Chapter 16 - Investment and Personal Financial Planning

Chapter16

QuestionsandProblemsforDiscussion

1. a. InterestonU.S.Treasurybondsistaxableincomeforfederalpurposesbuttaxexemptfor
statepurposes.
b. InterestonaStatebondistaxexemptforfederalpurposesbutmaybetaxableincomeor
taxexemptforstatepurposes,dependingonthetaxpayersstateofresidence.
c. Thestatedinterestpaidonacorporatebondistaxableincomeforbothfederalandstate
purposes.
d. Thestatedinterestpaidonacorporatebondandtheamortizationoftheoriginalissue
discount(OID)istaxableincomeforbothfederalandstatepurposes.
e. Dividendsonpreferredstockaretaxableincomeforbothfederalandstatepurposes.
Qualifieddividendincomeistaxedatapreferentialfederalrate.
f. Ordinarydividendspaidbymutualfundscanconsistofordinarytaxableincome,qualified
dividendincome,andcapitalgaindistributions.Qualifieddividendincomeandcapitalgain
distributionsaretaxedatapreferentialfederalrate.

2. Thelapseofatermlifeinsurancepolicyhasnoincometaxconsequences.

3. Mrs.SDprobablyshouldnotmovehersavingsintoataxdeferredannuity.Thevalueofthetax
deferralofferedbytheannuityisafunctionoftheinvestorsmarginalrate:thehighertherate,
thegreaterthevalueofthedeferral.BecauseMrs.SDisinthelowesttaxbracket,thevalueof
deferralmaybetoosmalltooffsetanyimplicittaxortransactioncostsassociatedwiththe
annuity.Thevalueoftaxdeferralalsodependsonthelengthoftimetheinvestorcanpostpone
receivingtaxableincome.IfMrs.SDmustliquidateherannuityinjustafewyearstofundher
movetoaretirementhome,thevalueofthebriefdeferralperiodisminimal.Moreover,shemay
berequiredtopayamonetarypenaltytotheannuitycompanyforaprematureliquidation(asthe
termisdefinedinthecontract).Thisadditionaltransactioncostwouldalmostcertainlynegate
thebenefitoftaxdeferral.

4. Ms.BwouldrecognizecapitalgainonthesaleofGGstockeventhoughsheimmediately
repurchasestheshares;thewashsaleruleappliesonlytorealizedlosses.However,shecan
maximizethevalueofher$12,000netcapitallossbydeducting$3,000thisyearandeachofthe
nextthreeyears.ThesedeductionsreduceAGIandresultinanannualtaxsavingsof$1,050
($3,000 35%).Ata6percentdiscountrate,NPVofthisstreamofsavingsis$3,857.In
contrast,ifMs.BimplementsherstrategytosellGGstock,the$12,000capitallossoffsetsa
$12,000capitalgainthatwouldbetaxedat15percentthreeyearshence.Ata6percent
discountrate,NPVofthis$1,800taxsavingsisonly$1,512.Consequently,Ms.Bshouldnot
sellanyGGstock.

5. Understatelaw,limitedpartnersareprohibitedfromactiveinvolvementinthepartnership
business.Consequently,theycannotmateriallyparticipateinthatbusiness,andtheirinterestin
thepartnershipisapassiveactivity.

6. IfMrs.KmateriallyparticipatesinTKsbusiness,sheshouldbeemployedbythecorporation
andreceivingasalaryreflectingthevalueofherservices.

7. Investorswithpassiveactivitylossesshouldbewillingtopayapremiumforprofitablerentalreal
estate(ascomparedtootherinvestmentswiththesameriskandbeforetaxrateofreturn)

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becausetheycanusethelossestosheltertherealestateincomefromtax.Consequently,the
marketvalueoftherealestateshouldincrease.

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8. Allthreelimitationspermittaxpayerstoclaimacurrentdeductiontotheextentofacertaintype
ofincome.Investmentinterestexpenseisdeductibletotheextentofnetinvestmentincome.
Capitallossesaredeductibletotheextentofcapitalgains.Passiveactivitylossesaredeductible
totheextentofpassiveactivityincome.

9. a. Mr.andMrs.FBs60percentequityinterestrepresentslegalcontrolofFBInc.Becausethe
ownerofthisequitycancontrolcorporatepolicy(includingdividendpayments),thevalueof
Mr.andMrs.FBsgifttotheirsonismorethan$6million(i.e.,thevalueshouldreflecta
controlpremium).
b. Theownerofa10percentminorityinterestcandolittletoinfluencecorporatepolicy.
Consequently,thevalueoftheinvestorsgifttohersonislessthan$1million(i.e.,thevalue
shouldreflectaminoritydiscount).

10. Thisstrategywastesonespouseslifetimetransfertaxexclusion.Mr.andMrs.Tshouldeach
bequeathpropertywithavalueequaltothecurrentyearexclusiontotheiroffspringandonlythe
remainderofhisorherpropertytothesurvivingspouse.Thisstrategyeliminatesanyestatetax
whenthefirstspousediesandallowseachspousetousehisorherlifetimetransfertax
exclusiontotransferpropertytoyoungergenerationfamilymembers.

