23/2008 5/19/2000 8/20/2010 Basis $7,250 $14,000 $10,750 $5,230 $7,300 Date Sold 7/22/2010 9/13/2010 10/12/2010 10/12/2010 11/14/2010 Amount Realized $4,500 $17,500 $15,300 $12,400 $3,500

a. What is Graysons net short-term capital gain or loss from these transactions?

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Chapter 11 - Investments

Graysons net short-term capital loss is $300, which is the net of the shortterm gains and losses for the year. This $300 loss is the short-term capital gain of $3,500 from Stock B (i.e. $17,500 14,000) less the short-term capital loss of $3,800 from Stock E (i.e. $3,500 7,300). b. What is Graysons net long-term gain or loss from these transactions? Graysons net long-term capital gain is $8,970, which is the net long-term gain less the long-term loss for the year. This is the net of the long-term capital gain of $11,720 (i.e. $4,550 from Stock C ($15,300 10,750) and $7,170 from Stock D ($12,400 5,230)) less the long-term capital loss of $2,750 from Stock A ($4,500 7,250). c. What is Graysons overall net gain or loss from these transactions? Graysons net capital gain is $8,670, which is the net short-term loss offset against the net long-term capital gain for the year because the signs are opposite. This $300 short-term capital loss (from part a) is netted against the $8,970 net long-term capital loss (from part b). d. What amount of the gain, if any, is subject to the preferential rate for certain capital gains? Graysons entire net capital gain of $8,670 will be taxed at the preferential rate. 61. [LO 2] George bought the following amounts of Stock A over the years: Stock A Stock A Stock A Date Purchased 11/21/1986 3/18/1992 5/22/2001 Number of Shares 1,000 500 750 Adjusted Basis $24,000 $9,000 $27,000

On October 12, 2010, he sold 1,200 of his shares of Stock A for $38 per share. a. How much gain/loss will George have to recognize if he uses the FIFO method of accounting for the shares sold? George will recognize $18,000 of long-term capital gain. This is the amount realized of $45,600 (i.e. $38 per shares multiplied by 1,200 shares) less the adjusted basis of $27,600. The adjusted basis is calculated under the FIFO method. This means the 1,200 shares sold were the first 1,200 purchased. Therefore the 1,200 sold were the 1,000 shares purchased on 11/21/1986 (basis of $24,000) and 200 of the shares purchased on 3/18/1992 (basis of $3,600 or $9,000 total basis divided by 500 shares purchased multiplied by the 200 shares sold).

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Chapter 11 - Investments

b. How much gain/loss will George have to recognize if he specifically identifies the shares to be sold by telling his broker to sell all 750 shares from the 5/22/2001 purchase and 450 shares from the 11/21/1986 purchase? Georges long-term capital gain is $7,800. This is the amount realized of $45,600 (i.e. $38 per shares multiplied by 1,200 shares) less the adjusted basis of $37,800. The adjusted basis is calculated under the specific identification method. George identified that the shares sold were the 750 purchased on 5/22/2001 (basis of $27,000) and 450 of the shares purchased on 11/21/1986 (basis of $10,800 or $24,000 total basis divided by 1,000 shares purchased multiplied by the 450 shares sold). 62. [LO 2] During the current year, Ron and Anne sold the following assets: Capital Market Tax Holding Period Asset Value Basis L stock $50,000 $41,000 > 1 year M stock 28,000 39,000 > 1 year N stock 30,000 22,000 < 1 year O stock 26,000 33,000 < 1 year Antiques 7,000 4,000 > 1 year Rental home 300,000* 90,000 > 1 year *$30,000 of the gain is 25 percent gain (from accumulated depreciation on the property). a. Given that Ron and Anne have taxable income of only $20,000 (all ordinary) before considering the tax effect of their asset sales, what is their gross tax liability for 2010 assuming they file a joint return? Ron and Annes netting process is reflected in the following table: Description Stock N Stock O Step 1: Antiques ShortTerm $8,000 $(7,000 ) $1,0 00 $3,000 $3,000 Long-term Overall LongTerm 28% LongTerm 25% LongTerm 15%

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Chapter 11 - Investments

Unrecaptured 1250 Gain Remaining Gain from Rental Property Stock L Stock B Step 2: Steps 4 and 5: Step 6: N/A Step 7 Step 8 Summary

$30,000 $180,000

$30,000 $180,000

$9,000 $(11,000) $211,000 $3,000 $1,000 $3,000 $30,000 $30,000

$9,000 $(11,000) $178,000

$178,000

Ron and Annes ordinary income will increase from $20,000 to $21,000 due to their $1,000 net short-term capital gain. Ron and Annes gross tax liability of $31,862.50 is computed as follows: Amount and Type of Income $16,750; ordinary Applicabl e Rate 10% Tax Explanation

$4,250; ordinary

15%

$1,675 $16,750 x 10% The first $16,750 of Ron and Annes $21,000 of ordinary income is taxed at 10% (see MFJ tax rate schedule for this and other computations). $637.50 $4,250 x 15%. Ron and Annes remaining $4,250 of ordinary income (21,000 16,750) is taxed at 15%.

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Chapter 11 - Investments

$30,000; 25% rate capital gain $3,000 28% rate capital gains $14,000; 15% rate capital gains

15%

$4,500 30,000 x 15%

15%

$450 $3,000 x 15%

0%

$164,000

15%

Gross tax liability

$14,000 x 0% $0 $14,000 ($68,000 - $21,000 ordinary income - $30,000 25% capital gain - $3,000 28% capital gain) of 15% rate capital gain fits into the remaining 15% bracket so it is taxed at 0%. $24,600 $164,000 x 15% All of the remaining $164,000 ($178,000 - $14,000) of 15% capital gain is in an ordinary income bracket greater than 15% so it is all taxed at 15%. $31,862.5 0

b. Given that Ron and Anne have taxable income of $150,000 (all ordinary) before considering the tax effect of their asset sales, what is their gross tax liability for 2010 assuming they file a joint return? The netting process used to determine Ron and Annes gross tax liability for the year is unchanged from the process used in part a. Ron and Annes ordinary income will increase from $150,000 to $151,000 due to their $1,000 net short-term capital gain. Ron and Annes gross tax liability of $65,563.50 is computed as follows:

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Chapter 11 - Investments

Amount and Type of Income $16,750; ordinary

Applicabl e Rate 10%

Tax

Explanation

$51,250; ordinary

15%

$69,300; ordinary

25%

$13,700; ordinary

28%

$1,675 $16,750 x 10% The first $16,750 of Ron and Annes $151,000 of ordinary income is taxed at 10% (see MFJ tax rate schedule for this and other computations). $7,687.50 $51,250 x 15%. The next $51,250 of Ron and Annes $151,000 of ordinary income is taxed at 15%. $17,325 69,300 x 25% The next $69,300 of Ron and Annes $151,000 of ordinary income is taxed at 25%. $3,836 $13,700 x 28% $13,700 ($151,000 - $137,300) taxed in 28% ordinary income bracket. $840 $3,000 x 28%

