Chapter 43 Taxation of investment vehicles.
An investor must consider income taxes (federal, state, and local) as part of the cost of any investment. The objective of financial and investment planning is to maximize the utility of invested capital in order to accomplish financial and personal goals. Consequently, investors must attempt to minimize the tax element of the investment cost in a manner that is consistent with those goals. An understanding of the basic concepts of the income tax law is therefore essential.
The complexity of the federal income tax law (not to mention the various state and local income tax laws) is almost overwhelming. Only qualified tax specialists should give specific tax advice. But advisers and investors must both have a working knowledge of (1) the issues involved in the acquisition and disposition of an investment, (2) the issues relating to income and expenses during the period the investment is held, (3) the federal income tax rate structure, and (4) some other selected investment tax topics. This chapter will focus on these four broad areas and subdivide them as follows:
1. Acquisition and Disposition Issues
a) Basis (including the "at risk" rules)
b) Business, energy, and rehabilitation tax credits
c) Timing of reporting gain or loss upon disposition
d) Character of gain or loss upon disposition
2. Issues relating to income and expenses while the investment is held
a) "Income" defined
b) Character of income or loss
c) Deductible expenses
d) Timing of recognition of income and expenses
3. The Federal income tax rate structure
a) Income tax rates
b) Capital gain tax rates
c) Qualified dividend income
d) Alternative minimum tax
e) The "kiddie" tax
4. Selected Investment Tax Issues
a) Original issue and market discounts and premiums
b) Short-sale rules
c) Wash-sale rules
d) Constructive-sale rules
e) Straddle rules
ACQUISITION AND DISPOSITION ISSUES
Basis is a key concept to the investor because it is the starting point for determining the amount of gain or loss on a sale or other disposition of property. It is also the measure of the maximum amount of depreciation or amortization allowable for certain types of assets.
An investor's original basis in a purchased asset is its cost. The cost of property is the amount the investor paid for it in cash or other property. For example, if Bob buys a rental property for $100,000 cash, his original basis in the acquired property is $100,000.
When property other than (or in addition to) cash is used to acquire an investment, and the transaction does not qualify as a tax-free exchange, the cost (basis) of the property acquired is the sum of (1) any cash paid plus (2) the fair market value of any property given in exchange for the property. For instance, if Bob purchased the rental property for $10,000 cash plus IBM stock worth $90,000, Bob's original basis in the rental property would be $100,000 [the sum of (1) the $10,000 cash paid plus (2 the $90,000 fair market value of the stock].
Typically, when an investor exchanges one property for another, the market value of the property given up and the market value of the property received will be approximately equal. The fair market value of both properties will, as a practical matter, usually be ascertained by reference to the property whose value is most easily determined. In the example in the previous paragraph, it is easy to determine Bob's basis in the rental property since Bob paid for the property with cash ($10,000) and publicly traded IBM stock ($90,000), the value of which can be easily found.
When property is acquired subject to a mortgage or other debt, the basis of the property is not merely the amount of the investor's equity in the property. The taxpayer can use as the basis: the total of (1) the cash, (2) the value of other property paid, and (3) the total amount of the debt. For example, if Rich buys a $1,000,000 apartment house, paying $250,000 in cash and borrowing the remaining $750,000, his basis in the property is the full $1,000,000.
At Risk Rules
An investor's ability to create basis through the use of debt is limited by the at risk rules. These rules provide that losses are deductible only to the extent the investor is personally at risk.
The at risk rules limit deductions for borrowing that attempt to be characterized as at risk for tax purposes when there is no actual economic risk to the investor. For instance, assume Georgia wants to purchase a $100,000 interest in an oil drilling venture. She intends to invest $20,000 of her own funds while borrowing the $80,000 balance. The bank providing the loan to Georgia has agreed to make a nonrecourse loan to her. In other words, the bank has no recourse to any of Georgia's other assets other than her interest in the oil drilling venture and will rely solely on the value of that property as its collateral for the debt. In the event Georgia cannot repay the loan, the bank cannot look to Georgia's other assets to cover the unpaid balance. Since the most Georgia can lose on her investment is $20,000 in cash, her deductions will be limited to that $20,000 (plus the amount of income generated from the investment).
The at risk rules cover essentially all investment activities except for real estate acquired before 1987. With respect to real estate subject to the at risk rules, qualified nonrecourse financing is treated as an additional amount at risk. Qualified financing is generally defined as borrowings (except convertible debt) from persons or entities actively engaged in the business of lending money (such as banks), and not loans or mortgages from the former owner of the property. Loans from or guaranteed by a federal, state, or local government agency will also qualify.
Aside from real estate investments, the at risk rules apply to the following examples of activities engaged in by an individual for the production of income:
1. Holding, producing, or distributing motion picture films or videotapes.
3. Exploring for or exploiting oil and gas reserves or geothermal deposits.
4. Leasing of depreciable personal property. An investor is considered at risk to the extent of:
1. Cash invested; plus
2. The basis of property invested; plus
3. Amounts borrowed for use in the investment that are secured by the investor's assets (other than the property used in the investment activity); plus
4. Amounts borrowed to the extent the investor is personally liable for repayment; plus
5. When the investment is made in partnership form--
a) The investor-partner's undistributed share of partnership income, plus
b) The investor-partner's proportionate share of partnership debt, to the extent he is personally liable for its repayment.
An investor is not considered at risk with respect to nonrecourse debt (other than qualified nonrecourse financing as described above) used to finance the activity, or to finance the acquisition of property used in the activity, or with respect to any other arrangement for the compensation or reimbursement of any economic loss. For example, if Georgia is able to obtain commercial insurance against the risk that the oil drilling fund will not return her original $20,000 cash investment, she would not be considered at risk to the extent of that insurance coverage.
Losses limited by the at risk provisions are not lost; instead, these amounts may be carried over and deducted in subsequent years (but only if the investor's at risk amount is sufficiently increased).
The benefit of previously deducted losses must be recaptured when the investor's at risk amount is reduced below zero. For example, assume Tania's loss deductions from her interest in an oil drilling venture total $5,000 through the end of last year. Her basis in the venture at the end of last year (after the deductions) was $1,000. In the current year Tania received $3,000 in cash distributions. That distribution reduces Tania's basis by $3,000 to -$2,000.
Since an investor cannot have a negative basis in an investment for tax purposes, Tania must recapture (i.e., report as income) the $2,000 of prior year deductible losses in order to bring her basis up to zero. In addition, Tania will not be able to deduct any losses from the venture in the current year because she has a zero basis.
Property Acquired From a Decedent
Under current law, when an investor dies (in any year other than 2010) the beneficiary of his property does not carry over (substitute) the decedent's basis as his own (the rules for property inherited from a decedent dying in 2010 are explained below). Instead, the basis of property acquired from or passing from a decedent is the fair market value of the property as of the date of (1) the investor's death, or (2) the federal estate tax alternate valuation date if the estate's executor elects that date (typically six months after the date of death). Therefore, if the value of an investment held until death has increased from the date of its acquisition, the potential gain (or loss in the case of a decrease in value) is never recognized for income tax purposes. An increase in the property's basis to its federal estate tax value is called a step up in basis.
Note that this stepped up basis is obtained even though no one pays income tax on the intervening appreciation. For example, if an individual had purchased stock that cost $10,000 and that had a fair market value of $50,000 at the time of his death, his beneficiary would receive a $50,000 basis for the stock. The $40,000 appreciation in the value of the stock would never be subjected to income tax. If the beneficiary then sold the property for $55,000, the taxable gain would be only $5,000 ($55,000 amount realized minus $50,000 basis).
But a step up in basis is not available for property that is income in respect of a decedent (IRD). IRD is income that a decedent was entitled to that was not included in taxable income in the year of death or a prior year. Some examples of IRD include qualified plans, IRAs, deferred compensation, and installment sale payments. IRD is included in income as received by the person receiving payments. A deduction may be available for income tax purposes for the estate tax attributable to the amount includable in income.
An executor or administrator may elect the alternate valuation method only if the election will decrease (1) the value of the gross estate and also (2) the amount of the federal estate tax imposed. Generally, an election to use the alternate valuation date means that the gross estate will include the property at its fair market value as of six months after the decedent's death. But if the estate distributes, sells, exchanges, or otherwise disposes of any property within six months after the decedent's death, the value of the property at that disposition date becomes the alternate value.
Example: Assume property purchased for $10,000 is worth $50,000 on the date of a widower's death. Assume that the executor sells the asset for $45,000 three months after the death. If the executor elects to use the alternate valuation date, the valuation date for this property would be the date of its sale. The property's basis becomes $45,000.
The estate realizes no tax gain or loss because the $45,000 amount realized on the sale is equal to the property's $45,000 basis.
As a result of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA2001), the stepped up basis at death rules are repealed for property acquired from a decedent after December 31, 2009. Note, however, that this repeal is scheduled to remain in effect for only one year. (All of the provisions of EGTRRA 2001 are subject to a sunset provision that, in effect, revokes the entire Act, including this repeal of stepped up basis.) For property inherited during 2010, modified carryover basis rules apply. The recipient of the property will receive a basis equal to the lesser of the adjusted basis in the hands of the decedent or the fair market value of the property as of the date of death. Under these rules, a partial basis step up is allowed, which is limited to $1,300,000 and an additional $3,000,000 in the case of a surviving spouse. The determination of which assets will receive the step up is discretionary in the sole control of the executor or administrator of the estate.
Property Acquired by Gift
When property is acquired by lifetime gift and the donee sells the property for a gain, the general rule is that the property in the hands of the donee has the same basis (subject to an adjustment discussed below) it had in the hands of the donor. This is called a substituted or carryover basis. The donee of the gift--the new owner--computes the basis by referring to the basis in the hands of the donor. In other words, the donor's basis is carried over to the donee. The result of this carryover is that gain will not escape tax forever but merely be deferred. The gain remains deferred only until the donee disposes of the property in a taxable transaction.
Example: Assume that Alex purchases stock for $3,000. After it appreciates in value to $9,000, he gives it to Sara. The basis of the stock in Sara's hands for determining gain on a later sale by Sara is still $3,000. Therefore, if she sells it for $10,000, she has a $7,000 gain.
When the donor's basis carries over to the donee, it is subject to an adjustment for any gift taxes paid on the net appreciation in the value of the gift (but not above the amount of the gift tax paid). For instance, in the example in the paragraph above, if the gift tax were $1,500, the donee's basis would be the $3,000 carryover basis plus a $1,000 adjustment, a total of $4,000.
The addition to basis is computed according to the following formula:
Net Appreciation in Value of Gift/Value of Gift at Transfer x Gift Tax Paid
= Gift Tax Adjustment to Basis
In our example, the computation would be
$9,000 - $3,000/$9,000 x $1,500
= $1,000 Adjustment to $3,000 Carryover Basis
The basis rule for determining loss on the sale of property acquired by gift is different from the rule for determining the amount of the gain on the sale. For purposes of determining the amount of a loss, the basis of the property in the hands of the donee is the lesser of (1) the donor's basis or (2) the fair market value of the property at the time of the gift. The purpose of this special provision is to prevent investors from gaining a tax benefit by transferring property with a built-in loss to persons who could take better advantage of tax losses.
Assume, for instance, that in the example above the value of the stock at the time of the gift was only $1,000. If Alex sold the stock, he would have a capital loss of $2,000 ($3,000 basis--$1,000 amount realized). If Alex had other capital losses of at least $3,000 but no capital gains, the $2,000 loss would be of no immediate tax benefit to him. Were it not for the special provision, Alex might give the stock to his father who had capital gains. If his father were allowed to use Alex's $3,000 basis, his father could sell the stock, take a $2,000 loss, and obtain the tax benefit from the loss that Alex himself could not have used. For this reason, the father, in determining his loss on the sale, must use as his basis the $1,000 fair market value of the property at the time of the gift, since that is lower than Alex's $3,000 basis. If Alex's father sold the property for $900, he would only recognize a $100 loss on the sale ($900 proceeds less $1,000 basis). If Alex's father sold the property at a time when it was worth only $1,200 (or any other amount between the $1,000 fair market value at the date of the gift or the $3,000 carryover basis), he would recognize no gain or loss.
General Business Tax Credits
A credit is a dollar-for-dollar reduction in the investor's tax. The energy, rehabilitation, and low-income tax credits are Congressional incentives to encourage investment in certain types of property used in a trade or business, including rental property.
The energy credit is a percentage of the taxpayer's qualified investment in energy property and is generally limited to 10%. This category includes solar energy and geothermal property. The rehabilitation credit is available for expenditures incurred to rehabilitate buildings that are certified historic structures or were initially placed in service before 1936. The credit is limited to 10% of qualified rehabilitation expenditures for buildings that are not certified historic structures. Rehabilitation expenditures for buildings that qualify as certified historic structures are eligible for a credit of 20%. A credit is also available for investment in certain low-income housing (see Chapter 20, "Real Estate").
The energy, rehabilitation, and low-income housing credits are aggregated with certain other credits to form the general business credit. The amount of the general business credit that may offset income taxes in any one year is limited.
The energy and rehabilitation tax credits are not without cost. The investor must reduce basis for purposes of computing both future depreciation deductions and gain or loss upon the sale or other taxable disposition of the asset.
The investor must reduce the property's basis by:
1. 50% of the business energy tax credit; and
2. 100% of the rehabilitation credits.
Upon early disposition of property for which the investor claimed an energy or rehabilitation credit, and that also reduced the investor's tax liability, the investor must recapture some or all of the investment credit (i.e., report as an additional tax). But if the investor holds the property for at least five full years from the date he placed it in service, the credit is not subject to recapture. Likewise, early dispositions triggered by the investor's death or by a tax-free transfer to a corporation in exchange for its stock will not result in recapture.
If recapture is required, the investor must add to his tax a portion of the credit as indicated in the following table:
If Disposition Occurs Percentage of Investment Before the End of Credit to be Recaptured 1 Year 100% 2 Years 80% 3 Years 60% 4 Years 40% 5 Years 20%
This recapture has the effect of increasing the investor's basis in the property (which was previously reduced when the credit was claimed). This adjustment to basis is treated as if it were made immediately before the disposition.
But the low-income housing credit is subjected to a 15-year recapture period rather than the 5-year schedule above. For additional information on the rehabilitation credit and the low-income housing credit, see Chapter 20, "Real Estate."
Timing of Reporting Gain or Loss upon Disposition
The ability to time the reporting of gain or loss is critical to enhancing the success of the investor. Deferring income until a later year, particularly a year in which the investor is in a lower tax bracket, or accelerating a deduction into a year in which the taxpayer has a great deal of income can significantly enhance the after-tax return from an investment.
The problems of determining the correct year to report income or take deductions flow from the requirement that income must be reported on the basis of annual periods. Although a few exceptions exist, as a general rule investors must report income and claim deductions according to annual accounting periods.
Most individuals are cash basis taxpayers. An investor (i.e., one who reports income as it is received and who takes deductions as expenses are paid) generally will recognize a gain or loss from the disposition of an asset at the time the transaction is closed. The mere signing of an agreement to sell does not trigger the recognition of gain or loss. A transaction is not closed until the seller transfers title to the property in exchange for cash or other proceeds.