11. Mr.andMrs.Bcanspendtheiraftertaxincomeorsave(invest)it.Theycanspendtheirwealth
(accumulatedincome),giveitawayduringtheirlife,orholdituntildeath,atwhichpointitwill
passtoanotherowner.

ApplicationProblems

1. a. Ms.Sstaxis$2,937($19,58015%preferentialrateonqualifieddividendincome).
b. Thetaxis$2,937.Ms.Sisinconstructivereceiptofthedividendincomeeventhoughitwas
automaticallyreinvestedinadditionalBenBowshares.

2. a. Mr.Laystaxis$7,711($22,03035%).
b. Mr.Laystaxis$6,813($6,139[$17,54035%]+$674[$4,49015%preferentialrate]).
c. Mr.Laystaxis$4,689($2,422[$6,92035%]+$2,267[$15,11015%preferentialrate]).

3. Mr.Ssbasisinhis620Carmelsharesis$9,160($9,300costbasis$140returnofcapital).

4. a. $753($2,690interest28%).
b. $753($2,690interest28%).
c. $753($2,690interest28%).
d. $753($2,690interest28%).
e. Mrs.Nunnsfederaltaxis0(municipalbondinterestistaxexempt).

5. a. $188($2,690interest7%)
b. Mrs.Nunnsstatetaxis0(federalbondinterestistaxexempt).
c. $188($2,690interest7%)

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6. Mrs.ZsbeforetaxincomefromthePennsylvaniabond $3,400
Virginiaincometaxat6% (204)
FederaltaxsavingsfromdeductionofVirginiatax
($20435%) 71
Aftertaxincome $3,267
$3,267$50,000investment=6.534%aftertaxrateofreturn

7. a. $74,800beforetaxcashflow$24,684taxcost($74,800interestincome33%)=$50,116
aftertaxcashflow.
b. 0beforetaxcashflow$24,684taxcost($74,800interestincome33%)=($24,684)
aftertaxcashflow.
c. 0beforetaxcashflow$24,684taxcost($74,800interestincome33%)=($24,684)
aftertaxcashflow.

8. a. $100,000redemptionproceeds$93,100costbasis=$6,900interestincome.
b. $100,000redemptionproceeds$100,000adjustedbasis($72,900cost+$27,100
amortizedOID)=0interestincome.

9. a. Mrs.Ulmmustrecognize$1,512OIDinterestincomein2005and$1,480OIDinterest
incomein2006.Herlongtermcapitalgainonthesaleofthebondiscomputedasfollows.
Amountrealizedonsale $84,180
Adjustedbasis($80,000+amortizedOID) (82,992)
Longtermcapitalgain $1,188

b. Mrs.Ulmdoesnotrecognizetheaccruedmarketdiscountasincome.However,whenshe
sellsthebond,shemustrecognizethe$2,992accruedmarketdiscount(basedonthe
bondsyieldtomaturity)asordinaryincomeandthe$1,188remaininggainaslongterm
capitalgain.
Amountrealizedonsale $84,180
Adjustedbasis (80,000)
Realizedgain $4,180
Ordinaryincome(accrueddiscount) (2,992)
Longtermcapitalgain $1,188

10. a. Amountrealized(4,052shares $18) $72,936

Adjustedbasis(cost+reinvesteddividends) (58,393)
Mr.Dalesrecognizedgain $14,543

b. Amountrealized(800shares $18) $14,400

Adjustedbasis($14costof800originalshares) (11,200)
Mr.Dalesrecognizedgain $3,200

c. Amountrealized(800shares $18) $14,400

Adjustedbasis($58,393 [800shares 4,052shares]) (11,529)
Mr.Dalesrecognizedgain $2,871

11. a. Mrs.Colerecognizes$7,220($38,500cashsurrendervalue$31,280investmentinthe
policy)asordinaryincome.
b. Mrs.Coles$400,000accelerateddeathbenefitisexcludablefromhertaxableincome.

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12. Mr.Fisentitledtoataxfreereturnofhis$50,000investmentintheannuitycontract.The
taxableportionofeach$1,300monthlypaymentiscomputedasfollows.
$50,000investment $312,000expectedreturn=.16026exclusionratio
Monthlypayment $1,300
Exclusionratio .16026
Taxfreereturnofinvestment $208
Taxableannuitypayment($1,300$208) $1,092

13. a. Mr.Fstotalannuitypaymentsfortheyear $15,600

Unrecoveredinvestment (1,875)
Taxablepayments $13,725

b. Unrecoveredinvestmentatbeginningofyear $1,875
TaxfreerecoveryfromJanuarypayment (208)
Unrecoveredinvestmentatdateofdeath $1,667

The$1,092taxableportionoftheJanuarypaymentisincludedingrossincome,andthe
$1,667unrecoveredinvestmentisreportedasanitemizeddeductiononMr.FsfinalForm
1040.