$3,000; 28% rate capital gains $30,000; 25% rate capital gains $178,000; 15% rate capital gains Gross tax liability

28%

25%

$7,500 $30,000 x 25%

15%

$26,700 $178,000 x 15%

$65,563.5 0

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Chapter 11 - Investments

63. [LO 2] During the current year, Ken and Marie sold the following assets: Capital Market Tax Holding Period Asset Value Basis R stock $34,000 $48,000 > 1 year S stock 18,000 27,000 > 1 year T stock 33,000 31,000 < 1 year U stock 17,000 18,000 < 1 year Stamp > 1 year Collection 8,000 11,000 Rental home 350,000* 90,000 > 1 year *$70,000 of the gain is 25 percent gain (from accumulated depreciation on the property). a. Given that Ken and Marie have taxable income of only $30,000 (all ordinary) before considering the tax effect of their asset sales, what is their gross tax liability for 2010 assuming they file a joint return? Ken and Maries netting process is reflected in the following table: Description Stock T Stock U Step 1: Stamps Unrecaptured 1250 Gain Remaining Gain from Rental Property Stock R Stock S Step 2: $(14,000) $(9,000) $234,000 $(14,000) $(9,000) ShortTerm $2,000 $(1,000 ) $1,0 00 $(3,000) $70,000 $190,000 $(3,000) $70,000 $190,000 Long-term Overall LongTerm 28% LongTerm 25% LongTerm 15%

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Chapter 11 - Investments

Steps 4 and 5: Step 6: Step 7 Step 8 Summary

$167,000 $(3,000) $1,000 $(3,000) $67,000 $67,000

$167,000

Ken and Maries ordinary income will increase from $30,000 to $31,000 due to their $1,000 net short-term capital gain. Their gross tax liability of $41,912.50 is computed as follows: Amount and Type of Income $16,750; ordinary Applicabl e Rate 10% Tax Explanation

$14,250; ordinary

15%

$37,000; 25% rate capital gain $30,000 25% rate capital gains $167,000; 15% rate capital gains Gross tax liability

15%

25%

15%

$1,675 $16,750 x 10% The first $16,750 of Ken and Maries $31,000 of ordinary income is taxed at 10% (see MFJ tax rate schedule for this and other computations). $2,137.50 $14,250 x 15%. Ken and Maries remaining $14,250 of ordinary income (31,000 16,750) is taxed at 15%. $5,550 $37,000 x 15% $37,000 ($68,000 - $31,000 ordinary income) of 25% rate capital gain fits into 15% ordinary bracket $7,500 $30,000 x 25% $30,000 ($67,000 25% rate gain $37,000 25% rate gain already taxed in 15% ordinary bracket) taxed in 25% bracket. $25,050 $167,000 x 15%

$41,912.5 0

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Chapter 11 - Investments

b. Given that Ken and Marie have taxable income of $120,000 (all ordinary) before considering the tax effect of their asset sales, what is their gross tax liability for 2010 assuming they file a joint return? The netting process used to determine Ken and Maries gross tax liability for the year is unchanged from the process used in part a. Ken and Maries ordinary income will increase from $120,000 to $121,000 due to their $1,000 net short-term capital gain. Their gross tax liability of $64,412.50 is computed as follows: Amount and Type of Income $16,750; ordinary Applicabl e Rate 10% Tax Explanation

$51,250; ordinary

15%

$53,000; ordinary

25%

$67,000; 25% rate capital gains $167,000; 15% rate capital gains Gross tax liability

25%

$1,675 $16,750 x 10% The first $16,750 of their $121,000 of ordinary income is taxed at 10% (see MFJ tax rate schedule for this and other computations). $7,687.50 $51,250 x 15%. The next $51,250 of their $121,000 of ordinary income is taxed at 15%. $13,250 53,000 x 25% The remaining $53,000 ($121,000 - $51,250 taxed at 15% - $16,750 taxed at 10%) of their $121,000 of ordinary income is taxed at 25%. $16,750 $67,000 x 25%

15%

$25,050 $167,000 x 15%

$64,412.5 0

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Chapter 11 - Investments

64.

[LO 2] In 2009, Tom and Amanda Jackson (married filing jointly) have $200,000 of taxable income before considering the following events: On May 12, 2010, they sold a painting (art) for $110,000 that was inherited from Grandma on July 23, 2008. The fair market value on the date of Grandma's death was $90,000 and Grandma's adjusted basis of the painting was $25,000. Applied a long-term capital loss carryover from 2009 of $10,000. Recognized a $12,000 loss on 11/1/10 sale of bonds (acquired on 5/12/01). Recognized a $4,000 gain on 12/12/10 sale of IBM stock (acquired on 2/5/10). Recognized a $17,000 gain on the 10/17/10 sale of rental property (the only 1231 transaction) of which $8,000 is reportable as gain subject to the 25 percent maximum rate and the remaining $9,000 is subject to the 15 percent maximum rate (the property was acquired on 8/2/04). Recognized a $12,000 loss on 12/20/10 sale of bonds (acquired on 1/18/10). Recognized a $7,000 gain on 6/27/10 sale of BH stock (acquired on 7/30/02). Recognized an $11,000 loss on 6/13/10 sale of QuikCo stock (acquired on 3/20/03).

Received $500 of qualified dividends on 7/15/10. Complete the required capital gains netting procedures and calculate the Jacksons 2010 tax liability. ST (d) 4,000 (f) (12,000) 28% (a) 20,000 LT 25% (e) 8,000 15% (c) (12,000) (e) 9,000 (g) 7,000 (h) (11,000) ($7,000) 7,000 $ 0 $ -0$ 0

(8,000) (8,000) 8,000 $-0$ 0 2010 Taxable Income: TI b/4 $200,000 Qual. Dividend 500

$20,000 (7,000) $13,000 (8,000) $ 5,000 (b) (5,000) $ 0

$8,000 $8,000 $ 8,000 (b) (5,000) $3,000

2010 Tax Liability: OI: 28% x ($200,000-137,300) $17,556 +26,687.50 44,243.50 CG: + 25% x $3,000 750 Div: + 15% x $500 75 Total tax liability $45,068.50
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Chapter 11 - Investments

LTCG 25% Taxable Inc 65.