An investor can defer the recognition of gain until the actual receipt of cash or other property in exchange for the asset sold. The key ingredient in an installment sale is that the seller will receive at least one payment in a year after the year of sale.
The installment sale provisions are particularly important to an investor who has sold an asset for a substantial profit and has received a cash down payment and note from the purchaser for the balance due. Usually, these notes are not readily transferable. Without the installment sale rules, the investor would incur a large tax in one year even if he does not have sufficient cash from the transaction to pay the tax. Installment sales are also indicated when an investor wants to sell property to another party who does not have enough liquid assets to pay for the property in a lump sum at closing. Installment sales are an important estate as well as financial planning tool and are used to shift wealth within the family unit as well as to protect appreciating assets from creditors.
The basic rules for installment sale reporting include the following:
1. A seller of property can defer as much or as little as desired and can set payments to fit his financial needs. Even if the seller receives payments in the year of sale, he may still use the installment method for the unpaid balance.
2. The seller does not have to receive any payments in the year of sale. An investor may contract to have payments made to him at the time when it is most advantageous (or the least disadvantageous).
3. Installment sale treatment is automatic unless the investor affirmatively elects not to have installment treatment apply. No special election is required.
4. The contract may provide that the installment note receivable is independently secured (such as with a letter of credit obtained from a bank) without triggering the recognition of income when the note is secured.
The tax law imposes several limitations on the use of the installment sale method of accounting for gain on the sale of property. One such limitation is that taxpayers may not use the installment sale method for the sale of stock or securities that are traded on an established securities market.
As a final note on installment sales, strict rules govern the use of the installment method for sales between related parties.
Character of Gain or Loss
The effect of having the gain from the sale of property treated as a capital gain rather than ordinary income can be substantial. Investors can use capital losses only to offset capital gains and a limited amount of ordinary income (no more than $3,000 per year--although unused capital losses may be carried forward and utilized in future years).
Investors determine the amount of capital gain or loss upon a taxable sale or exchange by computing the difference between the sales price or proceeds received and the investor's tax basis (usually his cost) in the capital asset. Certain provisions of the tax law require taxpayers to treat part of the gain as ordinary income, such as those provisions dealing with original issue discount and depreciation recapture.
With certain limited exceptions, all securities held by investors are considered capital assets. Most other assets held for investment purposes or for the production of income are also considered capital assets. In general, the following rules apply to the treatment of capital gains and losses:
1. Net capital gain (i.e., the excess of long-term capital gains over short-term capital losses) is determined by first separating the long-term capital gains and losses into three tax-rate groups. These groups are: (a) the 28% group, which generally includes collectibles gain and IRC Section 1202 gain; (b) the 25% group (i.e., IRC Section 1250 gain); and (c) the remainder group, consisting of long-term capital gains and losses not falling under (a) or (b). Any net short-term capital losses are then applied to reduce any net gain from the 28% group, 25% group, and remainder group in that order.
2. Adjusted net capital gain (i.e., net capital gain reduced, but not below zero) by the sum of unrecaptured IRC Section 1250 gain plus the 28% rate gain and then plus as his own--through 2008--qualifying dividend income). The reduced capital gains tax rate applies only to the adjusted net capital gain.
3. Taxpayers may use capital losses first to offset any capital gains. They are allowed to offset net capital losses against ordinary income on a dollar-for-dollar basis, but only to the extent of $3,000 per year ($1,500 in the case of married taxpayers filing separately).
4. Taxpayers may carry forward indefinitely any excess capital losses (from (3), above) and use them to offset future tax years' capital gains and up to $3,000 per year of ordinary income.
A capital asset falls into its category of short-term or long-term based upon the time the investor holds it. The calculation of the holding period begins on the day after the investor acquires the property. The same date in each successive month is considered the first day of a new month. The holding period includes the date on which the property is sold or exchanged. If property is acquired on the last day of a month, the holding period begins on the first day of the following month.
The specific holding periods are as follows: (1) short-term--held for one year or less--and (2) long-term--held for more than one year. Special rules apply in the case of gains or losses of: (1) regulated futures contracts; (2) nonequity option contracts; (3) foreign currency contracts; (4) short sales; (5) wash sales; (6) tax straddles; (7) constructive sales; and (8) constructive ownership transactions.
The tax law permits tacking of a holding period in the case of gifts, tax-free exchanges, and certain other nontaxable exchanges. Tacking means an investor may add the holding period of the prior owner to his own. For instance, if Sara gives Lara stock that Sara bought three years ago, Lara's holding period would include the three years that Sara held the stock, as well as the period Lara actually holds the stock.
When a person acquires an asset through bequest or inheritance, the recipient automatically and immediately treats the property as having a long-term holding period. This rule applies even if the decedent held the asset for less than one year. For example, assume Sam purchased shares of stock one month before his death. Sam's heir, Sandi, could sell the shares four months after Sam's death and still obtain long-term treatment on any gain.
Many investors buying stocks, bonds, mutual funds, or other investments have multiple holdings of the same types of assets. It, therefore, becomes necessary to be able to identify each separate share or unit of a multiple investment so that the investor can determine each share's own basis and holding period. Record keeping, documentation, and an information retrieval system are therefore all important tools for the sophisticated investor.
If an investor is unable to adequately identify the lot from which securities are sold or transferred, the investor must use the first-in, first-out (FIFO) method. This means that the investor will be deemed to have sold the securities in the order in which he acquired them. In some cases involving mutual fund shares, the tax law allows the investor to use an average basis method for ascertaining both tax basis and holding period.
INCOME AND EXPENSES WHILE THE INVESTMENT IS HELD
Tax law defines income in very broad terms. Income includes all income from whatever source derived that is not specifically excluded by a section of the Internal Revenue Code. The implication is that if an item is considered something other than a return of an investor's capital, it will be taxable unless otherwise specifically excluded by a provision in the Internal Revenue Code. The Supreme Court has defined income as "gains received from capital, from labor, or from both combined, provided it be understood to include profit gained through a sale or conversion of capital assets."
Common items realized by an investor that are specifically enumerated by the Internal Revenue Code as income include: (1) gains derived from dealings in property; (2) interest; (3) rents; (4) royalties; (5) dividends; (6) annuities; and (7) income from an interest in an estate or trust.
Note that the tax is levied only on income. The distinction in answering the question of whether an item is income lies between the terms "income" and "capital." An investor may recover, income tax free, his capital investment in an asset.
Among the very few items common to an investor specifically excluded from income by the Internal Revenue Code are: (1) interest on certain governmental obligations (e.g., many municipal bonds); (2) certain improvements by the lessee on the lessor's property; (3) generally, death proceeds received under a life insurance contract.
Whose income is it? This is an important issue that investors must resolve. An individual may have to report and pay tax on income that he never receives, but that someone else receives. Income is taxed to the person who: (1) earns it; (2) creates the right to receive it; (3) owns or controls the property that is the source of the income; or (4) has the right to control who will enjoy the benefit of it.
The tax rule governing income shifting is known as the "assignment of income doctrine." According to this doctrine, although one individual may shift income to another individual (which may create gift tax problems), the burden of income taxation will not change. The person who earns the income--or owns or controls the source of the income--is deemed to have received it and then passed it on to its actual recipient. For example, if an attorney directs a client to pay his fee to the attorney's mother, or a wealthy investor who owns an office building directs that all tenants pay rent directly to his widowed sister, the tax liability will not shift, despite the shift in income.
Although merely assigning income will not shift the burden of taxation, an assignment of an income-producing asset will cause the income derived from that asset to be taxed to the assignee. For example, if an individual makes a gift of securities or any other income producing property to his son, the son will be responsible for tax on the income produced by that property after the transfer.
To accomplish income shifting tax objectives, the owner must transfer the property before the income is actually earned and the transfer must be complete and bona fide. In addition, to shift the burden of income tax (as well as to remove it from the transferor's estate), the transferor must retain no control over either the property or the income it produces.
Character of Income or Loss
Under current tax law, it is necessary to distinguish among (1) earned income or losses (such as salary, or active business income or losses); (2) investment income (such as interest, dividends, royalties, and annuities); and (3) passive activity income or losses. These separate categories of income are important, since an investor may not use passive activity losses (and credits) to offset earned income or investment income. (Taxpayers may offset losses from active business endeavors against income from other active businesses, investment income, or passive activity income.) The passive activity loss limitations apply to estates and trusts, personal service corporations, and pass-through entities such as partnerships and S corporations, in generally the same manner as they apply to individuals. Passive activity losses of closely-held C corporations (where five or fewer shareholders own more than 50% of the stock value) can offset trade or business (earned) income, but not investment income of the corporation.
Taxpayers may carry forward disallowed passive activity losses and credits and treat them as deductions and credits from passive activities in the next taxable year. Taxpayers may deduct suspended losses from a passive activity in full when the taxpayer disposes of his entire interest in the passive activity in a fully taxable transaction. Taxpayers may not claim suspended credits in full in the year the taxpayer disposes of the interest in a passive activity. Rather they carry forward such credits until the taxpayer may use them to offset tax liability from passive income. But upon a fully taxable disposition of a passive activity, a taxpayer may elect to increase the basis of property immediately before the transaction by an amount equal to the portion of any suspended credit that reduced the basis of the property for the taxable year in which the credit arose.
Passive Activity Income or Loss
In general, the term passive activity means any activity that involves the conduct of any trade or business in which the taxpayer has an interest but does not materially participate. The definition of passive activity generally includes any rental activity of either real or tangible personal property regardless of whether the individual materially participates. With respect to equipment leasing, short-term rental to certain users (where the lessor provides substantial services) is an active business rather than a passive activity. In general, working interests in oil and gas property held directly or indirectly via a pass-through entity where the investor's liability is not limited (e.g., general partnership) will be treated as an active trade or business, not a passive activity.
Material Participation Defined--In general, a taxpayer will be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis. Substantial and bona fide management decision-making by an individual may constitute material participation. For example, if an individual performs managerial services on a full-time basis and the success of the business is dependent upon the exercise of business judgment by an individual, such services would constitute material participation. This test applies regardless of whether an individual owns an interest in the activity directly or through a pass-through entity such as a general partnership or an S corporation. Limited partnership interests are generally treated as not materially participating.
Net Investment Income Defined--Net investment income is not treated as passive activity income and, therefore, investors cannot offset this income with passive activity losses. Net investment income means (1) gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business; less (2) expenses (other than interest) that are clearly and directly allocable to such gross income; less (3) interest expense properly allocable to such gross income; plus (4) gains from the disposition of property generating the interest, dividend, royalty, etc. income; less (5) losses from the disposition of property generating the interest, dividend, royalty, etc. income. Investment income earned within a pass-through entity, such as a partnership or S corporation, retains its character when reported to each investor in the entity. Investors cannot use this income to reduce the passive activity losses that pass through to each investor.
Treatment of Former Passive Activity--If an activity is a former passive activity for any taxable year and has suspended losses or credits from prior years when the activity was passive, the investor may offset the current year's income from that activity with the suspended losses and the suspended credits may offset any current year's regular tax liability allocable to that activity. Any remaining suspended losses or credits continue to be treated as derived from a passive activity. Such losses and credits can be used to offset income or tax from that activity in years after it changed from passive to active, as well as income or tax from other passive activities.
Dispositions of an Entire Interest in a Passive Activity--Upon the taxable disposition (including abandonment) of an entire interest in a passive activity (or former passive activity), any suspended losses from the activity are no longer treated as passive activity losses and are allowable as a deduction against the taxpayer's income in the following order: (1) income or gain from the passive activity for the taxable year (including any gain recognized on the disposition); (2) net income or gain for the taxable year from all passive activities; (3) any other income or gain.
When an interest in a passive activity is transferred upon the death of the taxpayer, suspended losses may be deducted against income, but only to the extent such losses exceed the amount by which the basis of the interest in the activity is stepped-up at the taxpayer's death. Investors who dispose of an entire interest in a passive activity using an installment sale may deduct suspended losses each year based on the ratio of the gain recognized each year to the total gain on the sale.
If a person disposes of an interest in a passive activity by gift, the basis of the interest to the transferee is increased by the amount of the suspended losses generated from the interest. Such suspended losses added to the transferee's basis are not allowed as a deduction in any taxable year. The increase in basis will, of course, reduce the gain (or possibly increase the loss) from the ultimate taxable sale by the transferee.
Special Rules for Rental Real Estate--Where an individual owns an interest in rental real estate in which he actively participates, the individual may deduct up to $25,000 ($12,500 in the case of married taxpayers filing separately) of such losses or claim an equivalent amount of credits from the rental activity each year, regardless of the general limitations imposed on passive activities. This $25,000 annual allowance is reduced by 50% of the taxpayer's adjusted gross income (determined without regard to passive activity losses, taxable social security benefits, or IRA deductions) that exceeds $100,000 ($50,000 for married taxpayers filing separately). Consequently, the special $25,000 allowance is fully phased-out for taxpayers with adjusted gross income greater than $150,000 ($75,000 for married taxpayers filing separately).
Taxpayers may carry over any losses in excess of the $25,000 (or the reduced allowable amount) from rental real estate where there is active participation as suspended passive activity losses. Taxpayers may use such losses in computing the $25,000 allowable amount in subsequent years in which the investor actively participates in the rental real estate activity.
The requirement for active participation is less stringent than the test for material participation used in distinguishing a passive activity from an active interest in a trade or business. Generally, less personal involvement will be required. But an individual can never be considered to actively participate in a rental property during a period where neither the individual nor the individual's spouse has at least a 10% interest in the property. Except as provided in regulations, a limited partnership interest in real estate does not qualify as active participation.
In the case of the rehabilitation and low-income housing credits (but not losses), the $25,000 allowance applies on a credit equivalent basis, regardless of whether the individual actively participates in the rental real estate activity. Even if the interest is in a limited partnership, the credits may be claimed (up to the $25,000 credit equivalent). The phaseout of the credit equivalent for rehabilitation credits, regardless of when the property was placed in service, starts at adjusted gross income of $200,000, rather than $100,000. Similarly, with respect to property placed in service prior to 1990, phaseout of the $25,000 credit equivalent for the low-income housing tax credit starts at adjusted gross income of $200,000, rather than $100,000. With respect to property placed in service after 1989, there is no phaseout of the $25,000 credit equivalent for the low-income housing tax credit.
A deduction is permitted for many of the investment expenses incurred by an investor. These expenses fall into two major categories: (1) interest paid on amounts borrowed in order to acquire or hold taxable investments; and (2) other expenses paid in connection with the production of income.
Deductibility of Interest
Subject to some complex rules and limitations, investors may deduct interest paid or accrued within the taxable year on indebtedness. Interest can be defined as the compensation allowed by law or fixed by the parties for the use of money. Tax law allows no interest deduction, regardless of the label given to a particular payment, unless the investor has incurred (1) a valid obligation, (2) to pay a fixed or determinable sum of money, (3) in return for the use of money.
Sometimes mortgages contain penalty clauses if the mortgagor prepays the loan. These penalty payments are for the use of money and are therefore--as payments for the privilege of prepaying mortgage indebtedness--deductible as interest.