14. Mr.ListreatedassellinghisDragostockonthelastdayoftheyearforanamountrealizedof
zero.Therefore,herecognizesa$14,400longtermcapitalloss(unrecoveredbasisinthe
worthlessstock).

15. Mrs.Bcantreatthenonbusinessbaddebtasa$10,000shorttermcapitalloss.Notethatthe
debtisnotabusinessdebtbecauseshedidnotincurthedebtforherbusinesspurposes.Her
loanwasaninvestmentinMr.Jsbusiness.

16. a. Theexchangeofcommonstockforcommonstockinthesamecorporationisnontaxable.
Thus,CVFdoesnotrecognizeits$162,000realizedgain.
b. TheexchangeofJarviscommonstockforU.S.bondsistaxable.Thus,CVFmustrecognize
its$92,500realizedgain.
c. TheexchangeofJarviscommonstockforNewtoncommonstockistaxablebecauseitwas
notpursuanttoacorporatereorganization.Thus,CVFmustrecognizeits$55,000realized
gain.
d. TheexchangeofJarviscommonstockforNewtoncommonstockisnontaxablebecauseit
waspursuanttoacorporatereorganization.Thus,CVFdoesnotrecognizeits$55,000
realizedgain.

17. a. CVFsbasisinthe1,300sharesofJarvisvotingcommonstockis$225,000,whichisthe
substitutedbasisofthe2,000sharessurrenderedintheexchange.
b. CVFsbasisinitsU.S.bondsis$317,500,whichisthecostofthebonds.
c. CVFsbasisinits900sharesofNewtonstockis$280,000,whichisthecostofthestock.
d. CVFsbasisinits900sharesofNewtonstockis$225,000,whichisthesubstitutedbasisof
the2,000sharesofJarvisstocksurrenderedintheexchange.

18. a. Mrs.Beardcandeduct$3,000ofthecapitalloss.

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b. Mrs.Beardcandeduct$6,780ofthecapitalloss($3,780capitalgain+$3,000).
c. Mrs.Beardcandeducttheentire$12,290capitallossagainsther$15,610capitalgain.

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19. a. Mr.AlmsAGIis$58,850($61,850salary$3,000netcapitalloss).
b. Mr.AlmsAGIis$68,500($61,850salary+$6,650netcapitalgain($12,250capitalgain
$5,600capitalloss).
c. Mr.AlmsAGIis$60,350($61,850salary$1,500netcapitalloss($8,000capitalgain
distribution$5,600capitalloss$3,900capitallosscarryforward).

20. a. Mr.andMrs.Revelrecognizeda$6,100netlongtermcapitallossofwhichtheycandeduct
$3,000againstothersourcesofincome.Therefore,theirAGIis$203,200.
b. Mr.andMrs.Revelrecognizeda$380netlongtermcapitalgain.TheirAGIis$206,580.
c. Mr.andMrs.Revelrecognizeda$9,800netcapitallossofwhichtheycandeduct$3,000
againstothersourcesofincome.TheirAGIis$203,200.
d. Mr.andMrs.Revelrecognizeda$4,100netshorttermcapitallossofwhichtheycandeduct
$3,000againstothersourcesofincome.TheirAGIis$203,200.

21. a. Mr.andMrs.Revelhavea$3,100longtermcapitallosscarryforward.
b. Nocarryforward.
c. Mr.andMrs.Revelhavean$1,800shorttermcapitallosscarryforwardanda$5,000long
termcapitallosscarryforward.
d. Mr.andMrs.Revelhavea$1,100shorttermcapitallosscarryforward.

22. Ordinarytaxableincome $421,000

Capitaltransactions:
Netshorttermcapitalgain 14,300
Longtermcapitalgain $64,000
Longtermcapitalloss (12,900)
Netlongtermcapitalgain 51,100
Taxableincome $486,400

Taxon$435,300ordinaryincome(single) $131,429
Taxon$51,100longtermcapitalgainat15% 7,665
Mr.Jstax $139,094

23. a. $4,395($29,300longtermcapitalgain15%)
b. $5,695($2,895[$19,300LTCG15%]+$2,800[$10,000collectiblesgain28%])
c. $5,945($2,070[$13,800LTCG15%]+$3,875[$15,500unrecapturedSection1250gain
25%])
d. $6,816($840[$5,600LTCG15%]+$476[$1,700collectiblesgain28%]+$5,500
[$22,000unrecapturedSection1250gain25%])

24. Amountrealized $685,000

Adjustedbasis (544,700)
Gainrealized $140,300
TaxonunrecapturedSection1250gain
($51,90025%) $12,975
TaxonSection1231gaintreatedasLTCG
($88,40015%) 13,260

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Taxongainrealized $26,235

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25. a. Ordinarytaxableincome $191,000

Capitaltransactions:
LongtermcapitalgainonSetastocksale $67,400
Excludedgain(50percent) (33,700)
Gainonqualifiedsmallbusinessstocksale 33,700
Otherlongtermcapitalgain 8,600
Taxableincome $233,300