3,000 $203,500

[LO 2] For 2010, Sherri has a short-term loss of $2,500 and a long-term loss of $4,750. a. How much loss can Sherri deduct in 2010? Sherri has a $2,500 short-term capital loss and a $4,750 long-term capital loss. Because both are losses they cannot be netted. Individual taxpayers can offset $3,000 of capital loss against ordinary income, with short-term losses being offset first. b. How much loss will Sherri carryover to 2011 and what is the character of the loss carryover? Individual taxpayers can offset $3,000 of capital loss against ordinary income, with short-term losses being offset first. Therefore, Sherri can deduct the $2,500 short-term capital loss and $500 of the long-term capital loss in 2009. The remaining $4,250 of the long-term capital loss (i.e. $4,750 less the $500 deducted currently) is carried forward indefinitely. 66. [LO 2] Jermaine has the following losses during the current year: Loss Short-term capital loss Long-term capital loss Amount ($10,000) ($25,000)

How much capital loss can Jermaine deduct this year against his ordinary income? Jermaine can offset $3,000 of capital losses against ordinary income, with shortterm losses being offset first. Therefore, Jermaine can deduct $3,000 of the shortterm capital loss. The remaining $7,000 of the short-term capital loss (i.e. $10,000 less the $3,000 deducted currently) and the $25,000 long-term capital loss are carried forward indefinitely. 67. [LO 2] Three years ago, Adrian purchased 100 shares of stock in X Corp. for $10,000. On December 30 of year 4, Adrian sells the 100 shares for $6,000. a. Assuming Adrian has no other capital gains or losses, how much of the loss is Adrian able to deduct on her year 4 tax return? Adrian has a $4,000 long-term capital loss. She can offset $3,000 of the capital loss against ordinary income. The remaining $1,000 of the capital loss (i.e. $4,000 less the $3,000 deducted currently) is carried forward indefinitely.

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Chapter 11 - Investments

b. Assume the same facts as in part a, except that on January 20 of year 5, Adrian purchases 100 shares of X Corp. stock for $6,000. How much loss from the sale on December 30 of year 4 is deductible on Adrians year 4 tax return? What basis does Adrian take in the stock purchased on January 20 of year 5? Adrian has a realized $4,000 long-term capital loss on the sale of the 100 shares. However, she has purchased substantially identical stock within the 61 day period (30 days before the sale until 30 days after the sale); therefore, her loss is limited by the wash sale rules. Since Adrian purchased 100 shares the loss is not currently recognized. The loss is added to the basis of the new shares purchased. Thus, the basis of the 100 new shares of stock is $10,000 (i.e. the $6,000 purchase price plus the unrecognized loss of $4,000). 68. [LO 2] Christopher sold 100 shares of Cisco stock for $5,500 in the current year. He purchased the shares several years ago for $2,200. Assuming his marginal ordinary income tax rate is 28 percent, and he has no other capital gains or losses, how much tax will he pay on this gain? Christophers long-term capital gain is $3,300 ($5,500 amount realized less his $2,200 tax basis). Since Christophers marginal rate on ordinary income is above 15% his long-term capital gains rate must be 15%. Therefore, he will pay 15% of $3,300 or $495 in capital gains tax. 69. [LO 2] Christina, who is single, purchased 100 shares of Apple Inc. stock several years ago for $3,500. During her year-end tax planning, she decided to sell 50 shares of Apple for $1,500 on December 30. However, two weeks later, Apple introduced the iPhone, and she decided that she should buy the 50 shares (cost of $1,600) of Apple back before prices skyrocket. a. What is Christinas deductible loss on the sale of 50 shares? What is her basis in the 50 new shares? Christina has engaged in a wash sale because she bought identical stock within 30 days of selling Apple stock. Therefore, her $250 ($1,500 less $1,750) loss is disallowed. The basis of Christinas 50 shares of new Apple stock is $1,850 ($1,600 purchase price plus $250 of disallowed loss). b. Assume the same facts, except that Christina repurchased only 25 shares for $800. What is Christinas deductible loss on the sale of 50 shares? What is her basis in the 25 new shares? Christina has engaged in a partial wash sale because she bought 25 shares of identical stock within 30 days of selling Apple stock. Therefore, she may deduct $125 or 50% of her $250 ($1,750 less $1,500) loss; the remaining

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Chapter 11 - Investments

$125 is disallowed. The basis of Christinas 25 shares of new stock is $925 ($800 purchase price plus $125 of disallowed loss). 70. [LO 2] {Research}Arden purchased 300 shares of AMC common stock several years ago for $1,500. On April 30, Arden sold the shares of AMC common for $500 and then purchased 250 shares of AMC preferred stock two days later for $700. The AMC preferred stock is not convertible into AMC common stock. What is Ardens deductible loss from the sale of the 300 shares of AMC common stock? Section 1.1233-1(d) of the Income Tax Regulations indicates that common and preferred stock of the same company are not considered "substantially identical property" for purposes of applying the wash sale rules as long as the preferred stock is not convertible into common stock. Thus, Arden may deduct $1,000 dollars of loss from the sale of the AMC stock in the current year. 71. [LO 2] {Planning} Shaun bought 300 shares of Dental Equipment, Inc. several years ago for $10,000. Currently the stock is worth $8,000. Shauns marginal tax rate this year is 25 percent, and he has no other capital gains or losses. Shaun expects to have a marginal rate of 30 percent next year, but also expects to have a long-term capital gain of $10,000. To minimize taxes, should Shaun sell the stock on December 31 of this year or January 1 of next year (ignore the time value of money)? If Shaun sells the stock in the current year, he may deduct his $2,000 capital loss against his ordinary income. Given that his tax rate in the current year is 25 percent, this will produce a tax benefit of 25 percent of $2,000 or $500. On the other hand, if he waits until the following year to recognize the $2,000 capital loss, he must apply the loss against his $10,000 long-term capital gains taxed at a 15 percent rate. If he waits, his loss would produce a tax benefit of only 15 percent of $2,000 or $300. Therefore, Shaun should sell his stock in the current year. 72. [LO 2] {Planning} Irene is saving for a new car she hopes to purchase either four or six years from now. Irene invests $10,000 in a growth stock that does not pay dividends and expects a 6 percent annual before-tax return (the investment is tax deferred). When she cashes in the investment after either four or six years, she expects the applicable marginal tax rate on long-term capital gains to be 25 percent. a. What will be the value of this investment four and six years from now? Her investment will be worth $12,625 or 10,000 X (1+.06)4 after 4 years; and $14,185 or 10,000 X (1+.06)6 after 6 years. b. When Irene sells the investment, how much cash will she have after taxes to purchase the new car (four and six years from now)? After 4 years, Irene will pay taxes of 25 percent on her investment returns of $2,625 leaving her with investment returns after taxes of $1,969 or [(1-.25) X

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Chapter 11 - Investments

$2,625]. This, combined with her original $10,000 investment, will leave her with $11,969 to purchase the car. After 6 years, Irene will pay taxes of 25 percent on her investment returns of $4,185 leaving her with investment returns after taxes of $3,139 or [(1-.25) X $4,185]. This, combined with her original $10,000 investment, will leave her with $13,139 to purchase the car. 73. [LO2] {Planning} Komiko Tanaka invests $12,000 in LymaBean, Inc. LymaBean does not pay any dividends. Komiko projects that her investment will generate a 10 percent before-tax rate of return. She plans to invest for the long term. a. How much cash will Komiko retain, after-taxes, if she holds the investment for 5 years and then she sells it when the long-term capital gains rate is 15 percent? $12,000 * (1.10)5 = $19,326 amount received (12,000) basis in stock $7,326 long-term capital gain x 15 percent = 1,099 tax on gain Cash retained = $19,326 1,099 taxes = $18,227 b. What is Komikos after-tax rate of return on her investment in part (a)? ($18,227/12,000)1/5 1 = 8.7 percent c. How much cash will Komiko retain, after-taxes, if she holds the investment for 5 years and then sells when the long-term capital gains rate is 25 percent? $12,000 * (1.10)5 = $19,326 amount received (12,000) basis in stock $7,326 long-term capital gain x 25 percent = $1,832 tax on gain

Cash retained = $19,326 1,832 taxes = $17,494 d. What is Komikos after-tax rate of return on her investment in part (c)? ($17,494/12,000)1/5 1 = 7.83 percent e. How much cash will Komiko retain, after taxes, if she holds the investment for 15 years and then she sells when the long-term capital gains rate is 15 percent?