Points may also be considered interest. Points are premiums in addition to the stated interest rate that borrowers pay to obtain a loan. This additional charge is a percentage of the loan amount. Points are assessed and paid at the inception of the loan. If the borrower paid the fee as compensation for the use of money, it is interest and therefore deductible. Typically, borrowers deduct points ratably over the term of the loan; yet, if certain requirements are met, borrowers can deduct points in the year paid. On the other hand, if all or a part of the charge was for services provided by the lending institution to the investor, such as appraisal fees, that portion is not interest.
If one person pays the interest on another person's debt, the person paying the interest may not deduct the interest; only the person who is liable for the debt may claim the interest deduction. When there is joint- and-several liability (such as when a husband and wife are joint obligors or co-makers of a note), the obligation to pay the interest extends to each co-debtor, so each co-debtor may deduct whatever portion of the interest he pays.
Rules Limiting the Deductibility of Interest--Under current law, essentially all the interest expenses of an individual investor (other than interest incurred in the ordinary course of a trade or business in which the individual materially participates) are subject to one or more limitations. These limitations can be most easily described by the categories to which the debt is properly allocable. These categories include (1) passive activity interest, (2) investment interest, and (3) personal interest. Generally, the allocation of interest is based on the use of the proceeds of the underlying debt. Any interest expense properly allocable to a passive activity is added to other passive activity expenses in determining the annual limitation on the deductibility of passive activity losses (discussed above).
Investment interest generally includes interest expense paid on indebtedness properly allocable to property held for investment (other than passive activity investments). Investment interest is deductible only to the extent of net investment income.
Investment interest generally includes interest expense (1) allocable to the production of portfolio income (dividends, interest, royalties, etc.); (2) allocable to a trade or business in which the investor does not materially participate, (unless the activities are treated as a passive activity, in which case the interest expense is subject to the passive activity loss limitations); or (3) allocable to the portfolio income of a passive activity.
Net investment income means the excess of investment income over investment expenses. Investment income includes portfolio income (except from passive activity investments), net short-term and long-term capital gains, and ordinary income gains from the sale of investment property (other than passive activity investment property). Investment expenses include expenses (except interest) related to these sources of investment income.
Investors may carry over annual interest deductions that are disallowed solely due to the investment interest expense limitation indefinitely and deduct them against investment income in future years.
Individuals, estates and trusts are not allowed to deduct personal interest paid or accrued during the taxable year. Personal interest is defined to include all interest except: (1) interest expense incurred or continued in connection with the conduct of a trade or business; (2) investment interest expense; (3) interest expense taken into account in computing a taxpayer's income or losses from passive activities; (4) qualified residence interest (see below); (5) interest on qualified educational loans (see below); or (6) interest payable resulting from allowable extensions of payments of estate tax (on the value of reversionary or remainder interests in property).
With respect to mortgage debt incurred after October 13, 1987, taxpayers may deduct interest on mortgage acquisition indebtedness up to a total of $1 million ($500,000 in the case of married taxpayers filling separately) covering up to two homes. Acquisition indebtedness is debt incurred to finance the purchase or improvement of no more than two qualified residences. Taxpayers must reduce the amount of acquisition indebtedness upon which the interest deduction is computed by the amount of their principal payments. Taxpayers cannot increase acquisition indebtedness by refinancing unless they use the additional debt they received from the refinancing for additional improvements.
In addition to interest on acquisition indebtedness, taxpayers may deduct interest on home equity indebtedness of up to $100,000 ($50,000 for married taxpayers filing separately). Home equity indebtedness must be secured by the same two qualified residences as the acquisition indebtedness. But there is no limitation on the use of the home equity indebtedness funds.
Interest on qualified residence debt incurred prior to October 14, 1987 is treated as acquisition indebtedness that is not subject to the $1,000,000 limitation, and is deductible in full. In other words, such amounts are grandfathered under the post-October 14, 1987 rules. But the amount of pre-October 14, 1987 debt reduces (but not below zero) the amount of the $1,000,000 limitation on acquisition indebtedness incurred after October 13, 1987 (but does not reduce the amount of home equity debt that taxpayers can incur after that date). Any refinancing of pre-October 14, 1987 acquisition indebtedness that extends the term of the debt beyond the original term or exceeds the principal amount of the original debt will no longer qualify under the grandfather provision. But the interest on a debt with a balloon type principal payment requirement is deductible for the term of the first refinancing of such acquisition indebtedness, not to exceed 30 years.
Taxpayers with modified adjusted gross income (MAGl) up to certain limits may deduct interest payments due and paid on loans for qualified educational expenses. For these purposes, modified adjusted gross income is computed after applying the Social Security inclusion, moving expenses, and passive loss rules, but without regard either to the student loan interest deduction, the exclusion for amounts received in redemption of qualified education savings bonds, the foreign earned income exclusion and foreign housing exclusion, and amounts excluding sources from possessions or Puerto Rico.
Qualified educational expenses include tuition, fees, room and board, and related expenses. The maximum deduction is $2,500. No deduction is allowed for an individual who is claimed as a dependent on another taxpayer's return.
If MAGI exceeds certain limits, the deduction for interest on education loans is reduced. Single tax-payers may take no deduction if their MAGI is in excess of $65,000 and the amount of the deduction is reduced proportionately if MAGl is between $50,000 and $65,000.
Married taxpayers filing jointly may take no deduction if their MAGl is in excess of $130,000 and the amount of the deduction is reduced proportionately if MAGI is between $100,000 and $130,000. Married taxpayers filing separately may take no such deduction.
Taxpayers may not deduct interest that would otherwise be deductible if it is allocable to a class of income wholly exempt from tax (e.g., municipal bonds). The rationale is that if the taxpayer entirely excludes the income items from gross income, it is not necessary or appropriate to permit any interest deduction. This rule makes it difficult for an investor borrowing money for investment purposes to deduct interest on those loans if he also holds tax-exempt bonds for investment.
The tax law provides a number of other limitations on the deduction of interest that are of importance to investors. One such restriction is imposed on interest investors incur to purchase or carry market discount bonds (i.e., bonds purchased after original issue at a price below both its redemption price and its original issue price, because of an increase in the interest rates available on newly issued alternative investments). Such interest is not currently deductible to the extent the investor has deferred the recognition of current income. The investor may claim the interest deduction at the time he reports the market discount income, which is essentially the unreported interest that has accrued on the bond from the date of purchase until the date of disposition.
A similar restriction is imposed on interest expenses investors incur in financing non-interest-bearing short-term obligations such as Treasury bills. If the investor acquired the short-term obligation through a loan, the net interest expense is not deductible to the extent of the ratable portion of the bond discount attributable to the current year (the disallowed interest is, however, deductible upon the disposition of the bond). Interest is currently deductible if the investor elects to include the discount as income in the taxable year it is earned.
Deductibility of Investment Expenses Other than Interest
Many expenses investors incur are deductible (subject to the 2% floor on miscellaneous itemized deductions) if they meet certain requirements.
The requirements are that the investor must incur these expenses (1) for the production or collection of income; or (2) for the management, conservation, or maintenance of property held for the production of income; or (3) in connection with the determination, collection, or refund of any tax. Additionally, an investor's expenses must be (1) ordinary and necessary, (2) paid or incurred in the taxable year, and (3) expenses rather than capital expenditures. An expense is considered ordinary if it normally occurs or is likely to occur in connection with an investment similar to the one for which an expense deduction is claimed.
Common deductible investment-related expenses include (1) rental expenses of a safe deposit box used to store taxable securities; (2) subscriptions to investment advisory services; (3) investment counsel fees (whether or not the advice is followed); (4) custodian's fees; (5) service charges in connection with a dividend reinvestment plan; (6) service, custodial, and guaranty fees charged by the issuer of mortgage backed pass-through certificates; (7) bookkeeping services; (8) office expenses such as rent, water, telephone, stamps, and stationary incurred in connection with investment activities; (9) secretarial services relating to the management of rental property and investment record keeping; (10) premiums paid for an indemnity bond required for issuance of a new stock certificate to replace lost, stolen, destroyed, or mislaid certificates; and (11) fees incurred for tax advice (including (a) preparation of income tax returns, (b) cost of tax books used in preparing tax returns, (c) tax advice from attorneys and accountants, (d) legal fees for obtaining a letter ruling from the IRS, and (e) legal or accounting fees contesting a tax deficiency or claiming a refund (whether or not successfully).
But deductible investment related expenses of individuals are only deductible to the extent they exceed 2% of the taxpayer's adjusted gross income (AGl). For example, if Jon's deductible investment related expenses equal $4,500 in a year in which his AGI is $200,000, his allowable deduction for such expenses is limited to $500 ($4,500 - $4,000 [2% x $200,000]).
Common investment-related expenses that investors may not deduct (because they are personal or because they are not ordinary and necessary) also include travel to attend shareholders' meetings. An investment related expense need not be essential in order for it to be considered necessary. But it must be one that the investor reasonably believes is appropriate and helpful. Generally the courts will not question the investor's determination. The standard of what is or is not both ordinary and necessary depends on the situation in the community where the issue arises. If most investors in the same situation would have incurred the same expenditure, the taxpayer would satisfy the ordinary and necessary tests.
It is essential that an expense be paid or incurred in the taxable year (see "Timing and Recognition of Income and Expenses," below).
To be deductible, an expense must meet one additional major test--it must not be a capital expenditure. If an outlay is an expense, the taxpayer can deduct it immediately. If an outlay is considered the cost or part of the cost of an asset, the taxpayer must capitalize it. This means that the investor must add the outlay to the basis in the asset. If the asset is depreciable or amortizable, this increased basis will result in additional deductions over the life of the asset. The investor may otherwise use the increased basis to lower the gain or increase the loss upon a sale or other taxable disposition of the investment.
Common expenditures that are considered capital in nature and are, therefore, not currently deductible include: (1) brokers' commissions and fees in connection with acquiring investments (these are added to the basis of the property); (2) selling expenses (these are offset against selling price in determining capital gains and losses); and (3) expenses to defend, acquire, or perfect title to property (these are added to the basis of the property).
Timing of Recognition of Income and Expenses
Cash basis taxpayers report income in the year that they receive it and, generally, deduct expenses in the year that they pay it. The cash basis method is therefore essentially an "in and out of pocket" method of reporting. Items do not have to be received or paid in cash; receipts and payments in property are income and deduction items to the extent of the fair market value of the property received or paid.
Accrual basis taxpayers report income when they earn it, even if they do not receive the cash income until a subsequent tax year. Generally, accrual basis taxpayers deduct an expense when their liability for payment has become fixed and determinable. Most individuals are cash basis taxpayers. The following discussion will focus on the application of the general rules applicable to cash basis investors and four of the major exceptions.
Cash basis investors generally will include interest, royalty, dividend, and other investment income, as well as gains from the sale of investments, in gross income in the year in which they receive cash or other property. Cash basis investors generally will deduct interest and other expenses they incur in connection with their investments, as well as losses from the sale of investments, from gross income in the year in which they pay cash or other property. Thus, they may deduct interest expense, investment advisory fees, and other deductible expenses in the year paid. But generally they deduct losses on the sale of securities on the trade date (even if delivery and receipt of the proceeds occurs in the following year). Some exceptions to the general rules governing cash basis investors follow.
Under the doctrine of constructive receipt, an investor must include an item in gross income even though he does not actually take possession, if the item is (1) credited to his account, (2) set apart for him, or (3) otherwise made available so that he can obtain it at his own volition without any substantial conditions or restrictions. Therefore, income is taxable if the investor can take it when he wants it.
The purpose of the doctrine is to prevent investors from determining at will the year in which they will report income. Without the doctrine of constructive receipt, investors could postpone the taxability of income until the year in which they chose to reduce the item to their actual possession. For example, taxpayers must report interest credited to their bank savings accounts regardless of whether they withdraw the interest or leave it on deposit.
Constructive receipt will not apply if the taxpayer's control of the income is restricted in some meaningful manner. For instance, an investor will not be considered to have constructively received money or other property if (1) it is only conditionally credited, (2) it is indefinite in amount, (3) the payor has no funds, (4) the money is available only through the surrender of a valuable right, or (5) receipt is subject to any other substantial limitation or restriction. The doctrine of constructive receipt is particularly important to individuals whose employers have enhanced their financial security through nonqualified deferred compensation arrangements.
The economic benefit theory states that when employees receive from their employers a benefit that is the equivalent of cash, the employees are currently taxed on the value of that benefit. The most common example is where executives receive group term life insurance coverage in excess of the amount excludable from federal income tax. The employees must include in income an amount (computed from government tables) that represents the economic benefit they receive when their employer makes premium payments. The term insurance provided in a split-dollar arrangement and the incidental life insurance coverage employers sometimes provide in their qualified retirement plans are other examples of currently reportable economic benefits.
There is an important difference between the doctrine of constructive receipt and the economic benefit theory. The constructive receipt doctrine requires the inclusion of income when taxpayers have an unrestricted choice--that is, whether to take or not to take income set apart for them or credited to their account. This theory is concerned with the issue of when income is realized by the taxpayer.
Conversely, the economic benefit theory requires taxpayers to report income even if they cannot take the income. Under the economic benefit theory, all that is necessary to trigger taxation is that employees receive from their employer a benefit that is the equivalent of cash--that is, something with a (1) current, (2) real, and (3) measurable value. The economic benefit theory is concerned with whether the taxpayer has enjoyed a present benefit from his employer capable of measurement and subject to tax. This theory is concerned with the issue of what income is.
An employer often transfers property to an employee in connection with the performance of services. A business may give or sell stock or other property to a key employee but withhold, by separate agreement, significant rights. For example, an employer may transfer stock to an employee but restrict the employee's right to vote the stock or sell it. The idea is that the employer will withhold (restrict) property rights until the employee has performed certain specified services. If the employee fails to achieve the goal or meet the specified requirements, the employee may forfeit his right to the stock or other property.
Suppose an employer pays a bonus to an executive in the form of company stock. Assume the ownership of this stock is subject to certain restrictions, including a provision that if the employee leaves the company within a 5-year period he will forfeit the stock and will receive no compensation. Such property is appropriately called restricted stock or restricted property.
If an employer gave an employee property with no restrictions, the entire value of the property would constitute current compensation income. For instance, an employee who receives a bonus of 100 shares of his employer's stock currently selling for $200 a share realizes $20,000 of income. But, if certain requirements are met, an employer can compensate an employee in a manner that delays the tax until the employee is given full rights in the property.
The general rules governing restricted property (the IRC Section 83 rules) provide that employees will report transfers of restricted property as income in the first tax year in which the employees' rights are (1) not subject to any substantial risk of forfeiture and (2) transferable free of this risk. In other words, employees will not be subject to tax on restricted property as long as their rights to that property are forfeitable (subject to a substantial risk of forfeiture) and not transferable by them free of such risk. (This means that if employees should sell or give the property away, the recipients of the property must also be under a substantial risk that they (the new owner) would forfeit the property if the employees failed to satisfy the conditions necessary to obtain full ownership.)
Substantial risk of forfeiture means that rights in transferred property are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person or upon the occurrence of a condition related to the purpose of the transfer. In addition, there must be a realistic and substantial possibility of forfeiture if the specified condition is not satisfied. The following examples illustrate common situations that probably would not be considered substantial restrictions: (1) a consulting contract with a retiring executive that called for only occasional services at the executive's discretion, (2) a requirement that an employee must return the property if he commits a felony, or (3) a noncompetition provision (since this is largely within the employee's control).