Taxon$191,000ordinaryincome(HH) $45,985
Taxon$33,700capitalgainat28% 9,436
Taxon$8,600capitalgainat15% 1,290
Ms.EJstax $56,711

b. Inthiscase,Ms.EJdidnotholdtheSetastockformorethanfiveyears,andherlongterm
capitalgainonsaleisnoteligibleforthe50percentexclusion.
Ordinarytaxableincome $191,000
Capitaltransactions:
LongtermcapitalgainonSetastocksale $67,400
Otherlongtermcapitalgain 8,600
76,000
Taxableincome $267,000

Taxon$191,000ordinaryincome(HH) $45,985
Taxon$76,000capitalgainat15% 11,400
Ms.EJstax $57,385

26. Mr.EFrecognizedthefollowinglossesonsaleofhisLLGstock.
SaleofSection1244stockissuedtoMr.EF:
Amountrealized(500shares $16) $8,000
Adjustedbasis(cost) (45,000)
Ordinaryloss $(37,000)
SaleofstockpurchasedbyMr.EF:
Amountrealized(1,000shares $16) $16,000
Adjustedbasis(cost) (40,000)
Capitalloss $(24,000)
a. Salary $80,000
OrdinarylossonLLPstocksale (37,000)
Limitednetcapitallossdeduction (3,000)
Mr.EFsAGI $40,000
b. Salary $80,000
OrdinarylossonLLPstocksale (37,000)
Capitalgainonsaleofmarketablesecurities $20,000
CapitallossonLLPstocksale (24,000)
Netcapitalloss (4,000)
Limitednetcapitallossdeduction (3,000)
Mr.EFsAGI $40,000

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27. a. Ms.Reidsdeductionforher$3,900investmentinterestexpenseislimitedto$1,100.(IfMrs.
Reidtreatsher$1,100qualifieddividendincomeasinvestmentincome,thedividendwillnot
betaxedatthe15%preferentialrate.)
b. Ms.Reidsdeductionforher$3,900investmentinterestexpenseislimitedto$690.
c. Ms.Reidcandeductherentire$3,900investmentinterestexpense.

28. a. IfMr.andMrs.MSdonotelecttotreatanylongtermcapitalgainasinvestmentincome,
theirtaxis$10,103.
Salaries $84,000
Interestincome(investmentincome)* 963
Shorttermcapitalgain(investmentincome)* 600
Longtermcapitalgain 7,200
AGI $92,763
Itemizeddeductions: Investmentinterest* $1,563
Other 12,500
(14,063)
Exemptionamount($3,400 2) (6,800)
Taxableincome $71,900

Taxon$64,700ordinaryincome(MFJ) $9,023
Taxon$7,200longtermcapitalgainat15% 1,080
Mr.andMrs.MSstax $10,103
b. IfMr.andMrs.Poeelecttotreat$2,837oftheirlongtermcapitalgainasinvestment
income,theirtaxis$9,677.
Salaries $84,000
Interestincome(investmentincome)* 963
Shorttermcapitalgain(investmentincome)* 600
Longtermcapitalgain($2,837investmentincome)* 7,200
AGI $92,763
Itemizeddeductions: Investmentinterest* $4,400
Other 12,500
(16,900)
Exemptionamount($3,400 2) (6,800)
Taxableincome $69,063

Taxon$64,700ordinaryincome(MFJ) $9,023
Taxon$4,363longtermcapitalgainat15% 654
Mr.andMrs.MSstax $9,677

Mr.andMrs.Poeminimizetheircurrentyeartaxbyelectingtotreat$2,837oftheirlongterm
capitalgainasinvestmentincome.However,acomparisonofcurrentyeartaxliabilitiesignores
thepresentvalueofanyfuturetaxsavingsgeneratedbythecarryforwardofnondeductible
investmentinterestexpensethatresultsifMr.andMrs.Poedonotmaketheelection.

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29. a. Mr.Dstaxsavingsfromthelosswas$5,250($15,000shorttermcapitalgainoffsetby
$15,000capitalloss 35%).
b. Mr.Dstaxsavingsfromthelosswas$2,250($15,000longtermcapitalgainoffsetby
$15,000capitalloss 15%).
c. Mr.Dstaxsavingsfromthelosswas$4,200($15,00028percentrategainoffsetby
$15,000capitalloss 28%).
d. Mr.DsNPVofthetaxsavingsfromthelosswas$4,773.
Taxsavingsin2007($3,000deduction 35%) $1,050
Presentvalueofannualtaxsavingsin20082011
($1,050 3.546discountfactorat5%) 3,723
NPV $4,773

30. Grocerystorenetprofit $44,000

AdjustmentforonehalfofSEtax (3,109)
Dividendsandinterestincome 1,080
Passiveactivities: Rentallossdeductibleupto$25,000) (6,470)
LPinterest(nondeductibleloss) 0
Mr.andMrs.MorrissAGI $35,501