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Chapter 11 - Investments

$12,000 * (1.10)15 = $50,127 amount received (12,000) basis in stock $38,127 long-term capital gain x 15% = $5,719 tax on gain Cash retained = $50,127 5,719 taxes = $44,408 f. What is Komikos after-tax rate of return on her investment in part (e)? ($44,408/12,000)1/15 1 = 9.11 percent 74. [LO 2] {Research} Becky recently discovered some high-tech cooking technology that has advantages over microwave and traditional ovens. She received a patent on the technology that gives her exclusive rights to the technology for 20 years. Becky would prefer to retain the patent, but she doesnt want to deal with the manufacturing and marketing of the technology. She was able to reach a compromise. A little over a year after she secured the patent, Becky signed a contract with DEF Company giving DEF control to manufacture and market the technology. In exchange, Becky is to receive a royalty based on the sales of the technology. For tax purposes, Becky is not sure how to treat her arrangement with DEF. If the exchange with DEF is treated as a sale, she will recognize long-term capital gain because the patent is a capital asset held for more than a year. If the exchange is not treated as a sale, Becky will recognize ordinary income as she receives the royalties. (Hint: IRC 1235 and http://www.aicpa.org/Pages/Default.aspx) a. Is it possible for Becky to treat the exchange with DEF as a sale even though she never relinquishes actual title of the patent? If so, what requirements must she meet to treat the contract as a sale for tax purposes? Section 1235 allows certain contracts outlining an exchange to be treated as sales if the exchange meets following two criteria: (1) The exchange results in a transfer of property consisting of all substantial rights to a patent, and (2) the transferor is a holder of the patent. The first criteria (all substantial rights to a patent) require the transferor (i.e., Becky) to permanently give up all rights to control creation of income from the patent. The transferees (DEF) control cannot be limited geographically or by industry. Also the rights cannot be for a shorter period than the life of the patent.

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The second criterion requires the taxpayer to be an individual or a partner in a partnership. This restricts corporations from getting the beneficial sales treatment of the patent. In this case, Becky would qualify for capital gain treatment on the exchange with DEF. Thus, she would be taxed on the gain from the exchange at the preferential capital gains rates instead of the ordinary income rates applicable to royalty income. b. Does your answer to the question above change if Beckys contract with DEF gave DEF Company control over the income from the patent for the next 10 years of the patents remaining 19-year life? In this case, Becky would not meet the first criteria to qualify for sale treatment because she no longer transferred all substantial rights to the patent to DEF. Consequently, she would be required to treat the royalties as ordinary income rather than long-term capital gain. 75. [LO 3] {Planning} The Johnsons recently decided to invest in municipal bonds because their marginal tax rate is 40 percent. The return on municipal bonds is currently 3.5 percent and the return on similar taxable bonds is 5 percent. Compare the after-tax returns of the municipal and taxable bonds. a. Which type of bond should the Johnsons select?

Assuming the Johnsons marginal rate is 40 percent, their after-tax rate of return from taxable bonds would be 3 percent or 5 percent x (1-.40). Because this is less than the 3.5 percent rate of return from municipal bonds, they should purchase municipal bonds. b. What type of bond should the Johnsons select if their marginal tax rate was 20 percent? If the Johnsons marginal rate is 20 percent the after-tax rate of return from taxable bonds would be 4 percent or 5 percent x (1-.20). Under this assumption, the Johnsons should buy taxable bonds. c. At what marginal tax rate would the Johnsons be indifferent between investing in either taxable or municipal bonds? To discover the marginal tax rate at which the neighbors would be indifferent between investing in either type of bond, solve the following equation for t: 5 percent x (1-t) = 3.5 percent. It turns out that t equals 30 percent. In other words, the after-tax rates of return for both bonds are equal if the Johnsons have a marginal tax rate of 30 percent.

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76. [LO 3] Lynette VanWagoner purchased a life insurance policy to insure her mother Idon. Idon is currently 64. Insurance companies predict that women in her condition will live, on average, to be 81 years old. Lynette makes a one-time payment of $100,000 to purchase a life insurance policy on Idons life. The policy provides for a $1,000,000 death benefit and a cash surrender value equal to the original $100,000 premium plus a 7 percent annual rate of return on the premium. a. years? How much will Lynette receive after taxes if Idon dies in 14

If Lynette receives the life insurance proceeds after Idons death, she will receive $1,000,000 after taxes without regard to the number of years Idon lives after the policy is purchased because death benefits from life insurance policies are tax free. b. years? How much will Lynette receive after taxes if Idon dies in seven

Again, if Lynette receives the life insurance proceeds after Idons death, she will receive $1,000,000 after taxes without regard to the number of years Idon lives after the policy is purchased because death benefits from life insurance policies are tax free. c. How much will Lynette receive after taxes if Lynette decides to cash in the policy after four years when Idon is still living and Lynettes marginal tax rate is 28 percent? If Lynette decides to cash in the policy four years after purchasing it, she will receive $131,080 or 100,000 x (1.07)4 before taxes. Comparing the $131,080 proceeds to her original $100,000 investment, Lynettes taxable earnings will be $31,080. Given her assumed tax rate of 28 percent, she will pay $8,702 or (.28 x $31,080) in tax leaving her with $122,378 or ($131,080 - $8,702) after taxes. 77. [LO 3] Ben recently made a one-time investment of $20,000 in the Florida 529 educational savings plan for his three-year-old son, Mitch. Assume the plan yields a constant 6 percent return for the next 15 years. a. How much money will be available for Mitch after taxes when he begins college at age 18? Because earnings inside a 529 plan compound tax free, the 529 plan Ben set up for Mitch will be worth $47,931 or 20,000 x (1+.06)15 after fifteen years. If this amount is distributed to Mitch and he uses it to pay for qualified higher education expenses, neither he nor Ben will owe any tax on the distribution.