What happens when the restrictions expire? At the lapse of the restrictions, the employee must generally include in income the value of the property at that time. Sometimes an employer will remove restrictions in stages so that an employee may "earn out" of the restrictions.
But the employee has a choice--he can elect to have the value of the restricted property taxed to him immediately in the year he receives it (even though it remains nontransferable or subject to a substantial risk of forfeiture). If an employee makes this election within 30 days of receipt of the property, the general restricted property rules do not apply. Any appreciation in the value of the property is treated as capital gain rather than as compensation. The employee pays no tax at the time the risk of forfeiture expires (and will pay no tax until the property is sold or other wise disposed of in a taxable exchange). But if the property is later forfeited, no deduction is allowed for the loss.
An employee who makes this election must be willing to pay ordinary income tax on the fair market value of the property in the year he receives the stock or other property. He is gambling that the value of the property will increase considerably before the restrictions lapse (in which case he may be eligible to pay tax on any realized gain as capital gain). He is also gambling that he will not forfeit the stock before he is able to sell or dispose of it without restriction.
Another exception to the strict rule of includability of the fair market value of the property (upon the lapse of restrictions) concerns restrictions that affect value. This exception pertains to value-affecting restrictions, which, by their terms, will never lapse. For instance, if an employee may sell restricted property only at book value and that restriction, by its terms, will never lapse, that amount will be treated as the property's fair market value.
An employer's compensation deduction will be allowed at the time the employee recognizes income from restricted property. The amount of the deduction will be the same as the amount of income recognized by the employee.
In certain situations, cash basis investors can control the year in which they will take deductions. They can, for instance, prepay certain taxes and take the deduction in the year of payment even though the expenses relate to future years. This ability to time deductions is limited. For example, taxpayers cannot deduct the payment of multiple years' prepaid rent and insurance premiums in the year of payment. They generally must spread the deductions over the period covered by the prepayment if the deduction of the prepayment would materially distort income.
Special rules apply to the deductibility of interest expense for all taxpayers, whether they use the cash basis or the accrual method of accounting. A cash basis investor must deduct prepaid interest over the period of the loan to the extent the interest represents the cost of using the borrowed funds during each taxable year in the period. Generally, investors must deduct points paid on an investment loan ratably over the term of the loan. An investor on the accrual method of accounting accrues interest ratably over the loan period. This means the accrual method investor must deduct the interest ratably even if he prepays the interest.
THE FEDERAL INCOME TAX RATE STRUCTURE
Tax planning is such an important part of investment planning that advisers and investors need to have a complete understanding of the federal income tax rate structure. This section will discuss the federal income tax rate structure, the alternative minimum tax, and the "kiddie tax" on unearned (investment) income of children under age 18.
Ordinary Income Tax Rates
The income tax rates are applied to a taxpayer's taxable income, which can be defined as the amount of income that remains after a taxpayer subtracts all deductions and exemptions from gross income. For income tax rates, see Appendix I.
Capital Gain Tax Rates
For long-term capital gains properly taken into account after May 5, 2003 and before 2011, the 10% and 20% rates on capital gain are reduced to 5% (0% in 2008) and 15%, respectively. These rates apply for both the regular tax and the alternative minimum tax (AMT). In addition, gain from an installment sale that would have qualified for the 10% or 20% rates will now qualify for the 5% or 15% rate on payments collected after May 5, 2003 and before 2011. But the 25% rate on unrecaptured IRC Section 1250 gain and the 28% rate on collectibles and qualified small-business stock (IRC Section 1202 stock) still apply.
After 2010, the capital gain tax rates and rules are scheduled to revert to the old rates. Consequently, when planning for investment horizons beyond 2010, investors should know the rates and rules that will apply at that time under current law. (In the case of qualified 5-year gain--that is, adjusted net capital gain from capital assets held more than five years before their sale, and where the 10% rate had been reduced to 8% and the 20% rate had been reduced to 18%--note that the 8%/18% rates have been repealed. (1))
Qualified Dividend Income
Effective for tax years beginning after 2002 and before 2011, dividends received by an individual shareholder from certain corporations are generally taxed at the same rates that apply to long-term capital gains (see above). (2) Dividends received on common and preferred stock should qualify for the lower rates. Furthermore, dividends received by an S corporation, partnership, or LLC (if the LLC is taxed as a partnership or disregarded entity) should be eligible for the lower rates to the extent the dividends are ultimately taxed to individual (noncorporate) owners. These rates apply for both regular-tax and alternative-minimum-tax (AMT) purposes. (3)
For purposes of these rules, qualified dividend income means dividends received during the tax year from domestic corporations and qualified foreign corporations. A qualified foreign corporation is a corporation that is incorporated in a U.S. possession, or that is eligible for benefits of a comprehensive income tax treaty with the United States that the IRS determines is satisfactory for purposes of the IRC qualified dividend income rules, and that includes an exchange of information program. Corporations whose stock of American Depository Receipts (ADRs) is readily tradable on an established U.S. securities market also are qualified foreign corporations. But qualified foreign corporations do not include foreign personal holding companies, foreign investment companies, and passive foreign investment companies.
Several types of dividend income are specifically excluded from the definition of qualified dividend income, including the following:
1. Dividends received on the stock are not eligible for the reduced rates if the shareholder does not hold the share of stock for more than 60 days during the 121-day period beginning 60 days before the "ex-dividend date" (i.e., the first date following the declaration of a dividend on which the buyer of a stock will not be entitled to receive the next dividend). (4) In the case of preferred stock, the share of stock must be held for more than 90 days during the 181-day period beginning 90 days before the ex-dividend date;
2. Dividends on any share of stock to the extent that the taxpayer is under an obligation (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property;
3. Any amount taken into account as investment income under IRC Section 163(d)(4)(B) (which treats qualified dividend income as investment income if elected by the taxpayer) allowing the dividend to support a deduction for investment interest;
4. Dividends from corporations that are exempt from tax under IRC Sections 501 and 521;
5. Amounts that are allowed as a deduction under IRC Section 591 relating to dividends paid by mutual savings banks; and
6. Dividends paid on employer securities held by an employee stock ownership plan (ESOP).
Payments in lieu of dividends (e.g., dividends paid on stock that a broker has loaned to a customer, where the dividends are paid to the short sale buyer before the short sale is closed) are not eligible for the reduced dividend rates.
Dividends from Mutual Funds and REITs
With some restrictions, dividends received from regulated investment companies (RICs or mutual funds) are eligible for the reduced dividend rates. In the case of mutual funds, what currently comes out as dividends normally is made up of different types of income: interest, short-term capital gains, and dividends received from various stock investments. The interest income and short-term capital gains still will be taxed at the ordinary income rates; only the actual dividends included in the distributions will be eligible for the lower rates. Therefore, dividends from money market funds will generally be entirely ineligible for the lower dividend tax rates. If at least 95% of a RIC's gross income (other than long-term capital gains) is qualifying dividend income, the RIC will be able to designate 100% of its ordinary income dividends as qualifying for the lower dividend rates.
Most REIT dividends are not eligible for the reduced rate. (5) The 15% tax rate applies to REIT dividends that are attributable to: (1) dividends received by the REIT from non-REIT corporations (e.g., taxable REIT subsidiaries); and (2) income that was subject to tax by the REIT at the corporate level. REIT capital gain dividends are taxed at a maximum rate of 25% to the extent of unrecaptured IRC Section 1250 gains, and at a maximum rate of 15% thereafter. (6)
Alternative Minimum Tax
The tax law imposes an alternative minimum tax (AMT) so that individuals with substantial economic income will not be able to avoid a tax liability by using exclusions, deductions, and credits. The AMT attempts to broaden the taxable income base to insure that most investors will incur at least some tax liability. Because the actual tax liability of taxpayers is the greater of the regular tax and the AMT, any cuts in the regular tax that lowers taxpayers' regular tax liability below their AMT liability are not actual cuts in taxes.
But the number of taxpayers now paying AMT has grown rapidly and will continue to grow. Experts estimate that the number of AMT affected taxpayers will rise from about 2.4 million in 2003 to 35.5 million in 2010. Among the most important reasons for the expanding impact of the AMT is that AMT tax brackets and exemptions are not indexed for inflation, unlike other income tax items. Also, while certain credits--the child credit, the adoption credit, dependent childcare credit, and the HOPE and Lifetime Learning credits--have been allowed for AMT purposes for the past few years, they are not allowed for taxable years beginning after 2003.
Individuals pay alternative minimum tax to the extent that it exceeds their regular Form 1040 tax liability. If the tax computed under the AMT formula does not exceed the investor's regular tax, the AMT does not apply. For 2006, alternative minimum tax is computed as follows:
Taxable income (from Form 1040) +/- Certain adjustments to taxable income (listed below) + Tax-preference items (described below)/ = Alternative-minimum-taxable income (AMTI)
- Exemption: Joint Return
$62,550 - 25% (AMTI - $150,000) or
$42,500 - 25% (AMTI - $112,500) or
Married Filing Separately
$31,275 - 25% (AMTI - $75,000)
= Alternative-minimum-tax base x 26% of first $175,000 (7) plus 28% of amount > $175,000
= Tentative minimum tax before the foreign-tax credit - Credit for foreign taxes
= Tentative minimum tax - Regular tax (reduced by foreign-tax credit only)
= Alternative-minimum-tax liability
In 2006, the Congress continued the process of one-year band-aids to the growing politically sensitive topic of AMT relief by extending the enhanced AMT exemption for one more year over the baseline amount, and in fact increasing the amount. Unless Congress acts to extend such relief in future years, in subsequent years, the exemption amounts revert to the lower 2000 levels--$45,000, $33,750 and $22,500 for married taxpayers filing jointly, single taxpayers, and married taxpayers filing separately, respectively. Also, for years before 2011, the maximum tax rate on net capital gains (including qualifying dividends) is reduced from 20% to 15% for alternative-minimum-tax purposes. Corresponding reductions are made for those taxpayers in the 10% or 15% ordinary income tax brackets to 5%.
Adjustment to Taxable Income
The adjustments to taxable income include the following:
1. For property placed in service after 1986, adjust depreciation deductions to conform to special (less favorable) depreciation rules used for AMT purposes.
2. Adjust mining exploration and development costs, circulation expenditures, and research and development expense deductions to conform to special (less favorable) AMT amortization rules.
3. Recompute gains or losses on the sale of property to reflect the special depreciation rules used for AMT purposes.
4. Adjust long-term contracts entered into after February 28, 1986 using the percentage-of-completion method for purposes of the AMT.
5. Calculate net operating loss (NOL) deductions under special (less favorable) AMT rules and limit NOL to no more than 90% of AMT income. Certain AMT operating losses generated or taken as carry forwards in 2001 or 2002 can offset up to 100% of AMT income.
6. Add back certain itemized deductions allowable in computing regular taxable income in computing AMTI. These itemized deductions include state and local taxes, certain interest and miscellaneous deductions, to the extent allowable in computing regular taxable income. In addition, the medical expense deduction is subject to a 10% floor under the AMT as compared to a 7.5% of AGI floor used in computing regular taxable income. For purposes of this adjustment item, one does not take into account the phaseout of itemized deductions for certain upper income.
7. Add the excess of the fair market value of any incentive stock option (ISOs) stock received over the option exercise price (the bargain element) into AMTI in the year of exercise. When the taxpayer subsequently sells the option stock, the taxpayer may subtract the bargain element amount computed and added to AMTI in a previous year from AMTI computed in the year of sale.
8. Taxpayers may not use passive activity losses in determining AMTI, except to the extent the taxpayer is insolvent.
The tax preferences that taxpayers must add back when computing AMTI include:
1. The excess of accelerated depreciation or ACRS deductions over straight-line depreciation on real property placed in service before 1987 (to the extent not taken into account in computing the adjustment to taxable income discussed above).
2. Percentage depletion in excess of cost basis.
3. Accelerated depreciation on depreciable personal property placed in service before 1987 that is leased (to the extent not taken into account in computing the adjustment to taxable income discussed above).
4. Amortization of certified pollution control facilities.
5. Certain excess intangible drilling costs.
6. Tax-exempt interest on certain private activity bonds issued after August 7, 1986.
7. Use of the installment method by dealers in personal property.
8. For dispositions of IRC Section 1202 stock after May5, 2003 and before January 1, 2009, taxpayers need to treat only 7%, rather than the previous 28% or 42%, of the amount excluded from gross income under IRC Section 1202 (gains on sales of certain small business stock), as a preference item for AMT purposes.
Alternative Minimum Tax Credit
Individuals can take a credit against their regular tax liability in years in which their regular tax exceeds their computed alternative minimum tax. The amount of the credit is based on the amount of alternative minimum tax paid in excess of the regular tax computed in prior years. The credit is not available to the extent the prior years' AMT was attributed to excess percentage depletion, tax-exempt interest, or non-AMT itemized deductions. The credit is limited to the amount necessary to reduce the regular tax to the amount of AMT computed for the year in which the credit is claimed.
Tax Planning for the AMT
The existence of the alternative minimum tax places a premium on planning techniques. With the availability of the AMT credit, it is less critical to undertake some of the more drastic planning concepts when the taxpayer will be able to use the AMT credit within a year or two after the AMT tax would be due. Here are some planning ideas and considerations:
In order to avoid or minimize the effect of the AMT:
1. Determine the maximum amount of deductions or losses that an investor can claim before becoming subject to the AMT. Once an investor reaches the point where the AMT applies, any additional deductions will yield at most a 26% (or 28% as determined by AMTI) tax benefit.
2. An investor can reduce or eliminate tax preference items by: (a) electing to capitalize excess intangible drilling costs, mining exploration expenses, and research and experimentation expenses, and amortize them over the permissible AMT periods; (b) electing the AMT or straight-line methods of computing depreciation; or (c) considering an early disposition (in the year of exercise) of stock acquired through the exercise of an Incentive Stock Option.
When it has been determined that the investor will be subject to the AMT:
1. The investor should consider deferring current year deductions (which will be of minimal value because of the AMT) and save them for a future year when they will be more valuable, by: (a) postponing charitable contributions; (b) postponing elective medical treatments; or (c) delaying making estimated state tax payments.
2. The investor should consider accelerating ordinary income, since it will be taxed at no greater than the AMT rate. This can be accomplished, for example, by exercising options under an Incentive Stock Option Plan (ISO) and selling the stock within the same year. (This has the double advantage of qualifying the ordinary income from the accelerated sale of the ISO for the maximum AMT tax rate and eliminating the ISO as a tax preference item.)
The Impact of Capital Gains
Although not included in the list of tax preferences or tax adjustments, capital gains and qualifying dividends can play a significant, yet not well understood, role in the alternative minimum tax. While capital gains and qualifying dividends are taxed for AMT purposes at the same favorable rate they are taxed for regular tax purposes, they may still contribute indirectly to the creation of AMT in some circumstances.
First, capital gains increase the taxable income from which the alternative minimum taxable income is computed. For certain ranges of income, it may phase out a part of the AMT exemption applicable to the taxpayer. Depending on the amount of other ordinary income and the proportion of adjustments and preferences relative to regular taxable income, recognition of capital gains may cause the AMT. Second, large capital gains generally create a large state income-tax liability, which itself is a tax adjustment in computing AMT in the year paid.