31. a. Salary $62,300

BusinessincomefromVP 19,000
Passiveactivities: BL(nondeductibleloss) 0
Mr.KellysAGI $81,300
b. Salary $62,300
BusinesslossfromBL. (25,000)
Passiveactivities: VP 19,000
Mr.KellysAGI $56,300
c. Salary $62,300
BusinessincomefromVP 19,000
BusinesslossfromBL. (25,000)
Mr.KellysAGI $56,300
d. Salary $62,300
Passiveactivities: VPincome $19,000
BLdeductibleloss (19,000)
0
Mr.KellysAGI $62,300

32. a. Salary $59,000

Interestanddividends 4,400
AGIbeforerealestaterentalloss $63,400
Realestaterentalloss(deductibleupto$25,000) (25,000)
Ms.TNsAGI $38,400

b. Salary $113,400
Interestanddividends 4,400
AGIbeforerealestaterentalloss $117,800
Realestaterentalloss(deductibleupto
$25,000[50%$17,800excessAGI]) (16,100)
Ms.TNsAGI $101,700

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c. Salary $168,250
Interestanddividends 4,400
Ms.TNsAGI $172,650

33. Netprofitfromsoleproprietorship $75,000

AdjustmentforonehalfofSEtax (5,299)
Interestanddividends 1,500
Passiveactivities: Renthouse $9,500
ABCD(deductibleloss) (9,500)
0
Ms.AdamssAGI $71,201

BecauseMs.Adamsstaxfortheyearisthesamewithorwithoutthe$9,500rentincome,the
taxcostoftherentincomeiszero.

34. Salary $85,000

Capitaltransactions:
Gainonsaleofpartnershipinterest $14,000
Lossonsecuritiessale (12,000)
Netcapitalgain 2,000
Passiveactivities: Partnershipincome $2,100
Scorporationloss* (13,900)
(11,800)
Mr.DsAGI $75,200

Mr.DcandeducttheentireScorporationlossbecausehehas$16,100passiveactivityincome
fromothersources.The$14,000gainonsaleofthepartnershipinterestischaracterizedasboth
capitalgainandpassiveactivityincome,adualcharacterizationthatallowsMr.Dtodeductboth
hiscapitallossonthesecuritiessaleandhispassiveactivityloss.

35. a. Mr.Zeplincantransfer$276,000($12,00023donees)withoutmakingataxablegift.
b. Mr.andMrs.Zeplincantransfer$552,000($24,00023donees)withoutmakingataxable
gift.

36. a. Becausethe$738,000taxablegift($750,000FMV$12,000annualexclusion)islessthan
Mr.Itos$1millionlifetimeexclusion,noamountissubjecttogifttax.
b. The$438,000excessofthe$1,438,000taxablegift($1,450,000FMV$12,000annual
exclusion)overMr.Itos$1millionlifetimeexclusionissubjecttogifttax.
c. The$207,500excessofthe$620,500taxablegift($632,500FMV$12,000annual
exclusion)overMr.Itos$413,000remaininglifetimeexclusion($1million$587,000
previoustaxablegift)issubjecttogifttax.

37. Calliesinvestmentincome $5,831

Baseamount (1,700)
Excessinvestmentincome $4,131
Taxrate(parentsmarginalrate) .28
Tax $1,157
Calliesremainingtaxableincome $1,700
Standarddeduction (850)
Taxableincome $850

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Taxrate(single) .10
Tax $85
Calliestotaltax($1,157+$85) $1,242

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38. Grossestate $10,000,000
Debtsofthedecedent (789,000)
Funeralandadministrativeexpenses (95,600)
Deductiblebequests: FirstLutheranChurch $500,000
WesternWisconsinCollege 1,000,000
Mrs.JS 2,400,000
(3,900,000)
Mr.JSstaxableestate $5,215,400

39. a. Mrs.WPsamountrealizedonsale $200,000

Basis (138,000)
Gainrecognized $62,000
Mrs.WPstaxrateoncapitalgain .15
$9,300
Saleproceeds $200,000
Taxcost (9,300)
Mrs.WPsaftertaxsaleproceeds $190,700

b. Grandchildrensamountrealizedonsale $200,000
Basis(carryoverfromMrs.WP) (138,000)
Gainrecognized(onefourthbyeachseller) $62,000
Grandchildrenstaxrateoncapitalgain .05
$3,100
Saleproceeds $200,000
Taxcost (3,100)
Grandchildrensaftertaxsaleproceeds $196,900

c. Daughtersamountrealizedonsale $200,000
Basis(FMVatdateofdeath) (200,000)
Gainrecognized 0
Saleproceeds $200,000
Taxcost 0
Daughtersaftertaxsaleproceeds $200,000

IssueRecognitionProblems

1. IstheelectionbyacashbasisindividualtoaccrueinterestincomeonU.S.savingsbondsan
annualelection,orisitapermanentelectionthatmustapplyinallfuturetaxableyears?

2. IsMs.Asreceiptof1,450additionalSBSsharesataxableevent?Isastockdividendtaxableto
therecipient?Ifthestockdividendistaxable,whatisthedollaramountofthedividend?Whatis
Ms.Asbasisinhernew1,450sharesofSBSstock?