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b. Assume, instead, that when Mitch turns 18, he decides to forego college and spend his time as a traveling artist. If Mitchs parents give him the amount in

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the 529 plan to pursue his dreams, how much will he keep after taxes if his marginal tax rate is 10 percent? If Mitch becomes a traveling artist, he will pay taxes and penalties on the earnings portion of the $47,931 distribution. Because the original investment in the account was $20,000, the earnings portion of the $47,931 distribution would be $27,931. This amount will be subject to Mitchs ordinary 10 percent tax rate plus a 10 percent penalty rate. Thus, Mitch will pay $5,586 or $27,931 x 20 percent in taxes and penalties leaving him with $42,345 to pursue his dreams as a traveling artist. 78. [LO 4] Rich and Shauna Nielson file a joint tax return, and they itemize deductions. Assume their marginal tax rate on ordinary income is 25 percent. The Nielsons incur $2,000 in miscellaneous itemized deductions, excluding investment expenses. They also incur $1,000 in noninterest investment expenses during the year. What tax savings do they receive from the investment expenses under the following assumptions: a. Their AGI is $90,000.

The Nielsons have $3,000 of miscellaneous itemized deductions including investment expenses. These deduction are only deductible to the extent they exceed 2 percent of AGI. If AGI is $90,000, 2 percent of AGI is $1,800 and $1,200 of the $3,000 is deductible. The deductible portion is first treated as investment expense and then noninvestment miscellaneous itemized deductions. In this situation, all $1,000 of the investment expenses are deductible ($200 of the other miscellaneous itemized deductions are deductible). The tax benefit of the investment expenses is $250 (i.e., $1,000 deduction x 25 percent marginal tax rate). b. Their AGI is $130,000.

If AGI is $130,000, 2 percent of AGI is $2,600. In this case only $400 of the miscellaneous itemized deductions are deductible. Because the deductible portion is first considered to be the investment expenses, all $400 of the deductible miscellaneous itemized deductions are considered to be investment expenses. The tax benefit from the $400 deductible investment expense is $100 (i.e., $400 x 25 percent). 79. [LO 4] Mickey and Jenny Porter file a joint tax return, and they itemize deductions. The Porters incur $2,000 in employment-related miscellaneous itemized deductions. They also incur $3,000 of investment interest expense during the year. The Porters income for the year consists of $150,000 in salary, and $2,500 of interest income.

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a. What is the amount of the Porters investment interest expense deduction for the year?

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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. What would their investment interest expense deduction be if they also had a ($2,000) long-term capital loss? 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. 80. [LO 4] {Planning} On January 1 of year 1, Nick and Rachel Sutton purchased a parcel of undeveloped land as an investment. The purchase price of the land was $150,000. They paid for the property by making a down payment of $50,000 and borrowing $100,000 from the bank at an interest rate of 6 percent per year. At the end of the first year, the Suttons paid $6,000 of interest to the bank. During year 1, the Suttons only source of income was salary. On December 31 of year 2, the Suttons paid $6,000 of interest to the bank and sold the land for $210,000. They used $100,000 of the sale proceeds to pay off the $100,000 loan. The Suttons itemize deductions and are subject to a marginal ordinary income tax rate of 35 percent. a. Should the Suttons treat the capital gain from the land sale as investment income in year 2 in order to minimize their year 2 tax bill? In year one, the Suttons incurred $6,000 of investment interest expense but did not have any investment income so the investment interest expense is not deducted and is carried over to year 2. In year 2, the Suttons incurred another $6,000 of investment interest expense. Combined with the carryover from year 1, the Suttons had $12,000 of investment interest expense they could potentially deduct in year 2. In year 2, the Suttons have $60,000 of long-term capital gain. None of this long-term capital gain is investment income unless the Suttons elect to have some of it taxed at ordinary rates. If the Suttons dont elect to tax any of the capital gain as ordinary income, they would not be able to deduct any of the investment interest expense and they would owe taxes of $9,000 (i.e., $60,000 x 15 percent). The Suttons would have a $12,000 investment expense carry forward to next year. If the Suttons elect to include $12,000 of the long-term capital gain in investment income and have it taxed at ordinary rates, the Suttons would owe tax of $4,200 ($12,000 x 35 percent) on this portion of the capital gain and they would owe $7,200 of taxes on the rest of the capital gain (i.e., $48,000 x

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15 percent). The $12,000 investment interest expense deduction would save the Suttons $4,200 in taxes (i.e., $12,000 x 35 percent). The end result is that if the Suttons make the election, they will owe $7,200 in taxes (i.e., $4,200 + $7,200 - $4,200). They will not however have an investment interest expense carry forward. Making the election would make sense for the Suttons if they did not expect to have any investment income for the foreseeable future. b. How much does this cost or save them in year 2? In terms of the year 2 tax bill only, making the election to tax some of the long-term capital gain at ordinary rates saves the Suttons $1,800 in taxes (i.e., $9,000 - $7,200). 81. [LO 4] {Research} George recently received a great stock tip from his friend, Mason. George didnt have any cash on hand to invest, so he decided to take out a $20,000 loan to facilitate the stock acquisition. The loan terms are 8 percent interest with interest-only payments due each year for five years. At the end of the five-year period the entire loan principal is due. When George closed on the loan on April 1, 2010, he decided to invest $16,000 in stock and to use the remaining $4,000 to purchase a four-wheel recreation vehicle. Mason is unsure how he will treat the interest paid on the $20,000 loan. In 2010, Mason paid $1,200 interest expense on the loan. For tax purposes, how should he treat the 2010 interest expense? (Hint: visit www.irs.gov and consider IRS Publication 550) IRS Publication 550 indicates that if you borrow money for personal purposes as well as for investment, you must allocate the debt among those purposes. This means that only interest expense paid on the portion of debt that was used for the investment in the stocks can be deducted as investment interest. The interest paid on the loan allocated to the personal portion isnt deductible to the taxpayer. Therefore, in determining the deductibility of the $1,200 interest expense paid by George during 2010, George would allocate 80 percent (i.e., $16,000 / 20,000) of the interest expense to the purchase of the stock and 20 percent (i.e., $4,000 / 20,000) of the interest expense to the purchase of the 4-wheeler. Consequently, George would have $960 of investment interest expense (80 percent x $1,200) and he would have $240 (i.e., 20 percent x $1,200) of nondeductible personal interest. 82. [LO5] Larry recently invested $9,000 in purchasing a limited partnership interest. His share of the debt in the partnership is $11,000, but he is not personally responsible for paying the debt in the event the partnership cannot pay it. In addition, Larrys share of the limited partnership loss for the year is $2,000, his share of income from a different limited partnership was $1,000, and he had $3,000 of dividend income from the stock he owns. a. What is Larrys tax basis in the limited partnership after considering his $2,000 loss for the year?