The "Kiddie Tax"--Unearned Income of Certain Minor Children
The net unearned income of a child who has not reached age 18 by year-end and who has at least one parent alive at year-end is subjected to a special tax computation. (8) Unearned income means income from sources other than wages, salaries, professional fees, and other amounts received as compensation for personal services actually rendered. The tax payable by the child on the net unearned income is essentially the additional amount of tax that the parent would have had to pay if the net unearned income of the child were included in the parent's taxable income. Effectively, the minor children's unearned income is taxed at the parent's highest marginal federal tax rate for the type of investment income involved.
If the parents have two or more minor children with unearned income to be taxed at the parents' marginal tax rate, all of the children's applicable unearned income will be added together and the tax calculated. The tax is then allocated to each child based on the child's pro-rata share of the unearned income.
There are three levels of a minor's unearned income involved in the calculation of the tax on such income:
1. Generally, a minor child's unearned income is exempt from tax up to the amount of the child's standard deduction. (The standard deduction of a child claimed as a dependent is limited to the greater of (a) $850 (in 2006) or (b) the sum of $300 (in 2006) and the amount of his earned income, not to exceed the regular standard deduction amount for the year ($5,150 in 2006). After the first $850 (in 2006) is used to offset the child's unearned income, any excess is available to offset earned income of the child).
2. The next $850 (in 2006) of unearned income is taxable at the child's bracket.
3. Unearned income in excess of the first $1,700 (in 2006) is taxed to the child at the appropriate parent's rate.
In addition to the limitation on their standard deductions, children that may be claimed as dependents on a parent's return may not claim a personal exemption.
The kiddie tax rules apply regardless of the source of the children's assets producing the unearned income. It does not matter whether the children used their own earned income to purchase the investment assets producing the income, or received the assets (or funds) as an inheritance or a gift from grandparents, parents, or other sources.
Parents may elect to include their children's unearned income over $1,700 (in 2006) on their own return, thus avoiding the necessity of filing a return for each child. The election is available if the child has income of more than $850 (in 2006) but less than $8,000 (in 2006), all of which is from interest and dividends. But an additional tax is imposed equal to $85 (in 2006) or 10% of the income over $850 (in 2006), whichever is less, for each child to whom the election applies.
In the case of unmarried parents, the parent whose taxable income is used in computing the tax on the unearned income of the minor child is the custodial parent. In the case of parents who are married but filing separately, the marginal rate of the parent with the greater taxable income will be used in the calculation.
The tax impact of the kiddie tax rules is potentially greatest with respect to investment income, such as interest, that is taxed as ordinary income. If the children would be in the 10% or 15% tax bracket, the children's ordinary investment could be taxed at a rate as high as 35%, depending upon the parent's income tax bracket.
With respect to qualifying dividends and long-term capital gains, the maximum impact of the kiddie tax rules is to raise the tax rate from 5% to 15%. This will occur only if the children's total income would put them in the 10% or 15% federal income tax brackets and the parents are in a higher tax bracket. If the children would be in a federal tax bracket that is greater than the 15% bracket, the kiddie tax will have no tax impact at all, since the tax rate on qualifying dividends and long-term capital gains will be 15% for both the parents and the children.
SELECTED INVESTMENT TAX ISSUES
Original Issue and Market Discounts and Premiums (9)
Original issue discount (OID) arises when corporate or governmental borrowers originally issue bonds or notes (or other similar debt instruments) at a price that is less than the stated redemption price at maturity (i.e., par or face value). The extreme example is zero coupon bonds that borrowers issue at deep discounts from the redemption value at maturity. The difference between the issue price (the original buyer's initial basis in the bond) and the redemption price is the original issue discount. But a de minimis exception provides that the discount can be ignored if it less than 1/4 of 1% (0.0025) of the stated redemption price multiplied by the number of complete years to maturity. (10)
Purchasers or lenders must include the amount of OID in income as it accrues over the life of the debt instrument. (11) The purpose of the OID rules is to prevent purchasers of OID bonds from deferring tax on the interest they are implicitly earning each year until the bonds mature, or until the owners sell, exchange, or otherwise dispose of the bonds. For deep discount bonds, this means that bondholders may have tax liability that exceeds the actual cash interest income from the bonds.
For bonds issued after April 4, 1994, bondholders must accrue the OID at a constant rate (explained below). Bondholders may use accrual periods of different lengths provided that no accrual period is longer than one year. Generally, if the bond pays some periodic interest, the accrual period is equal to the period between interest payments. Interest payments may occur either on the first day or final day of an accrual period. (12)
In many, if not most, cases, an accrual period may span two taxable years of the bondholder. Bondholders apportion to each taxable year the amount of OID in the accrual period spanning the two tax years by ratably allocating the period's accrued discount to each day in the period. For instance, if the accrual period is the three months from November 1 to January 31 and the OID accruing in that three-month period is $184, the bondholder would allocate $2 to each day in this 92 day period ($184 / 92). Thus, a calendar year taxpayer would include $122 (61 days in November and December x $2) of this period's OID in income for the current tax year and $62 (31 days in January x $2) in the subsequent tax year. These OID allocation rules apply to both accrual basis and cash basis taxpayers. (13)
Bondholders add the amount of OID taken into income each period to their basis in the bond. The constant rate method requires bondholders to accrue interest on the bond at its yield to maturity. The yield to maturity is the rate that equates the issue price to the present value of all scheduled cash interest payments on the bond, if any, plus the present value of the redemption.
Example: On February 1, 2004, XYZ Corp. issues 5-year bonds with a redemption value of $10,000 and a stated interest rate of 4.5%. The bonds pay interest of $225 semiannually on January 31 and July 31 each year. The subscription or issue price is $9,000. Since the original issue discount--$1,000--is greater than the de minimis amount (0.0025 x $10,000 x 5 = $125), the OID rules apply to the bondholders.
The yield to maturity (with semiannual compounding and 6-month accrual periods) is equal to the rate that equates $9,000 with (1) the present value of 10 semiannual cash interest payments of $225, plus (2) the present value of the $10,000 redemption value payable in five years. The 6-month rate that satisfies this condition is 3.449% (6.899% annual rate, or 7.018% effective annual rate). Therefore, the schedule of principal values, cash interest, taxable interest, and OID interest would be as follows over the 5-year period until maturity:
Imputed OID (Taxable) Interest Current Interest (Imputed Basis Stated ([Basis. Interest-- ([Basis.sub.t-1] (Cash) sub.t-1] x Stated Date + OID.sub.t]) Interest 3.449%) Interest) 2/1/2004 9,000.00 -- -- -- 8/1/2004 9,085.44 225.00 310.44 85.44 2/1/2005 9,173.83 225.00 313.39 88.39 8/1/2005 9,265.27 225.00 316.44 91.44 2/1/2006 9,359.86 225.00 319.59 94.59 8/1/2006 9,457.71 225.00 322.85 97.85 2/1/2007 9,558.94 225.00 326.23 101.23 8/1/2007 9,663.66 225.00 329.72 104.72 2/1/2008 9,771.99 225.00 333.33 108.33 8/1/2008 9,884.06 225.00 337.07 112.07 2/1/2009 10,000.00 225.00 340.94 115.94
Since the beginning and end of the accrual periods do not coincide with the calendar year, bondholders must compute their reportable OID interest income by ratably allocating the OID on a daily basis. Taxpayers will report the cash interest payments in the year they actually receive them whereas accrual basis taxpayers will also have to apportion the cash interest income to the year in which it accrues.
The number of days from August 1 to January 31 of the following year is 184 and the number of days from August 1 to December 31 each year is 153. Therefore, bondholders must include 153 / 184 of the OID for the accrual period ranging from August 1 to January 31 to the period from August 1 to December 31 each year and 31 / 184 of the OID to the following year. Therefore the schedule of taxable interest income for a taxpayer would look as follows:
Stated Total (Cash) Taxable Date Interest OID Interest Interest 2/1/04-7/31/04 225.00 85.44 310.44 8/1/04-12/31/04 0.00 153/184 x 88.39 = 73.50 73.50 Total 2004 225.00 158.94 383.94 1/1/05-1/31/05 225.00 31/184 x 88.39 = 14.89 239.89 2/1/05-7/31/05 225.00 91.44 316.44 8/1/05-12/31/05 0.00 153/184 x 94.59 = 78.65 78.65 Total 2005 450.00 184.98 634.98 1/1/06-1/31/06 225.00 31/184 x 94.59 = 15.94 240.94 2/1/06-7/31/06 225.00 97.85 322.85 8/1/06-12/31/06 0.00 153/184 x 101.23 = 84.17 84.17 Total 2006 450.00 197.96 647.96 1/1/07-1/31/07 225.00 31/184 x 101.23 = 17.06 242.06 2/1/07-7/31/07 225.00 104.72 329.72 8/1/07-12/31/07 0.00 153/184 x 108.33 = 90.08 90.08 Total 2007 450.00 211.86 661.86 1/1/08-1/31/08 225.00 31/184 x 108.33 = 18.25 243.25 2/1/08-7/31/08 225.00 112.07 337.07 8/1/08-12/31/08 0.00 153/184 x 115.94 = 96.41 96.41 Total 2008 450.00 226.73 676.73 1/1/09-1/31/09 225.00 31/184 x 115.94 = 19.53 244.53 Total 2009 225.00 19.53 244.53
Market discounts or premiums in bond prices arise as a result of fluctuations in market rates of interest or changes in the borrower's credit rating after the bond is originally issued. If bondholders sell, exchange, or otherwise dispose of an OID bond before maturity, they determine their gain or loss in reference to their adjusted basis. Generally, the gain or loss is treated as long-term or short-term capital gain or loss, depending upon the bond owner's holding period. (14)
Example: The bondholder in the previous example sells the bond on September 30, 2006 for $9,100. From the first table above, the bondholder's adjusted basis in the bond on August 1, 2006 is $9,457.71. September 30, 2006 is 61 days into the next 184-day accrual period. The OID for the next accrual period is $326.23, so the amount allocable to the 61-day period is 61/184 x $326.23 = $108. (15). The bondholder must include this amount in income for the year and increase his basis accordingly. Therefore, the bondholder's adjusted basis in the bond on September 30, 2006 is $9,565.86 and the bondholder realizes a $465.86 long-term capital loss on the sale ($9,565.86 - $9,100).
How does the new bondholder treat the purchase? If a bond was originally issued at par, the market discount is the amount by which the stated redemption price exceeds the taxpayer's basis in the bond immediately after its acquisition. (15) If the bond was originally issued at a discount and later purchased on the market for less than the original issue price increased by the amount of original issue discount accruing since issue up to the date of purchase, the difference is market discount. (16) Therefore, a person who purchases a bond that was originally issued at a discount measures the market discount or premium not by reference to the redemption value, but by reference to the basis adjusted for OID. Similar to original issue discounts, if the total market discount is less than 1/4 of 1% (.0025) of the stated redemption price at maturity (or, if the bond was issued at a discount of the issue price increased by original issue discount accruing since issue to the date of purchase) multiplied by the number of complete years until maturity, it is treated as if there is no market discount. (17)
In general, investors do not include market discount in income until they sell or dispose of the bond. But if they purchase a bond that was originally issued at a discount, they must continue to accrue the OID at a constant rate over the remaining term until the bond matures or until they sell or dispose of the bond, just as if they were the original bondholders. They must include the OID in income as it accrues and increase their bases accordingly.
Example: The investor who purchased the bond on September 30, 2006 from the original bondholder for $9,100 (at a $465.86 market discount) holds the bond to maturity. The bondholder's adjusted basis at maturity will be $9,534.14 ($9,100 plus the accrued OID until maturity).
Although an investor who buys a bond at a market discount generally does not have to accrue the market discount over the remaining term of the bond, upon the sale, exchange, redemption, or other disposition of the bond for a price in excess of the bondholder's adjusted basis, the investor must treat as ordinary interest income any gain up to the amount of the market discount. Any gain in excess of the market discount is treated as long-term or short-term capital gain, depending upon the investor's holding period. If the amount received is less than the investor's adjusted basis, the loss is treated as long-term or short-term capital loss, depending upon the investor's holding period.
Example: If the investor who purchased the bond on September 30, 2006 at a $465.86 market discount holds the bond to maturity, the difference between his adjusted basis of $9,534.14 and the $10,000 redemption price, $465.86, is exactly equal to the market discount. Therefore, the investor must report this entire amount as interest income on his tax return for that year.
Assume instead that the investor sells the bond on January 31, 2008 for $9,950. From the first table above, the investor's adjusted basis would be $9,306.13 ($9,771.99 less the $465.86 market discount). Once again, the first $465.86 of the gain is treated as ordinary interest income, but the amount in excess of $9,771.99, that is, $178.01, is treated as long-term capital gain.
Investors may make an election to include market discount as it accrues on bonds and notes other than tax-exempt obligations purchased before May 1, 1993, short-term obligations, U.S. Savings Bonds, or certain obligations arising from installment sales of property. (18) In general, deferring the tax on market discounts until disposition of the bond is preferable. But investors may wish to make the election if they have insufficient investment income to absorb all of their investment interest expense on borrowing to finance their investments. Once an investor makes this election, it applies to all obligations having market discount (other than tax-exempt obligations purchased before May 1, 1993, short-term obligations, certain obligations arising from installment sales of property, or U.S. Savings Bonds) acquired by the taxpayer in the tax year of the election, and any future years (whether or not using borrowed funds) unless the investor petitions the IRS to revoke the election. (19)
If an investor elects to accrue market discount, the default method is to accrue the discount on a ratable basis. Investors determine the daily accrual under the ratable accrual method by dividing the total market discount on the bond by the number of days after the date of acquisition up to and including the date of maturity. Alternatively, an investor may elect to use the constant yield method, similar to the original issue discount rules, with respect to particular bonds and notes. Once elected, the constant yield election is irrevocable with respect to that particular bond. But investors may use the ratable method with respect to any other market discount bonds, unless they choose separately for each bond to apply the constant yield method. (20)
In general, investors recover both original issue and market premiums (amounts paid in excess of the face or redemption value of a bond), as part of their basis in the bond. If the investor sells, redeems, or otherwise disposes of the bond for more (less) than it originally cost the investor, the gain (loss) is treated as long-term or short-term capital gain (loss), depending on the investor's holding period.
Investors are willing to pay premiums for bonds when the interest being paid by the bond is greater than the current market rate of interest on bonds of similar quality and risk. Essentially, investors will bid up the price until the yield to maturity on their investment in the bond equals the market rate. But the premium creates an unfavorable tax-timing and conversion problem. Investors pay tax at their ordinary income tax rates as the interest is paid on the bond but have to wait until they dispose of or redeem the bond to recover their premium. In addition, the gain or loss relative to their cost is capital, not ordinary, in nature. Consequently, if investors hold bonds until maturity and redeem them at par, they will treat the amount of the premium as a long-term capital loss. Instead of offsetting interest income taxable at the investor's ordinary rate, the loss usually will offset capital gains that are generally taxed at a more favorable rate than interest income. Consequently, not only is the recovery of the premium delayed, but investors will typically recover less in taxes than they paid earlier on the portion of the interest payments attributable to the premium.