3. MustMr.Lcharacterizehisentire$24,000lossrealizedontheworthlessbondascapitalloss?
CanMr.Lcharacterize$6,000ofhisworthlesssecuritylossasordinarybecauseitrepresents
accruedordinaryinterestincome?

4. CanMr.andMrs.Gamortizethe$3,000premiumasdeductibleinterestexpenseoverthelifeof
thebond?IfMr.andMrs.Gholdthebondtomaturity,willtheyrecognizea$3,000capitalloss
orordinarylosswhentheyredeemthebondfor$50,000?

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5. CanMrs.Bclaima$12,000ordinaryabandonmentlossbecauseshesurrenderedhershares
backtoNNCorporationwhenthesharesstillhadsomeminimalvalue?

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6. CanMs.Xreporta$3,500nonbusinessbaddebtasacapitallossonhertaxreturn?Wasthe
substanceoftheoriginaltransactionbetweenMs.Xandherdaughteraloanoragift?DidMs.X
intendthatherdaughterrepaytheloan?

7. DoesMr.Ohavea$10,000businessbaddebt(fullydeductible)ora$10,000nonbusinessbad
debt(capitalloss)?DidMr.OmaketheloantoMNOPaspartofhisbusinessorasan
investment?

8. Whathappenstoanindividualslosscarryforwardswhenthatindividualdies?AreanyofMs.Ts
losscarryforwardsdeductibleonherfinalForm1040?CananothertaxpayerinheritMs.Tsloss
carryforwards,ordothecarryforwardsdiewithher?

9. Whenanindividualsellsaninterestinapassiveactivitytoarelatedparty,cantheindividual
deductanysuspendedlossesfromtheactivity?

10. Doestheabandonmentofaninterestinapassiveactivityqualifyasadispositionthattriggersa
deductionforanysuspendedlossesfromtheactivity?

11. DoesthetransferofMr.OGspropertyintotrustqualifyforamaritaldeductionforfederalestate
taxpurposes?DoesMrs.OGsincomeinterestinthetrustqualifyforamaritaldeduction?

12. Isthe$140,000valueoftheIRAincludedinMr.Dstaxableestate?WhenMr.Dsson
withdrawsfundsfromtheIRAinheritedfromhisfather,mustthesonrecognizethewithdrawals
astaxableincome?IsthesonstaxbasisintheinheritedIRAsteppedupto$140,000(FMVat
dateofdeath)sothatawithdrawalofthe$140,000fundbalanceisataxfreereturnofbasisto
theson?

13. WhatisMr.ASstaxbasisintherealpropertyaftertohiswifesdeath?Isthebasisinonehalfof
thepropertyorthebasisintheentirepropertysteppeduptoFMVonthedeathofacoowner?

ResearchProblems

1. ThisproblemisbasedonthefactsinDorothyDyev.UnitedStates,121F.3d1399(CA10,
1997).TheIRSarguedthatMs.Dyemustclaimthelegalfeesincurredinhersuitagainsther
stockbrokerasmiscellaneousitemizeddeductions(subjecttothe2percentAGIfloor).The
TenthCircuitCourtofAppealsappliedtheoriginofclaimdoctrinetoconcludethattheportion
ofthelegalfeesrelatingtoMrs.Dyesprocurementofcapitalgainincomeshouldbetreatedasa
capitallossratherthananordinarydeduction.Basedonthisdecision,Mrs.Bakercannether
legalfeesagainstthecapitalgainfromhersettlement.

2. ThesequenceofeventssuggeststhatToddZimlerbelievedthathecouldconvert$100,000of
the$125,000unrealizedcapitallossontheinvestmentlandtoordinaryloss.However,Section
1244(d)(1)preventssuchaconversion.Thisparagraphappliesifanindividualmadeataxfree
exchangeofpropertyforSection1244stock,andthebasisofthepropertyexceededitsFMV.
Whentheindividualsellsthestock,anySection1244ordinarylossmustbereducedbysuch
excess.Withoutthisanticonversionrule,ToddssaleofhisSection1244stockwouldresultin
a$100,000Section1244lossanda$23,000capitalloss.However,becausethebasisofthe
investmentlandthatToddexchangedforthestockwas$125,000morethanthelandsFMV,
ToddsSection1244lossisreducedtozero,andherecognizesa$123,000capitalloss.

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3. AccordingtoSection469(h)(2),RachelslimitedinterestinHNPartnershipisapassiveactivity
(i.e.abusinessactivityinwhichRacheldoesnotmateriallyparticipate).Consequently,her
$3,810lossisdeductiblein2007onlytotheextentthatshehaspassiveactivityincomeforthe
year.TheclassificationofRachelsinterestinJamsnJelliesLLCaseitheractiveorpassive
dependsonwhetherher592hoursofworkrepresentsmaterialparticipationintheLLCs
business.AccordingtoReg.Sec.1.4695T(a)(1),anindividualmateriallyparticipatesinan
activityiftheindividualparticipatesformorethan500hoursduringtheyear.Basedonthis500
hourrule,RachelmateriallyparticipatedintheLLCsbusinessfor2007,andhershareof
ordinarybusinessincomeisactiveratherthanpassive.HerconsultingincomefromtheLLCand
hersalaryasalibrarianarenotpassiveactivityincomeaccordingtoSection469(e)(3).
Therefore,Rachelhasnopassiveactivityincomefor2007andcannotdeductanyofher
partnershiploss.