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Larrys tax basis in the limited partnership is $18,000, which equals his $9,000 payment for his partnership interest plus his $11,000 share of partnership debt less his $2,000 share of partnership loss for the year. b. What is Larrys at-risk amount in the limited partnership after considering the $2,000 loss for the year? Larrys at-risk amount is only $7,000 ($9,000 investment less $2,000 share of loss) because he is not at risk for his share of partnership debt. c. How much of Larrys $2,000 loss from the limited partnership can he deduct in the current year? Before considering his $2,000 loss, Larrys tax basis is $20,000 ($9,000 investment plus $11,000 share of partnership debt) and his at-risk amount is $9,000 (at-risk amount doesnt include nonrecourse debt). Therefore the basis and at-risk hurdles do not apply. However, Larry still may not deduct $1,000 of the $2,000 loss because he only has $1,000 of passive income for the year. Therefore, Larry has a $1,000 passive activity loss carryover. 83. [LO5] Joe recently invested $11,000 in purchasing a limited partnership interest. His share of the debt in the partnership is $3,000, but he is not personally responsible for paying the debt in the event the partnership cannot pay it. In addition, Joes share of the limited partnership loss for the year is $12,000, his share of income from a different limited partnership was $3,000 and he had $7,000 of dividend income from the stock he owns. a. What is Joes tax basis in the limited partnership after considering his $12,000 loss for the year? Joes tax basis in the limited partnership is $2,000 which equals his $11,000 payment for his partnership interest plus his $3,000 share of partnership debt less his $12,000 share of partnership loss for the year. Because Joes $14,000 basis before his loss was larger than his loss, the loss is not limited by his tax basis. b. What is Joes at-risk amount in the limited partnership after considering the $12,000 loss for the year? Before considering his loss from the limited partnership, Larrys at-risk amount is only $11,000 because he is not at risk for his share of partnership debt. After considering the loss for the year, Joes at-risk amount is zero because any loss in excess of his at-risk amount must be carried forward to the following year.

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c. How much of Joes $12,000 loss from the limited partnership can he deduct in the current year? First, Joes $12,000 loss is limited to his $11,000 at-risk amount leaving a $1,000 at-risk carryover. The remaining $11,000 loss is further limited to the $3,000 amount of passive income Joe receives from a different partnership leaving an $8,000 passive activity loss carryover. At the end of the day, Joe may only deduct $3,000 of his $12,000 loss currently. 84. [LO5] Rubio recently invested $15,000 in purchasing a limited partnership interest. His share of the debt in the partnership is $5,000, but he is not personally responsible for paying the debt in the event the partnership cannot pay it. In addition, Rubios share of the limited partnership loss for the year is $22,000, his share of income from a different limited partnership was $5,000, and he had $40,000 in wage income and $10,000 in long-term capital gains. a. What is Rubios tax basis in the limited partnership after considering his $22,000 loss for the year? Rubios initial tax basis in the limited partnership includes the $15,000 amount he paid to purchase the interest plus his $5,000 share of partnership debt for a total of $20,000. Rubios $22,000 loss reduces his tax basis to zero leaving him with a $2,000 loss carryover because of the tax basis loss limitation. b. What is Rubios at-risk amount in the limited partnership after considering the $22,000 loss for the year? Rubios initial at-risk amount in the limited partnership is $15,000 or the $15,000 amount he paid to purchase the interest. Rubio may not include his share of the partnership debt because he is not at risk for this amount. Rubios $22,000 loss reduces his at-risk amount to zero leaving him with a $5,000 at-risk carryover ($20,000 loss allowed under the tax basis limitation less the $15,000 amount Rubio has at risk). c. How much of Rubios $22,000 loss from the limited partnership can he deduct in the current year? After applying the tax basis and at-risk limitations, Rubio can potentially deduct $15,000 of loss. However, because Rubio is a limited partner this loss is considered a passive loss. Therefore, Rubio may only deduct this loss in the current year to the extent he has passive income. Because Rubio has only passive income of $5,000 (from another limited partnership), he may only deduct $5,000 of the $15,000 loss leaving him with a $10,000 passive activity loss carry forward.

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85. [LO 5] Anwar owns a rental home and is involved in maintaining it and approving renters. During the year he has a net loss of $8,000 from renting the home. His other sources of income during the year were a salary of $111,000 and $34,000 of longterm capital gains. How much of Anwars $8,000 rental loss can he deduct currently if he has no sources of passive income? Because Anwar meets the definition of an active participant and has adjusted gross income of less than $150,000, before considering his rental loss, he may deduct $2,500 of the loss against his other income. His $2,500 deduction is computed as follows: Description (1) Maximum deduction available before phase-out (2) Phase-out of maximum deduction (3) Maximum deduction in current year (4) Rental loss in current year (5) Rental loss deductible in current year Passive loss carry forward Amount $25,000 $22,500 [($145,000 AGI 100,000) x .5] $2,500 (1) (2) $8,000 $2,500 Lesser of (3) or (4) $5,500 (3) (4) Explanation

Comprehensive Problems
86. [LO 1, 2, 3] {Planning} As noted in the chapter, Nick inherited $100,000 with the stipulation that he invest it to financially benefit his family. Nick and Rachel decided they would invest the inheritance to help them accomplish two financial goals: purchasing a Park City vacation home and saving for Leas education. Initial Investment Investment Horizon Vacation Home $50,000 5 years Leas Education $50,000 18 years

The Suttons have a marginal income tax rate of 30 percent (capital gains rate of 15 percent), and have decided to investigate the following investment opportunities.

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5 Years

Annual AfterTax Rate of Return

18 Years

Annual AfterTax Rate of Return

Corporate bonds Dividend-paying stock (no appreciation) Growth stock Municipal bond Qualified tuition program

5.75% 3.50% Future Value is $65,000 3.20% 5.75%

4.75% 3.50% Future Value is $140,000 3.10% 5.50%

Complete the two annual after-tax rates of return columns for each investment and provide investment recommendations for the Suttons. Considering after-tax rates of return alone, the computations below suggest that the Suttons should invest in growth stocks to save for the vacation home and invest in a qualified tuition program for their daughters education. Before making a final decision, the Suttons should also consider relevant nontax factors including differences in risk across the investments. 5 Years (home) Corporate Bonds Dividend-Paying Stock, pref. rate 15% (no appreciation) Growth Stock Municipal Bond Qualified Tuition Program 5.75% 3.50% FV is $65,000 3.20% 5.75% Annual After Tax Rate of Return 4.025% 2.975% 18 Years (education) 4.75% 3.50% FV is $140,000 3.10% 5.50% Annual After Tax Rate of Return 3.325% 2.975%

4.65% 3.20% 3.60%*

5.30% 3.10% 5.5 % or 3.84% **

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Growth Stock Calculations: FV of Growth Stock After-Tax in 5 Years: 65,000 [.15 x (65,000 -50,000)] = $62,750 Annual After-tax rate of return= [($62,750/50,000)1/5 1] = 4.65% FV of Growth Stock After-Tax in 18 Years: 140,000 [.15 x (140,000 -50,000)] = $126,500 Annual After tax rate of return= [($126,500/50,000)1/18 1] =5.3% Qualified Tuition Program Calculations: FV of QTP in 5 Years: 50,000 x (1+.0575)5 = $66,126 FV of QTP After-Tax in 5 Years: 66,123 [.4 x (66,126 -50,000)] = $59,676 * The appreciation is subject to tax at 40 percent (30 percent + penalty of 10 percent) Annual After Tax Rate of Return= [($59,676/50,000)1/5 1] = 3.6% FV of QTP in 18 Years: 50,000 x (1+.055)18 = $131,073 FV of QTP After-Tax in 18 Years if Funds Not Used for Education: 131,073 [.4 x (131,073 - 50,000)] = $98,644 ** If not used for educational purposes the appreciation is subject to tax at 40 percent (30 percent + penalty of 10 percent) Annual After Tax Rate of Return= [($98,644/50,000)1/18 1] = 3.84% 87. [LO 1, 2, 3, 4] During 2010, your clients, Mr. and Mrs. Howell, owned the following investment assets: Investment Assets Date Acquired Purchase Price Brokers Commission Paid at Time of Purchase $100 $300