As a result of this generally adverse tax treatment with respect to premiums, the tax law permits investors to elect to amortize premiums over the remaining life of the bonds (or, in some cases, until an earlier call date). (21) For bonds acquired after December 31, 1987, an electing taxpayer applies the part of the premium attributable to the year as an offset to interest payments received on the bond to which the premium is attributable. (22)
The amount of the bond premium amortizable in any year is determined by the issue date of the bond.
* If the bond was issued before September 28, 1985, taxpayers may use any reasonable method, including the straight line or ratable method.
* If the bond was issued after September 27, 1985, the taxpayers must use the constant yield to maturity method analogous to the OID rules. (23)
Investors must reduce their bases in the bonds by the amount of premium that is applied to reduce interest payments each year. (24)
The election to amortize applies to all taxable bonds that the investor owns at the beginning of the first year to which the election applies and to all bonds acquired thereafter. Investors may revoke the election only with the consent of the IRS. (25)
Although a bondholder can elect to amortize premiums on taxable bonds, premiums on tax-exempt bonds must be amortized. For tax-exempt bonds acquired on or after March 2, 1998, a bondholder amortizes bond premium under the same rules that apply to taxable bonds. But in the case of tax-exempt bonds, bond premium in excess of qualified stated interest is treated under a separate rule. If the bond premium allocable to an accrual period exceeds the qualified stated interest allocable to the accrual period, the excess is a nondeductible loss.
Short sales occur when investors agree to sell property they do not own (or own but do not wish to sell). They make this type of sale in two steps.
1. They sell short. They borrow property and deliver it to a buyer.
2. They close the sale. At a later date, they either buy identical property and deliver it to the lender or make delivery out of property that they held at the time of the sale.
Investors do not realize gain or loss until delivery of property to close the short sale. They will have a capital gain or loss if the property used to close the short sale is a capital asset.
Exception if Property Becomes Worthless--A different rule applies if the property sold short becomes substantially worthless. In that case, the investor must recognize gain as if the short sale were closed when the property became substantially worthless.
Exception for Constructive Sales--Entering into a short sale may cause investors to be treated as having made a constructive sale of property. In that case, they will have to recognize gain on the date of the constructive sale. For details, see "Constructive Sale Rules," below.
Short-Term or Long-Term Capital Gain or Loss
As a general rule, investors determine whether they have short-term or long-term capital gain or loss on a short sale by the amount of time they actually hold the property eventually delivered to the lender to close the short sale.
Example: Even though Jim does not own any stock of the Ace Corporation, he contracts to sell 100 shares of it, which he borrows from his broker. After 13 months, when the price of the stock has risen, Jim buys 100 shares of Ace Corporation stock and immediately delivers them to his broker to close out the short sale. His loss is a short-term capital loss because his holding period for the delivered property is less than one day.
Special Rules--Special rules may apply to gains and losses from short sales of stocks, securities, and commodity and securities futures (other than certain straddles) if investors held or acquired property substantially identical to that sold short. But if the amount of property they sold short is more than the amount of that substantially identical property, the special rules do not apply to the gain or loss on the excess.
Gains and Holding Period--If investors held the substantially identical property for 1 year or less on the date of the short sale, or if they acquired the substantially identical property after the short sale and by the date of closing the short sale, then:
Rule 1: Their gain, if any, when they close the short sale is a short-term capital gain, and
Rule 2: The holding period of the substantially identical property begins on the date of the closing of the short sale or on the date of the sale of this property, whichever comes first.
Losses--If, on the date of the short sale, investors held substantially identical property for more than 1 year, any loss they realize on the short sale is a long-term capital loss, even if they held the property used to close the sale for 1 year or less. Certain losses on short sales of stock or securities are also subject to wash-sale treatment. For more information, see "Wash Sale Rules," below.
Mixed Straddles--Under certain elections, investors can avoid the treatment of loss from a short sale as long term under the special rule. These elections are for positions that are part of a mixed straddle. See "Other Elections" under "Mixed Straddles," below, for more information about these elections.
Reporting Substitute Payments
If any broker transferred an investor's securities for use in a short sale, or similar transaction, and received certain substitute dividend payments on the investor's behalf while the short sale was open, that broker must give the investor a Form 1099-MISC or a similar statement, reporting the amount of these payments. Form 1099-MISC must be used for those substitute payments totaling $10 or more that are known on the payment's record date to be in lieu of an exempt-interest dividend, a capital gain dividend, a return of capital distribution, or a dividend subject to a foreign tax credit, or that are in lieu of tax-exempt interest. Investors do not treat these substitute payments as dividends or interest. Instead, they report the substitute payments shown on Form 1099-MISC as "Other income" on line 21 of Form 1040.
Substitute payment--A substitute payment means a payment in lieu of:
1. Tax-exempt interest (including OID) that has accrued while the short sale was open, and
2. A dividend, if the ex-dividend date is after the transfer of stock for use in a short sale and before the closing of the short sale.
Payments in Lieu of Dividends--If investors borrow stock to make a short sale, they may have to remit to the lender payments in lieu of the dividends distributed while they maintain their short position. They can deduct these payments only if they hold the short sale open at least 46 days (more than 1 year in the case of an extraordinary dividend as defined below) and they itemize deductions. They deduct these payments as investment interest on Schedule A (Form 1040).
If investors close the short sale by the 45th day after the date of the short sale (1 year or less in the case of an extraordinary dividend), they cannot deduct the payment in lieu of the dividend that they make to the lender. Instead, they must increase the basis of the stock used to close the short sale by that amount. To determine how long a short sale is kept open, do not include any period during which the investor holds, has an option to buy, or is under a contractual obligation to buy substantially identical stock or securities.
If an investor's payment is made for a liquidating distribution or nontaxable stock distribution, or if he buys more shares equal to a stock distribution issued on the borrowed stock during his short position, the investor has a capital expense. The investor must add the payment to the cost of the stock sold short.
Exception--If investors close the short sale within 45 days, the deduction for amounts they pay in lieu of dividends will be disallowed only to the extent the payments are more than the amount that they receive as ordinary income from the lender of the stock for the use of collateral with the short sale. This exception does not apply to payments in place of extraordinary dividends.
Extraordinary Dividends--If the amount of any dividend investors receive on a share of preferred stock equals or exceeds 5% (10% in the case of other stock) of the amount realized on the short sale, the dividend they receive is an extraordinary dividend.
Wash Sale Rules
Investors cannot deduct losses from sales or trades of stock or securities in a wash sale. A wash sale occurs when investors sell or trade stock or securities at a loss and within 30 days before or after the sale investors
1. buy substantially identical stock or securities,
2. acquire substantially identical stock or securities in a fully taxable trade, or
3. acquire a contract or option to buy substantially identical stock or securities.
If the loss was disallowed because of the wash sale rules, the investor adds the disallowed loss to the cost of the new stock or securities. The result is the investor's basis in the new stock or securities. This adjustment postpones the loss deduction until the disposition of the new stock or securities. The holding period for the new stock or securities begins on the same day as the holding period of the stock or securities sold.
Example: Sue buys 100 shares of X stock for $1,000. She sells these shares for $750 and within 30 days from the sale she buys 100 shares of the same stock for $800. Because Sue bought substantially identical stock, she cannot deduct her loss of $250 on the sale. But she adds the disallowed loss of $250 to the cost of the new stock, $800, to obtain her basis in the new stock, which is $1,050.
Example: Sara is an employee of a corporation that has an incentive pay plan. Under this plan, she is given 10 shares of the corporation's stock as a bonus award. Sara includes the fair market value of the stock in her gross income as additional pay. She later sells these shares at a loss. If she receives another bonus award of substantially identical stock within 30 days of the sale, Sara cannot deduct her loss on the sale.
Options and Futures Contracts
The wash sale rules apply to losses from sales or trades of contracts and options to acquire or sell stock or securities. They do not apply to losses from sales or trades of commodity futures contracts and foreign currencies. See "Coordination of Loss Deferral Rules" and "Wash Sale Rules" under "Straddles," below, for information about the tax treatment of losses on the disposition of positions in a straddle. Losses from the sale, exchange, or termination of a securities future contract to sell generally are treated in the same manner as losses from the closing of a short sale.
The wash sale rules apply if investors sell common stock at a loss and, at the same time, buy warrants for common stock of the same corporation. But if investors sell warrants at a loss and, at the same time, buy common stock in the same corporation, the wash sale rules apply only if the warrants and stock are considered substantially identical.
In determining whether stock or securities are substantially identical, investors must consider all the facts and circumstances in their particular case. Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation. But they may be substantially identical in some cases. For example, in reorganization, the stocks and securities of the predecessor and successor corporations may be substantially identical.
Similarly, bonds or preferred stock of a corporation are not ordinarily considered substantially identical to the common stock of the same corporation. But where the bonds or preferred stock are convertible into common stock of the same corporation, the relative values, price changes, and other circumstances may make these bonds or preferred stock and the common stock substantially identical. For example, preferred stock is substantially identical to the common stock if the preferred stock
1. is convertible into common stock,
2. has the same voting rights as the common stock,
3. is subject to the same dividend restrictions,
4. trades at prices that do not vary significantly from the conversion ratio, and
5. is unrestricted as to convertibility.
More or Less Stock Bought than Sold
If the number of shares of substantially identical stock or securities investors buy within 30 days before or after the sale is either more or less than the number of shares they sold, the investors must determine the particular shares to which the wash sale rules apply. Investors do this by matching the shares bought with an equal number of the shares sold. Match the shares bought in the same order that an investor bought them, beginning with the first shares bought. The shares or securities so matched are subject to the wash sale rules.
Example: Joe bought 100 shares of M stock on September 24 for $5,000. On December 21, he bought 50 shares of substantially identical stock for $2,750. On December 28, he bought 25 shares of substantially identical stock for $1,125. On January 4 the following year Joe sold for $4,000 the 100 shares he bought the past September. He has a $1,000 loss on the sale. But because he bought 75 shares of substantially identical stock within 30 days of the sale, he cannot deduct the loss ($750) on 75 shares. Joe can deduct the loss ($250) on the other 25 shares. The basis of the 50 shares bought on the past December 21 is increased by two-thirds (50 -f 75) of the $750 disallowed loss. The new basis of those shares is $3,250 ($2,750 + $500). The basis of the 25 shares bought on the past December 28 is increased by the rest of the loss to $1,375 ($1,125 + $250).
Example: John bought 100 shares of M stock on September 24. On February 1 the following year he sold those shares at a $1,000 loss. On each of the 4 days from February 12-15 he bought 50 shares of substantially identical stock. John cannot deduct his $1,000 loss. He must add half the disallowed loss ($500) to the basis of the 50 shares bought on February 12. Add the other half ($500) to the basis of the shares bought on February 13.
Loss and Gain on Same Day
Loss from a wash sale of one block of stock or securities cannot be used to reduce any gains on identical blocks sold the same day.
Example: During 2000, Bill bought 100 shares of X stock on each of three occasions. He paid $158 a share for the first block of 100 shares, $100 a share for the second block, and $95 a share for the third block. On December 23, 2005, Bill sold 300 shares of X stock for $125 a share. On January 6, 2006, he bought 250 shares of identical X stock. He cannot deduct the loss of $33 a share on the first block because within 30 days after the date of sale he bought 250 identical shares of X stock. In addition, Bill cannot reduce the gain realized on the sale of the second and third blocks of stock by this loss.
The wash sale rules do not apply to a dealer in stock or securities if the loss is from a transaction made in the ordinary course of business.
The wash sale rules apply to a loss realized on a short sale if investors sell, or enter into another short sale of, substantially identical stock or securities within a period beginning 30 days before the date the short sale is complete and ending 30 days after that date. For purposes of the wash sale rules, a short sale is considered complete on the date the short sale is entered into, if:
1. On that date, an investor owns stock or securities identical to those sold short (or by that date the investor enters into a contract or option to acquire that stock or those securities), and
2. The investor later delivers the stock or securities to close the short sale.
Otherwise, a short sale is not considered complete until the property is delivered to close the sale. This treatment also applies to losses from the sale, exchange, or termination of a security's futures contract to sell.
Example: On June 2, Sonya buys 100 shares of stock for $1,000. She sells short 100 shares of the stock for $750 on October 6. On October 7, she buys 100 shares of the same stock for $750. Sonya closes the short sale on November 17 by delivering the shares bought on June 2. She cannot deduct the $250 loss ($1,000--$750) because the date of entering into the short sale (October 6) is considered the date the sale is complete for wash sale purposes and she bought substantially identical stock within 30 days from that date.
Residual Interests in a REMIC
The wash sale rules generally will apply to the sale of an investor's residual interest in a real estate mortgage increased vestment conduit (REMIC) if, during the period beginning 6 months before the sale of the interest and ending 6 months after that sale, the investor acquires any residual interest in any REMIC or any interest in a taxable mortgage pool that is comparable to a residual interest.
How to Report
Report a wash sale or trade on line 1 or line 8 of Schedule D (Form 1040), whichever is appropriate. Show the full amount of the loss in parentheses in column (f). On the next line, enter "Wash Sale" in column (a) and the amount of the loss not allowed as a positive amount in column (f).
In 1997 Congress expanded the Internal Revenue Code by adding IRC Section 1259, titled "Constructive Sales Treatment for Appreciated Financial Positions." The section says that when investors enter into certain transactions involving an "appreciated financial position in stock," a partnership interest, or certain debt instruments, they have, in effect, made a sale.
In general, a gain or loss is taken into account for tax purposes when realized. A gain or loss generally is realized, with respect to a capital asset, at the time the asset is sold, exchanged, or otherwise disposed of. Investors generally do not have to pay taxes on "paper" gains--they only have to pay taxes when they actually sell a stock and "realize" the gain on the sale.
Prior to the Taxpayer Relief Act of 1997, transactions designed to reduce or eliminate risk of loss on stock or financial assets generally did not cause income realization. For example, a taxpayer could lock in gains on securities by entering into a "short sale against the box" (i.e., when the taxpayer owns securities that are the same as, or substantially identical to, securities borrowed and sold short).
Example: Frank owns 1,000 shares of XYZ stock, with a cost basis of $30/share. The shares are now trading for $90 a share. Frank would like to lock in his gains on this stock, but does not really want to sell the shares and face a large tax liability. So, instead of selling, Frank goes "short" on 1,000 shares of XYZ. Since Frank has not sold the original stock, he pays no taxes on his "paper" gain since the gain is not yet "realized" by sale or other disposition.
By executing the "short sale against the box," Frank has taken virtually all of his cash out of the stock (via the short sale), but is now protected against any future losses on the shares. If the stock goes up, his "long" position increases, but his "short" position decreases. If the stock goes down, his "short" position increases, but his "long" position decreases. So Frank has, in effect, locked in his gain and received his cash without selling any of the shares or creating a taxable transaction. Of course, Frank will have to cover the short position sometime in the future, but he may be able to manipulate his finances in such a way that the future gain will have less tax impact (such as being used to offset a substantial capital loss in the future). This is an example of a "short sale against the box."
Under prior law, the form of the transaction was respected for income tax purposes, and the investor was not required to recognize any gains on the substantially identical property at the time of the short sale. Pursuant to rules that allowed specific identification of securities delivered on a sale, Frank could obtain open transaction treatment by identifying the borrowed securities as the securities delivered. When it was time to close out the borrowing, the taxpayer could choose to deliver either the securities held or newly purchased securities. The Code only provided rules to prevent investors from using short sales against the box to accelerate losses or to convert short-term capital gains into long-term capital gains, or long-term capital losses into short-term capital losses.