TaxPlanningCases

1. Ms.Kshouldsellthe800sharesacquiredonDecember3,2001,and200oftheshares
acquiredonJuly12,1997.Sheheldbothblocksformorethan12months;consequently,her
recognizedgainwillbelongtermcapitalgaintaxedat15percent.Thesharespurchasedin
2001haveahigherpersharebasisthanthosepurchasedin1997,andtheirsalewillgenerate
lessgain.Ms.Kshouldnotsellanyqualifiedsmallbusinessstock(thesharesacquiredon
September30,2004)untilafterSeptember30,2009.Ifshesellsthestockbeforethisdate,she
isnoteligibleforthe50percentexclusion.IfMs.KsellsthestockacquiredonOctober2,2007,
shewouldrecognizeshorttermcapitalgaintaxedat35percent.

2. IfMs.EHcashesinthepolicy,heraftertaxcashflowwouldbe$82,750.
Cashsurrendervalue $95,000
Investmentinpolicy (46,000)
Ordinarygainrecognizedonsurrender $49,000
Taxrate .25
Tax $12,250
Cashproceedsonsurrender $95,000
Taxcost (12,250)
Aftertaxcashflow $82,750

Ifsheborrowsagainstthepolicyandrepaysthedebtfromthedeathbenefit,theNPVofher
aftertaxcashflowswouldbe$93,553.
Loanproceedsinyear0 $70,000
Presentvalueofinterestpaymentsinyears1through9
($3,500 6.802discountfactorat6%) (23,807)
Presentvalueofyear9deathbenefitlessrepayment
($80,000 .592discountfactorat6%) 47,360
NPV $93,553
Thus,Ms.EHshouldborrowagainstthepolicytomaximizeNPVofcashflows.

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 Chapter 16 - Investment and Personal Financial Planning

3. a. IfMr.andMrs.KQcandeducttheannualinterestandtaxpaymentsrequiredtocarrythe
landforfiveyears,theNPVofthecashflowsispositiveandtheyshouldmakethe
investment.
Investment Interestand TaxSavings NetCash
Year inLand Taxes fromDeduction Flow PresentValue
0 $(40,000) $(40,000) $(40,000)
1 $(6,000) $2,100 (3,900) (3,576)
2 (6,000) 2,100 (3,900) (3,284)
3 (6,000) 2,100 (3,900) (3,011)
4 (6,000) 2,100 (3,900) (2,761)
5 (6,000) 2,100 (3,900) (2,535)
$(55,167)
Salesproceedsnetofdebtrepayment $100,000
Taxcostofsale:
Amountrealized $160,000
Basisinland (100,000)
Gainrecognized $60,000
Taxrate .15
Tax (9,000)
Aftertaxcashfromsale $91,000
Presentvalue($91,000 .650discountfactor) 59,150
NPV $3,983

b. IfMr.andMrs.Bcannotdeducttheinterestandtaxpaymentsandelecttocapitalizethem,
theNPVofcashflowsisnegativeandtheyshouldnotmaketheinvestment.
Investment Interestand TaxSavings NetCash
Year inLand Taxes fromDeduction Flow PresentValue
0 $(40,000) $(40,000) $(40,000)
1 (6,000) 0 (6,000) (5,502)
2 (6,000) 0 (6,000) (5,052)
3 (6,000) 0 (6,000) (4,632)
4 (6,000) 0 (6,000) (4,248)
5 (6,000) 0 (6,000) (3,900)
$(63,334)
Salesproceedsnetofdebtrepayment $100,000
Taxcostofsale:
Amountrealized $160,000
Basisinland (130,000)
Gainrecognized $30,000
Taxrate .15
Tax (4,500)
Aftertaxcashfromsale $95,500
Presentvalue($95,500 .650discountfactor) 62,075
NPV $(1,259)

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 Chapter 16 - Investment and Personal Financial Planning

4. Mr.andMrs.UwillpayAMTintheyearsinwhichMr.Uexerciseshisincentivestockoptions,
andtheirtotaltax(regulartaxandAMT)willbe$85,736.
Taxableincome $260,000
AMTadjustmentsandpreferences 75,000
AMTI $335,000
Exemption($62,550$46,250) (16,300)
TaxableAMTI $318,700
Tentativeminimumtax:
$175,000 26% $45,500
$143,700 28% 40,236
$85,736
Regulartaxon$260,000(MFJ) (65,000)
AMT $20,736

Iftheypurchasethecorporatebondandearnanadditional$5,000taxableincome,theirtotaltax
willbe$87,486.
Taxableincome $265,000
AMTadjustmentsandpreferences 75,000
AMTI $340,000
Exemption($62,550$47,500) (15,050)
TaxableAMTI $324,950
Tentativeminimumtax:
$175,000 26% $45,500
$149,950 28% 41,986
$87,486
Regulartaxon$265,000(MFJ) (66,650)
AMT $20,836
Therefore,theincrementaltaxcostoftheadditionalincomeis$1,750($87,486$85,736),and
theannualaftertaxcashflowfromtheinvestmentis$3,250($5,000$1,750).