300 shares of IBM common 11/22/07 $10,350 200 shares of IBM common 4/3/08 $43,250 3,000 shares of Apple preferred 12/12/08 $147,000 $1,300 2,100 shares of Cisco common 8/14/09 $52,500 $550 420 Shares of Vanguard mutual fund 3/2/10 $14,700 No load fund* *No commissions are charged when no load mutual funds are bought and sold. Because of the downturn in the stock market, Mr. and Mrs. Howell decided to sell most of their stocks and mutual fund in 2010 and to reinvest in municipal bonds. The following investment assets were sold in 2010:

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Investment Assets

Date Sold

Sale Price

300 shares of IBM common 5/6/10 $13,700 3,000 shares of Apple preferred 10/5/10 $221,400 $2,000 2,100 shares of Cisco common 8/15/10 $63,250 $650 451 Shares of Vanguard mutual fund 12/21/10 $15,700 No load fund* *No commissions are charged when no load mutual funds are bought and sold. The Howells broker issued them a Form 1099 showing the sales proceeds net of the commissions paid. For example, the IBM sales proceeds were reported as $13,600 on the Form 1099 they received. In addition to the sales reflected in the table above, the Howells provided you with the following additional information concerning 2010: The Howells received a Form 1099 from the Vanguard mutual fund reporting a $900 long-term capital gain distribution. This distribution was reinvested in 31 additional Vanguard mutual fund shares on 6/30/10. In 2005, Mrs. Howell loaned $6,000 to a friend who was starting a new multilevel marketing company called LD3. The friend declared bankruptcy in 2010, and Mrs. Howell has been notified that she will not be receiving any repayment of the loan. The Howells have a $2,300 short-term capital loss carryover and a $4,800 longterm capital loss carryover from prior years. The Howells did not instruct their broker to sell any particular lot of IBM stock. The Howells earned $3,000 in municipal bond interest, $3,000 in interest from corporate bonds, and $4,000 in qualified dividends. The Howells paid $5,000 in investment interest expense during the year ($1,000 is attributable to their municipal bond investments). The Howells paid $2,000 for investment advice during the year but did not have any additional miscellaneous itemized deductions.

Brokers Commission Paid at Time of Sale@ $100

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Assume the Howells have $130,000 of wage income during the year.

a. Go to the IRS web site (www.IRS.gov) and download the most current version of Schedule D. Use page 1 of Schedule D to compute net long-term and short-term capital gains. Then, compute the Howells tax liability for the year (ignoring the alternative minimum tax and any phase-out provisions) assuming they file a joint return, they have no dependents, they dont make any special tax elections, and their itemized deductions total $25,000. The Howells Schedule D for the year would be completed as follows:

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The Howells net capital gain is then included with their other income for the year in calculating their final tax liability for the year. Description Wage Income Interest Income Qualified Dividends Net Capital Gains from Schedule D Adjusted Gross Income Total Itemized Deductions Amount 130,000 3,000 4,000 71,700 208,700 (25,000) Explanation Given Given Given See Schedule D above The effect of investment advice fees and investment interest expense already included in this number

Personal Exemptions Taxable Income

(7,300) 176,400

The Howells 2010 tax liability would be $28,905. This is calculated by determining ordinary income of $100,700 which is $176,400 of taxable income minus $71,700 net long-term capital gain that will be taxed at 15% and minus $4,000 qualified dividends that will be taxed at 15%. The tax on $100,700 is $17,537.50 and the 15% tax on long-term capital gains and qualified dividends of $75,700 is $11,355. This results in a total 2010 tax liability of $28,892.50. b. Are there any tax planning recommendations related to the stock sales that you should have shared with the Howells before their decision to sell? Mr. and Mrs. Howell should have told their broker to sell the 200 shares of IBM acquired on 4/3/08 first, using the specific identification method. Because these shares have a much higher tax basis than the shares acquired on 11/22/07, the Howells would have reported a much smaller long-term capital gain in 2010 from the sale of the 300 IBM shares. However, at this point in time, its too late to implement this deferral strategy. Mr. and Mrs. Howell should have consulted with their tax advisor prior to the sale.

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c. Assume the Howells short-term capital loss carryover from prior years is $82,300 rather than $2,300 as indicated above. If this is the case, how much short-term and long-term capital loss carryover remains to be carried beyond 2010 to future tax years? If we assume the Howells short-term capital loss carryover into 2010 was $82,300 rather than $2,300 as originally assumed, a number of things change. First, the net short-term capital loss for the year increases to $88,200. When netted against the net long-term capital gain for the year of $79,900, a net short-term capital loss for the year of $8,300 remains. $3,000 of this loss can be used to reduce ordinary income, and the remaining $5,300 constitutes a short-term capital loss carryover to future tax years. 88. WAR (We Are Rich) has been in business since 1980. WAR is an accrual method sole proprietorship that deals in the manufacturing and wholesaling of various types of golf equipment. Hack & Hack CPAs have filed accurate tax returns for WARs owner since WAR opened its doors. The managing partner of Hack & Hack (Jack) has gotten along very well with the owner of WAR Mr. Someday Woods. However, in early 2010, Jack Hack and Someday Woods played a round of golf and Jack, for the first time ever, actually beat Mr. Woods. Mr. Woods was so upset that he fired Hack & Hack and has hired you to compute his 2010 tax liability. Mr. Woods was able to provide you with the following information from prior tax returns. The taxable income numbers reflect the results from all of Mr. Woods activities except for the items separately stated. You will need to consider how to handle the separately stated items for tax purposes. Also, note that the 20052009 numbers do not reflect capital loss carryovers.
Ordinary taxable income Other items not included in ordinary taxable income Net gain (loss) on disposition of 1231 assets Net long-term capital gain (loss) on disposition of capital assets ($15,000) $1,000 ($7,000) ($5,000) $3,000 10,000 ($6,000) 2005 $4,000 2006 $2,000 2007 $94,000 2008 $170,000 2009 $250,000