In addition, under prior law, investors could also lock in gains on certain property by entering into offsetting positions in the same or similar property. Under the straddle rules, when investors realized a loss on one offsetting position in actively traded personal property, they generally could deduct this loss only to the extent that the loss exceeded the unrecognized gain in the other positions in the straddle. In other words, investors were prevented from taking losses equal to the gains in the offsetting straddle positions, but they were not forced to realize the gains until they closed out the offsetting positions. In addition, rules similar to the short-sale rules prevented investors from changing the tax characteristics of gains and losses recognized on the offsetting positions in a straddle.
In other words, under prior law, investors could employ methods that would allow them to lock in gains on, and hedge the risk in, a financial position without actually selling the position.
Current Tax Law
Investors are treated as having made a constructive sale when they enter into certain transactions involving an appreciated financial position (defined later) in stock, a partnership interest, or certain debt instruments. Investors must recognize gain as if the position were disposed of at its fair market value on the date of the constructive sale. This gives them a new holding period for the position that begins on the date of the constructive sale. Then, when investors close the transaction, they reduce their gain (or increase their loss) by the gain recognized on the constructive sale.
Investors are treated as having made a constructive sale of an appreciated financial position if they
1. enter into a short sale of the same or substantially identical property;
2. enter into an offsetting notional principal contract relating to the same or substantially identical property;
3. enter into a futures or forward contract to deliver the same or substantially identical property (including a forward contract that provides for cash settlement); or
4. acquire the same or substantially identical property (if the appreciated financial position is a short sale, an offsetting notional principal contract, or a futures or forward contract).
Investors are also treated as having made a constructive sale of an appreciated financial position if a person related to them enters into a transaction described above with a view toward avoiding the constructive sale treatment. Related parties include
1. Members of the investor's family. This includes only brothers and sisters, half-brothers and half- sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).
2. A partnership in which an investor directly or indirectly owns more than 50% of the capital interest or the profits interest.
3. A corporation in which an investor directly or indirectly owns more than 50% in value of the outstanding stock.
4. A tax-exempt charitable or educational organization that is directly or indirectly controlled, in any manner or by any method, by the investor or by a member of the investor's family, whether or not this control is legally enforceable.
Example: On May 1, April bought 100 shares of ABC Corporation stock for $1,000. On September 3, she sold short 100 shares of ABC stock for $1,600 (the classic "short against the box"). She made no other transactions involving ABC stock for the rest of the year and the first 30 days of the following year (we'll discuss the importance of this statement a bit later). April's short sale is treated as a constructive sale of an appreciated financial position because a sale of her ABC stock on the date of the short sale would have resulted in a gain. Therefore, she is required to recognize a $600 short-term capital gain from the constructive sale for the tax year in which the sale took place. In addition, she is required to begin a new holding period in her ABC stock that starts on September 3 and her basis in these ABC shares would be increased to $1,600.
Example: On January 10, Ian "shorts" 200 shares of XYZ Corporation stock for $5,000. On August 15 of the same year, he "goes long" 200 shares of XYZ stock for $3,500. Ian made no other transactions in XYZ stock for the rest of the year, and the first 30 days of the following year (again, the relevance of this statement will be discussed later). His "long" position will be treated as a constructive sale, and he will be required to recognize a short-term gain in the amount of $1,500 for the tax year in which the constructive sale took place. The new holding period for his short position will begin August 15, and his new basis for his short position will be $3,500.
The objective of this second example is to show that the rules work either way. An appreciated financial position could be a "long" position or a "short" position.
Exception for Nonmarketable Securities
A contract for sale of any stock, debt instrument, or partnership interest that is not a marketable security is not a constructive sale if it settles within 1 year of the date an investor enter into it.
Exception for Certain Closed Transactions
Transactions in which all of the following conditions are true are not treated as a constructive sale:
1. An investor closed the transaction before the end of the 30th day after the end of his tax year.
2. An investor held the appreciated financial position throughout the 60-day period beginning on the date he closed the transaction.
3. An investor's risk of loss was not reduced at any time during that 60-day period by holding certain other positions.
If a closed transaction is reestablished in a substantially similar position during the 60-day period beginning on the date the first transaction was closed, this exception still applies if the reestablished position is closed before the end of the 30th day after the end of the investor's tax year in which the first transaction was closed and, after that closing, (2) and (3) above are true.
In other words, investors are required to ignore the constructive sale rules if they close the offsetting position prior to January 30th of the following tax year, and they retain their original position for at least 60 days after closing the offsetting position. In addition, they are prohibited from entering into any other type of offsetting position for that same 60-day period.
The examples above included the statement the investor "made no other transactions in the stock for the rest of the year and the first 30 days of the following year." As a result of the closed-transaction rules it may be possible with the proper moves for investors to overcome the constructive sale rules. (See Chapter 41, "Hedging and Option Strategies," for a discussion of these techniques.)
Appreciated Financial Position
This is any interest in stock, a partnership interest, or a debt instrument (including a futures or forward contract, a short sale, or an option) if disposing of the interest would result in a gain. But an appreciated financial position does not include the following:
1. Any position from which all of the appreciation is accounted for under marked to market rules, including IRC Section 1256 contracts (regulated futures contract, foreign currency contract, non-equity option, dealer equity option, or dealer securities futures contract).
2. Any position in a debt instrument if
a) The position unconditionally entitles the holder to receive a specified principal amount,
b) The interest payments (or other similar amounts) with respect to the position are payable at a fixed rate or a variable rate described in Treasury Section 1.860G-1(a)(3) of the regulations, and
c) The position is not convertible, either directly or indirectly, into stock of the issuer (or any related person).
3. Any hedge with respect to a position described in (2).
Certain Trust Instruments Treated as Stock
For the constructive sale rules, an interest in an actively traded trust is treated as stock unless substantially all of the value of the property held by the trust is debt that qualifies for the exception to the definition of an appreciated financial position (explained in (2) above).
Sale of Appreciated Financial Position
A transaction treated as a constructive sale of an appreciated financial position is not treated as a constructive sale of any other appreciated financial position, as long as an investor continues to hold the original position. But if an investor holds another appreciated financial position and disposes of the original position before closing the transaction that resulted in the constructive sale, the investor is treated as if, at the same time, he constructively sold the other appreciated financial position.
A straddle is any set of offsetting positions on personal property. For example, a straddle may consist of a purchased option to buy and a purchased option to sell on the same number of shares of the security, with the same exercise price and period.
Personal Property--This is any property of a type that is actively traded. It includes stock options and contracts to buy stock, but generally does not include stock.
Straddle Rules for Stock--Although stock is generally excluded from the definition of personal property when applying the straddle rules, it is included in the following two situations:
1. The stock is part of a straddle in which at least one of the offsetting positions is
a) an option to buy or sell the stock or substantially identical stock or securities,
b) a securities futures contract on the stock or substantially identical stock or securities, or
c) a position on substantially similar or related property (other than stock).
2. The stock is in a corporation formed or availed of to take positions in personal property that offset positions taken by any shareholder.
Position--A position is an interest in personal property. A position can be a forward or futures contract, or an option. An interest in a loan that is denominated in a foreign currency is treated as a position in that currency. For the straddle rules, foreign currency for which there is an active interbank market is considered to be actively traded personal property.
Offsetting Position--This is a position that substantially reduces any risk of loss investors may have from holding another position. But if a position is part of a straddle that is not an identified straddle (described later), they do not treat it as offsetting to a position that is part of an identified straddle.
Presumed Offsetting Positions--Two or more positions will be presumed to be offsetting if
1. the positions are established in the same personal property (or in a contract for this property), and the value of one or more positions varies inversely with the value of one or more of the other positions;
2. the positions are in the same personal property, even if this property is in a substantially changed form, and the positions' values vary inversely as described in the first condition;
3. the positions are in debt instruments with a similar maturity, and the positions' values vary inversely as described in the first condition;
4. the positions are sold or marketed as offsetting positions, whether or not the positions are called a straddle, spread, butterfly, or any similar name; or
5. the aggregate margin requirement for the positions is lower than the sum of the margin requirements for each position if held separately.
Related Persons--To determine if two or more positions are offsetting, investors will be treated as holding any position that their spouses hold during the same period. If investors take into account part or all of the gain or loss for a position held by a flow-through entity, such as a partnership or trust, they are also considered to hold that position.
Loss Deferral Rules
Generally, investors can deduct a loss on the disposition of one or more positions only to the extent that the loss is more than any unrecognized gain they have on offsetting positions. Unused losses are treated as sustained in the next tax year.
Unrecognized Gain--This is
1. the amount of gain investors would have had on an open position if they had sold it on the last business day of the tax year at its fair market value, and
2. the amount of gain realized on a position if, as of the end of the tax year, gain as been realized, but not recognized.
Example: On July 1 Dave entered into a straddle. On December 16 he closed one position of the straddle at a loss of $15,000. On December 31 the end of his tax year, Dave has an unrecognized gain of $12,750 in the offsetting open position. On his return for the year, his deductible loss on the position he closed is limited to $2,250 ($15,000 - $12,750). He must carry forward to the following year the unused loss of $12,750.
Exceptions--The loss deferral rules do not apply to
1. a straddle that is an identified straddle at the end of the tax year,
2. certain straddles consisting of qualified covered call options and the stock to be purchased under the options,
3. hedging transactions, and
4. straddles consisting entirely of IRC Section 1256 contracts (but see "Identified Straddle," next).
Identified Straddle--Losses from positions in an identified straddle are deferred until investors dispose of all the positions in the straddle. Any straddle (other than a straddle described in (2) or (3) above) is an identified straddle if all of the following conditions exist:
1. Investors clearly identified the straddle on their records before the close of the day on which they acquired it.
2. All of the original positions that investors identify were acquired on the same day.
3. All of the positions included in item (2) were disposed of on the same day during the tax year, or none of the positions were disposed of by the end of the tax year.
4. The straddle is not part of a larger straddle.
Qualified Covered Call Options and Optioned Stock--A straddle is not subject to the loss deferral rules for straddles if both of the following are true:
1. All of the offsetting positions consist of one or more qualified covered call options and the stock to be purchased from the investor under the options.
2. The straddle is not part of a larger straddle. But see "Special Year-End Rule," later, for an exception.
Qualified covered call options are any options investors grant to purchase stock they hold (or stock they acquire in connection with granting the option), but only if all of the following are true:
1. The option is traded on a national securities exchange or other market approved by the Secretary of the Treasury.
2. The option is granted more than 30 days before its expiration date.
3. The option is not a deep-in-the-money option.
4. The investor is not an options dealer who granted the option in connection with his activity of dealing in options.
5. Gain or loss on the option is capital gain or loss.
A deep-in-the-money option is an option with a strike price lower than the lowest qualified benchmark (LQB). The strike price is the price at which the option is to be exercised. The LQB is the highest available strike price that is less than the applicable stock price. But the LQB for an option with a term of more than 90 days and a strike price of more than $50 is the second highest available strike price that is less than the applicable stock price. Strike prices are listed in the financial section of many newspapers.
The availability of strike prices for equity options with flexible terms does not affect the determination of the LQB for an option that is not an equity option with flexible terms.
The applicable stock price for any stock for which an option has been granted is
1. the closing price of the stock on the most recent day on which that stock was traded offset before the date on which the option was granted, or
2. the opening price of the stock on the day on which the option was granted, but only if that price is greater than 110% of the price determined in (1).
If the applicable stock price is $25 or less, the LQB will be treated as not less than 85% of the applicable stock price. If the applicable stock price is $150 or less, the LQB will be treated as not less than an amount that is $10 below the applicable stock price.
Example: On May 13 Andy held XYZ stock and he wrote an XYZ/September call option with a strike price of $120. The closing price of one share of XYZ stock on May 12 was $130.25. The strike prices of all XYZ/ September call options offered on May 13 were as follows: $110, $115, $120, $125, $130, and $135. Because the option has a term of more than 90 days, the LQB is $125, the second highest strike price that is less than $130.25, the applicable stock price. The call option is a deep-in-the-money option because its strike price is lower than the LQB. Therefore, the option is not a qualified covered call option, and the loss deferral rules apply if Andy closed out the option or the stock at a loss during the year.
Capital Loss on Qualified Covered Call Option--If investors hold stock and they write a qualified covered call option on that stock with a strike price less than the applicable stock price, they treat any loss from the option as long-term capital loss if, at the time the loss was realized, gain on the sale or exchange of the stock would be treated as long-term capital gain. The holding period of the stock does not include any period during which the investors are the writers of the option.
Special Year-End Rule--The loss deferral rules for straddles apply if all of the following are true:
1. The qualified covered call options are closed or the stock is disposed of at a loss during any tax year.
2. Gain on disposition of the stock or gain on the options is includable in gross income in a later tax year.
3. The stock or options were held less than 30 days after the closing of the options or the disposition of the stock.
How to Report Gains and Losses (Form 6781)
Investors report each position (whether or not it is part of a straddle) on which they have unrecognized gain at the end of the tax year and the amount of this unrecognized gain in Part III of Form 6781. They use Part II of Form 6781 to figure their gains and losses on straddles before entering these amounts on Schedule D (Form 1040). They should include a copy of Form 6781 with their income tax return.
Coordination of Loss Deferral Rules and Wash Sale Rules
Rules similar to the wash sale rules apply to any disposition of a position or positions of a straddle. The rules work as follows. First apply Rule 1, explained next, and then apply Rule 2. But Rule 1 applies only if stocks or securities make up a position that is part of the straddle. If a position in the straddle does not include stock or securities, use Rule 2.
Rule 1--Investors cannot deduct a loss on the disposition of shares of stock or securities that make up the positions of a straddle if, within a period beginning 30 days before the date of that disposition and ending 30 days after that date, they acquired substantially identical stock or securities. Instead, the loss will be carried over to the following tax year, subject to any further application of Rule 1 in that year. This rule will also apply if they entered into a contract or option to acquire the stock or securities within the time period described above. See "Loss Carryover," later, for more information about how to treat the loss in the following tax year.
Dealers--For dealers in stock or securities, this loss treatment will not apply to any losses they sustained in the ordinary course of their business.
Example: Bruce is not a dealer in stock or securities. On December 2 he bought stock in XX Corporation (XX stock) and an offsetting put option. On December 13 there was $20 of unrealized gain in the put option and he sold the XX stock at a $20 loss. By December 16, the value of the put option had declined, eliminating all unrealized gain in the position. On December 16, Bruce bought a second XX stock position that is substantially identical to the XX stock he sold on December 13. At the end of the year there is no unrecognized gain in the put option or in the XX stock. Under these circumstances, the $20 loss will be disallowed for the current tax year under Rule 1 because, within a period beginning 30 days before December 13, and ending 30 days after that date, Bruce bought stock substantially identical to the XX stock he sold.
Rule 2--Investors cannot deduct a loss on the disposition of less than all of the positions of a straddle (their loss position) to the extent that any unrecognized gain at the close of the tax year in one or more of the following positions is more than the amount of any loss disallowed under Rule 1:
1. successor positions,
2. offsetting positions to the loss position, or
3. offsetting positions to any successor position.