Iftheypurchasetheprivateactivitybond,theadditional$3,750incomeisnotsubjecttoregular
taxbutisapreferenceitemthatincreasesAMTIto$338,750.Theirtotaltaxwillbe$87,049.
Taxableincome $260,000
AMTadjustmentsandpreferences 78,750
AMTI $338,750
Exemption($62,550$47,188) (15,362)
TaxableAMTI $323,388
Tentativeminimumtax:
$175,000 26% $45,500
$152,938 28% 41,549
$87,049
Regulartaxon$260,000(MFJ) (65,000)
AMT $22,049
Theincrementaltaxcostoftheadditionalincomeis$1,313($87,049$85,736),andtheannual
aftertaxcashflowfromtheinvestmentis$2,437($3,750$1,313).Therefore,thecorporate
bondisthesuperiorinvestmentforMr.andMrs.U.

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5. a. TheNPVofcashflowsfromInvestmentAis$15,028.
Annualbeforetaxcashflow $7,200
Taxcost($7,200taxableincome 25%) (1,800)
$5,400
Aftertaxcashflowinyears02:
$5,400 2.783discountfactor $15,028
BecauseMs.ZHhasnopassiveactivityincome,shecannotdeductthe$50,000ofyear0
and1lossesfromInvestmentPuntilyear2,whentheinvestmentgenerates$73,000
passiveactivityincome.Consequently,theNPVofcashflowsfromInvestmentPisonly
$14,783.
TaxableIncome/ (TaxCost)/ NetCash Present
Year Cashflow (DeductibleLoss) TaxSavings Flow Value
0 0 0 0 0 0
1 0 0 0 0 0
2 $23,000 $23,000 (5,750) $17,250 $14,783
Therefore,InvestmentAisthesuperiorinvestment.

b. TheNPVofcashflowsfromInvestmentAis$13,024.
Annualbeforetaxcashflow $7,200
Taxcost($7,000taxableincome 35%) (2,520
)
$4,680
Aftertaxcashflowinyears02:
$4,680 2.783discountfactor $13,024
BecauseMs.ZHhas$40,000passiveactivityincomeinyears0and1,shecandeductthe
lossesgeneratedbyInvestmentP.Consequently,NPVofcashflowsfromInvestmentPis
$14,668.
TaxableIncome/ (TaxCost)/ NetCash Present
Year Cashflow (DeductibleLoss) TaxSavings Flow Value
0 0 $(25,000) $8,750 $8,750 $8,750
1 0 (25,000) 8,750 8,750 8,103
2 $23,000 73,000 (25,550) (2,550) (2,185)
NPV $14,668
Therefore,InvestmentPisthesuperiorinvestment.

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6. a. IfMs.BBinvestsintheTNBLimitedPartnership,her$8,000partnershipincomewouldbe
passiveactivityincome.Therefore,shecoulddeducther$5,700suspendedpassiveactivity
lossin2008.Hernettaxableincomewouldbe$2,300,hertaxcostat25%wouldbe$575,
andheraftertaxincomewouldbe$7,425($8,000partnershipincome$575taxcost),
whichrepresentsa7.425%returnonher$100,000investment.
IfMs.BBinvestsinthebondfund,her$10,000interestincomewouldbeportfolio
income.Becauseshehasnopassiveactivityincome,shecouldnotdeducthersuspended
passiveactivitylossin2008.Hernettaxableincomewouldbe$10,000,hertaxcostat25%
preferentialratewouldbe$2,500,andheraftertaxincomewouldbe$7,500($10,000
interest$2,500taxcost),whichrepresentsa7.5%returnonherannualinvestment.Thus,
themutualfundisthebetterinvestment.

b. IfMs.BBinvestsintheTNBLimitedPartnership,her$8,000partnershipincomewouldbe
passiveactivityincome.Therefore,shecoulddeducther$5,700suspendedpassiveactivity
lossin2008.Hernettaxableincomewouldbe$2,300,hertaxcostat35%wouldbe$805,
andheraftertaxincomewouldbe$7,195($8,000partnershipincome$805taxcost),
whichrepresentsa7.195%returnonher$100,000investment.
IfMs.BBinvestsinthebondfund,her$10,000interestincomewouldbeportfolio
income.Becauseshehasnopassiveactivityincome,shecouldnotdeducthersuspended
passiveactivitylossin2008.Hernettaxableincomewouldbe$10,000,hertaxcostat35%
preferentialratewouldbe$3,500,andheraftertaxincomewouldbe$6,500($10,000
interest$3,500taxcost),whichrepresentsa6.5%returnonherannualinvestment.Thus,
thepartnershipinterestisthebetterinvestment.

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