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In 2010, Mr. Woods had taxable income in the amount of $460,000 before considering the following events and transactions that transpired in 2010: a. On January 1, 2010, WAR purchased a plot of land for $100,000 with the intention of creating a driving range where patrons could test their new golf equipment. WAR never got around to building the driving range; instead, WAR sold the land on October 1, 2010, for $40,000. b. On August 17, 2010, WAR sold its golf testing machine, Iron Byron and replaced it with a new machine Iron Tiger. Iron Byron was purchased and installed for a total cost of $22,000 on February 5, 2006. At the time of sale, Iron Byron had an adjusted tax basis of $4,000. WAR sold Iron Byron for $25,000. c. In the months October through December 2010, WAR sold various assets to come up with the funds necessary to invest in WARs latest and greatest inventionthe three dimple golf ball. Data on these assets are provided below: Placed in Service (or purchased) 4/4/09 3/1/08 2/1/07 7/1/09 11/30/08 Sold Initial Basis $3,000 $8,000 $12,000 $45,000 $10,000 Accumulated Depreciation $540 $3,000 $0 $0 $0 Selling Price $2,900 $4,000 $20,000 $48,000 $8,000

Asset Somedays black leather sofa (used in office) Somedays office chair Marketable securities Land held for investment Other investment property

10/16/10 11/8/10 12/1/10 11/29/10 10/15/10

d. Finally, on May 7, 2010, WAR decided to sell the building where they tested their plutonium shaft, lignite head drivers. WAR purchased the building on January 5, 1998, for $190,000 ($170,000 for the building, $20,000 for the land). At the time of the sale, the accumulated depreciation on the building was $50,000. WAR sold the building (with the land) for $300,000. The fair market value of the land at the time of sale was $45,000. Compute Mr. Woods taxable income after taking into account the transactions described above. In addition, record the effects of the transactions above in Mr. Woods Schedule D and Schedule 4797 (use the most current version of these schedules) to be attached to his Form 1040. The table below reflects the impact of Mr. Woods asset dispositions on his taxable income for the year:

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Item TI before adjustments Loss from sale of land held < 1 year Sec. 1245 recapture Sec. 1250 recapture Sec. 1231 gain recaptured as ordinary (5-yr lookback rule) Net Sec. 1231 gain (after application of look back rule) Net long-term capital gain from investments (before capital loss carry forwards) Capital loss carryforwards TI after adjustments Notes:

Amount $460,000 (60,000) 18,440 0 6,000 156,000 9,000

Notes A B C D D E

Character Ordinary Ordinary Ordinary Ordinary Capital Capital

(3,000) $586,440

Capital

A. Received $100,000 for property with a $40,000 basis resulting in a $60,000 loss. Because the property was not held for more than one year, it is not Sec. 1231 property and the loss is ordinary. B. Section 1245 recapture turns what would otherwise be Sec. 1231 gain into ordinary income. The amount of gain recaptured under Sec. 1245 is the amount of the gain on the sale of an asset that results because depreciation has lowered the basis. Iron Byron (Sec. 1231 property) had a tax basis of $4,000 and was sold for $25,000 resulting in a $21,000 gain. Of the $21,000 gain, $18,000 was due to depreciation deductions lowering the tax basis (i.e., if the $18,000 of depreciation deductions had not been taken, the basis would have been $18,000 higher and the gain would have been $18,000 lower). As a result, $18,000 of the gain is recaptured as ordinary income under Sec. 1245, while the remaining $3,000 gain is considered a Sec. 1231 gain. The Sofa is Sec. 1231 property and was sold at a gain of $440 [$2,900 ($3,000 540)]. Because the entire gain is less than the accumulated depreciation, the entire $440 gain is recaptured as ordinary income under Sec. 1245. So, in total, the gain on the sale of assets that is recaptured as ordinary income under Section 1245 is $18,440 ($18,000 + 440). C. This relates to the sale of the building. Section 1250 recapture applies to real property that is being depreciated using an accelerated method of depreciation. The amount of recapture is the amount by which accelerated depreciation exceeds the

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amount of depreciation that would have been taken if the straight-line method of depreciation had been used (but in no case would the recapture exceed the actual gain on the sale). In this case, the building was sold for $255,000 ($300,000 selling price for the land and the building less the $45,000 fair market value of the land). The adjusted basis of the property was $120,000 so the gain on the sale is $135,000. Because the building was depreciated under the straight-line method, there is no recapture under Section 1250. However, since Someday is an individual taxpayer, he will be subject to a special capital gains rate (maximum 25%) on the portion of the $135,000 that is unrecaptured Section 1250 gain. In this case, WAR took $50,000 of depreciation, so $50,000 of the $135,000 is treated as an unrecaptured Section 1250 gain and could be taxable to Someday at the 25% tax rate. The remaining $85,000 is taxed at the regular 15% capital gain rate. D. Section 1231 gains for the year include $3,000 gain on the sale of Iron Byron (see note B) and a $135,000 gain from the sale of the building (see note C) and a Sec. 1231 gain on the sale of the land (sold with the building) in the amount of $25,000 (i.e., $45,000 - $20,000). So total Sec. 1231 gains are $163,000 ($3,000 + $135,000+ $25,000). The only Sec. 1231 loss was a ($1,000) loss from the sale of the chair. Netting the gains and losses results in a net Section 1231 gain of $162,000. Because this is a net gain the 5 yr. lookback rule applies. In 2008, WAR had a Section 1231 loss of ($6,000). No 1231 gains were recognized in 2009. As a result, $6,000 of the $162,000 net 1231 gain in 2010 must be recaptured as ordinary income. In the final analysis, WAR recognizes $6,000 of ordinary income under the lookback rule, and WAR recognizes $156,000 of net 1231 gains that are treated as long-term capital gains. E. WAR recognized an $8,000 long-term capital gain on the sale of securities ($20,000 12,000), a long-term capital gain of $3,000 on the land held for investment ($48,000 45,000), and a ($2,000) long-term capital loss on the sale of other investment property. This results in a net long-term capital gain of $9,000. F. In 2005, WAR had a long-term capital loss of ($15,000) and a Sec. 1231 gain of $3,000 (treated as a long-term capital gain). Consequently, Mr. Woods had a ($12,000) long-term capital loss carry forward that can be carried forward indefinitely. After offsetting the $10,000 1231 gain, the $1,000 of net long-term capital gain, and $1,000 of ordinary income in 2006, the long-term capital loss carry forward from 2005 is reduced to zero. The long-term capital loss of ($7,000) in 2007 reduces ordinary income by $3,000 in 2007 leaving a ($4,000) long-term capital loss to carry forward to 2008. The ($6,000) net Sec. 1231 loss in 2008 reduces ordinary taxable income in 2008 by $6,000, and the ($4,000) long-term capital loss carried forward from 2007 further reduces ordinary taxable income in 2008 by $3,000 leaving a ($1,000) long-term capital loss to carry forward to 2009. In 2009, WAR had a ($5,000) long-term capital loss, and a ($1,000) long-term capital loss carried forward from 2008 of which $3,000 can be used to offset ordinary income in 2009 leaving ( $3,000) of long-term capital loss to carry forward to 2010. In 2010, Mr. Woods had net Sec. 1231 gains of $156,000 (see note D) and long-term capital gains

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of $9,000 (see note E). So WAR is able to deduct the entire ($3,000) of long-term capital loss carry forwards in 2010. Mr. Woods Schedule D and Form 4797 would be completed as follows:

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