Successor Position--A successor position is a position that is or was at any time offsetting to a second position, if both of the following conditions are met:
1. The second position was offsetting to the loss position that was sold.
2. The successor position is entered into during a period beginning 30 days before, and ending 30 days after, the sale of the loss position.
Example: On November 1 Connie entered into offsetting long and short positions in non-IRC Section 1256 contracts. On November 12 she disposed of the long position at a $10 loss. On November 14, she entered into a new long position (successor position) that is offsetting to the retained short position, but that is not substantially identical to the long position disposed of on November 12. Connie held both positions through year-end, at which time there was $10 of unrecognized gain in the successor long position and no unrecognized gain in the offsetting short position. Under these circumstances, the entire $10 loss will be disallowed for the current tax year because there is $10 of unrecognized gain in the successor long position.
Example: The facts are the same as in the previous example, except that at year end Connie has $4 of unrecognized gain in the successor long position and $6 of unrecognized gain in the offsetting short position. Under these circumstances, the entire $10 loss will be disallowed for the current tax year because there is a total of $10 of unrecognized gain in the successor long position and offsetting short position.
Example: The facts are the same as in the first example above, except that at year end Connie has $8 of unrecognized gain in the successor long position and $8 of unrecognized loss in the offsetting short position. Under these circumstances, $8 of the total $10 realized loss would be disallowed for current tax year because there is $8 of unrecognized gain in the successor long position.
Loss Carryover--If investors have a disallowed loss that resulted from applying Rule 1 and Rule 2, they must carry it over to the next tax year and apply Rule 1 and Rule 2 to that carryover loss. For example, a loss disallowed in 2007 under Rule 1 will not be allowed in 2008, unless the substantially identical stock or securities (which caused the loss to be disallowed in 2007) were disposed of during 2008. In addition, the carryover loss will not be allowed in 2008 if Rule 1 or Rule 2 disallows it.
Example: The facts are the same as in the example under Rule 1 above. On December 31 Connie sells the second XX stock at a $20 loss and there is $40 of unrecognized gain in the put option. Under these circumstances, she cannot deduct for that tax year either the $20 loss disallowed in that tax year or the $20 loss she incurred for the December 31 sale of XX stock. Rule 1 does not apply because the substantially identical XX stock was sold during the year and no substantially identical stock or securities were bought within the 61-day period. But Rule 2 does apply because there is $40 of unrecognized gain in the put option, an offsetting position to the loss positions.
Capital Loss Carryover--If the sale of a loss position would have resulted in a capital loss, investors treat the carryover loss as a capital loss on the date it is allowed, even if they would treat the gain or loss on any successor positions as ordinary income or loss. Likewise, if the sale of a loss position (in the case of IRC Section 1256 contracts) would have resulted in a 60% long-term capital loss and a 40% short-term capital loss, investors treat the carryover loss under the 60/40 rule, even if they would treat any gain or loss on any successor positions as 100% long-term or short-term capital gain or loss.
Exceptions--The rules for coordinating straddle losses and wash sales do not apply to the following loss situations:
1. loss on the sale of one or more positions in a hedging transaction,
2. loss on the sale of a loss position in a mixed straddle account--see the discussion later on the mixed straddle account election,
3. loss on the sale of a position that is part of a straddle consisting only of IRC Section 1256 contracts.
Holding Period and Loss Treatment Rules
The holding period of a position in a straddle generally begins no earlier than the date on which the straddle ends (the date investors no longer hold an offsetting position). This rule does not apply to any position investors held more than 1 year before they established the straddle. But see Exceptions, later.
Example: On March 6, 2005, Patti acquired gold. On January 4, 2006, she entered into an offsetting short gold forward contract (nonregulated futures contract). On April 1, 2006, she disposed of the short gold forward contract at no gain or loss. On April 8, 2006, she sold the gold for a gain. Because the gold had been held for 1 year or less before the offsetting short position was entered into, the holding period for the gold begins on April 1, 2006, the date the straddle ended. Gain recognized on the sale of the gold will be treated as short-term capital gain.
Loss Treatment--Treat the loss on the sale of one or more positions (the loss position) of a straddle as a long-term capital loss if both of the following are true:
1. Investors held (directly or indirectly) one or more offsetting positions to the loss position on the date they entered into the loss position.
2. Investors would have treated all gain or loss on one or more of the straddle positions as long-term capital gain or loss if they had sold these positions on the day they entered into the loss position.
Mixed Straddles--Special rules apply to a loss position that is part of a mixed straddle and that is a non-IRC Section 1256 position. A mixed straddle is a straddle
1. that is not part of a larger straddle,
2. in which all positions are held as capital assets,
3. in which at least one (but not all) of the positions is an IRC Section 1256 contract, and
4. for which the mixed straddle election (Election A, discussed later) has not been made.
Investors treat the loss as 60% long-term capital loss and 40% short-term capital loss, if all of the following conditions apply:
1. Gain or loss from the sale of one or more of the straddle positions that are IRC Section 1256 contracts would be considered gain or loss from the sale or exchange of a capital asset.
2. The sale of no position in the straddle, other than an IRC Section 1256 contract, would result in a long-term capital gain or loss.
3. The investor has not made a straddle-by-straddle identification election (Election B) or mixed straddle account election (Election C), both discussed later.
Example: On March 1 Diana entered into a long gold forward contract. On July 15 she entered into an offsetting short gold regulated futures contract. She did not make an election to offset gains and losses from positions in a mixed straddle. On August 9 Diana disposed of the long forward contract at a loss. Because the gold forward contract was part of a mixed straddle and the disposition of this non-IRC Section 1256 position would not result in long-term capital loss, the loss recognized on the termination of the gold forward contract would be treated as a 60% long-term and 40% short-term capital loss.
Exceptions--The special holding period and loss treatment for straddle positions does not apply to positions that
1. constitute part of a hedging transaction,
2. are included in a straddle consisting only of IRC Section 1256 contracts, or
3. are included in a mixed straddle account (Election C), discussed later.
If investors disposed of a position in a mixed straddle and made one of the elections described in the following discussions, they report their gain or loss as indicated in those discussions. If investors do not make any of the elections, they report their gain or loss in Part II of Form 6781. If they disposed of the IRC Section 1256 component of the straddle, they enter the recognized loss (line 10, column (h)) or their gain (line 12, column (f)) in Part I of Form 6781, on line 1. They do not include it on line 11 or 13 (Part II).
Mixed Straddle Election (Election A)--Investors can elect out of the marked to market rules for all IRC Section 1256 contracts that are part of a mixed straddle. Instead, the gain and loss rules for straddles will apply to these contracts. But if they make this election for an option on an IRC Section 1256 contract, the gain or loss treatment discussed earlier under "Options" will apply, subject to the gain and loss rules for straddles.
Investors can make this election if
1. at least one (but not all) of the positions is an IRC Section 1256 contract, and
2. each position forming part of the straddle is clearly identified as being part of that straddle on the day the first IRC Section 1256 contract forming part of the straddle is acquired.
If investors make this election, it will apply for all later years as well. It cannot be revoked without the consent of the IRS. If they made this election, they should check box A of Form 6781. They do not report the IRC Section 1256 component in Part I.
Other Elections--Investors can avoid the 60% long-term capital loss treatment required for a non-IRC Section 1256 loss position that is part of a mixed straddle, described earlier, if they choose either of the two following elections to offset gains and losses for these positions:
1. Election B--Make a separate identification of the positions of each mixed straddle for which they are electing this treatment (the straddle-by-straddle identification method).
2. Election C--Establish a mixed straddle account for a class of activities for which gains and losses will be recognized and offset on a periodic basis.
These two elections are alternatives to the mixed straddle election. Investors can choose only one of the three elections. They use Form 6781 to indicate their election choice by checking box A, B, or C, whichever applies.
Straddle-by-Straddle Identification Election (Election B)--Under this election, investors must clearly identify each position that is part of the identified mixed straddle by the earlier of
1. the close of the day the identified mixed straddle is established, or
2. the time the position is disposed of.
If investors dispose of a position in the mixed straddle before the end of the day on which the straddle is established, this identification must be made by the time they dispose of the position. Investors are presumed to have properly identified a mixed straddle if independent verification is used.
The basic tax treatment of gain or loss under this election depends on which side of the straddle produced the total net gain or loss. If the net gain or loss from the straddle is due to the IRC Section 1256 contracts, gain or loss is treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss. Investors enter the net gain or loss in Part I of Form 6781 and identify the election by checking box B.
If the net gain or loss is due to the non-IRC Section 1256 positions, gain or loss is short-term capital gain or loss. Investors enter the net gain or loss on Part I of Schedule D and identify the election.
For the specific application of the rules of this election, see Treasury Regulation Section 1.1092(b)-T.
Example: On April 1, Jackie entered into a non-IRC Section 1256 position and an offsetting IRC Section 1256 contract. She also made a valid election to treat this straddle as an identified mixed straddle. On April 8, she disposed of the non-IRC Section 1256 position at a $600 loss and the IRC Section 1256 contract at an $800 gain. Under these circumstances, the $600 loss on the non-IRC Section 1256 position will be offset against the $800 gain on the IRC Section 1256 contract. The net gain of $200 from the straddle will be treated as 60% long-term capital gain and 40% short-term capital gain because it is due to the IRC Section 1256 contract.
Mixed Straddle Account (Election C)--Investors may elect to establish one or more accounts for determining gains and losses from all positions in a mixed straddle. They must establish a separate mixed straddle account for each separate designated class of activities.
Generally, investors must determine gain or loss for each position in a mixed straddle account as of the close of each business day of the tax year. They offset the net IRC Section 1256 contracts against the net non-IRC Section 1256 positions to determine the "daily account net gain or loss." If the daily account amount is due to non-IRC Section 1256 positions, the amount is treated as short-term capital gain or loss. If the daily account amount is due to IRC Section 1256 contracts, the amount is treated as 60% long-term and 40% short-term capital gain or loss. On the last business day of the tax year, investors determine the "annual account net gain or loss" for each account by netting the daily account amounts for that account for the tax year. The "total annual account net gain or loss" is determined by netting the annual account amounts for all mixed straddle accounts that they had established.
The net amounts keep their long-term or short-term classification. But no more than 50% of the total annual account net gain for the tax year can be treated as long-term capital gain. Any remaining gain is treated as short-term capital gain. Also, no more than 40% of the total annual account net loss can be treated as short-term capital loss. Any remaining loss is treated as long-term capital loss.
The election to establish one or more mixed straddle accounts for each tax year must be made by the due date (without extensions) of the investor's income tax return for the immediately preceding tax year. If investors begin trading in a new class of activities during a tax year, they must make the election for the new class of activities by the later of either
1. the due date of their return for the immediately preceding tax year (without extensions), or
2. 60 days after they entered into the first mixed straddle in the new class of activities.
Investors make the election on Form 6781 by checking box C and then attach Form 6781 to their income tax return for the immediately preceding tax year, or file it within 60 days, if that applies. They should report the annual account net gain or loss from a mixed straddle account in Part II of Form 6781. In addition, they must attach a statement to Form 6781 specifically designating the class of activities for which a mixed straddle account is established.
For the specific application of the rules of this election, see Treasury Regulation Section 1.1092(b)-4T.
Interest Expense and Carrying Charges Relating to Mixed Straddle Account Positions--Investors cannot deduct interest and carrying charges that are allocable to any positions held in a mixed straddle account. They should treat these charges as an adjustment to the annual account net gain or loss and allocate them proportionately between the net short-term and the net long-term capital gains or losses.
(1.) The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) extends the sunset provisions of JGTRRA 2003 by two years. JGTRRA2003 originally repealed IRC Secs. 1(h)(2), 1(h)(9). When the 5%/15% rates "sunset" after 2010, the 8%/18% rates will, once again, be effective. JGTRRA 2003, Sec. 107 as modified by TIPRA 2005.
(2.) The reduction in rates for dividends does not apply to corporate taxpayers. As under prior law, corporations will generally be entitled to a dividends received deduction of 70% or more of qualifying dividend income.
(3.) IRC Sec. 1(h)(11).
(4.) See Ann. 2004-11 2004-10 IRB 581; IRS News Release IR-2004-22 (2-19-2004). See also the 2003 edition of Publication 550 (Investment Income and Expenses), pp. 2, 19-20, at: www.irs.gov.
(5.) Available data indicates that in 2003, about one third of REIT dividends qualified for the lower 15% tax rate. National Association of Real Estate Investment Trusts, REITs and the New Tax Law: Questions and Answers, at: www.nareit.com.
(6.) National Association of Real Estate Investment Trusts, REITs and the New Tax Law: Questions and Answers, at: www.nareit.com.
(7.) $87,500 for married taxpayers filing separately
(8.) TIPRA 2006 modified the kiddie tax to set the age limitation at minors under the age of 18; however, it will not apply if such minor is married and files a joint return. Some relief is available for beneficiaries of qualified disability trusts, as such income distributions to a minor are recharacterized for this purpose as earned income regardless of the actual character of the income.
(9.) The discussion addresses the discount and premium rules for debt instruments with a fixed stated rate. For rules applying to variable rate debt instruments and debt instruments that provide for contingent payments, see Treas. Reg. [section] 1.1272-1(b)(2).
(10.) IRC Sec. 1273(a). For example, a corporation could issue a 20-year bond with a $10,000 par or redemption value at a price as low as $9,500 and buyers could ignore the discount. ($10,000 x 0.0025 = $25; $25 x 20 years = $500.)
(11.) Similar rules apply to tax-exempt municipal bonds with original issue discount with respect to the accrual of OID and adjustment of basis. But the OID accruing each period is tax exempt, just like the cash interest payments.
(12.) Treas. Reg. [section] 1.1272-1(b)(1).
(13.) Gaffney v. Comm., TC Memo 1997-249.
(14.) Gain on the sale, exchange, or retirement of a bond is treated as ordinary income to the extent of unaccrued original issue discount if at the time of original issue there existed an intention to call the bond prior to maturity. According to final regulations, an intention to call exists only if there is an agreement not provided for in the debt instrument that the issuer will redeem the instrument prior to maturity. Treas. Reg. [section] 1.1271-1(a)(1). This rule is not applicable to publicly offered bonds. Treas. Reg. [section] 1.1271-1(a)(2)(i).
(15.) IRC Sec. 1278(a)(2).
(16.) IRC Sec. 1278(a)(2)(B).
(17.) IRC Sec. 1278(a)(2)(C).
(18.) IRC Sec. 1278(b).
(19.) IRC Sec. 1278(b)(3).
(20.) IRC Sec. 1276(b)(2).
(21.) IRC Sec. 171.
(22.) IRC Sec. 171(e). Prior to this, amortized premiums were deductions, not offsets.
(23.) IRC Sec. 171(b)(3).
(24.) IRC Sec. 1016(a)(5); Treas. Reg. [section] 1.1016-5(b).
(25.) IRC Sec. 171(c)(2); Treas. Reg. [section] 1.171-4.
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|Title Annotation:||Techniques of Investment Planning|
|Publication:||Tools & Techniques of Investment Planning, 2nd ed.|
|Date:||Jan 1, 2006|
|Previous Article:||Chapter 42 Leveraging investment assets.|
|Next Article:||Chapter 44 Tax-efficient investment strategies.|