Chapter 11

Chapter 11Student: ___________________________________________________________________________

1. Generally, interest income is taxed at preferential capital gains rates and dividend income is taxed at ordinary rates.   True    False

 2. Interest earned on U.S. savings bonds is interest received at sale or maturity but must be taxed

annually.   True    False

 3. An investment's time horizon does not affect after-tax rates of return on investments taxed annually.   

True    False 4. When a taxable bond is issued at a premium, the taxpayer must calculate and apply the yearly

amortization amount to reduce a portion of the actual interest payments that taxpayers include in gross income.   True    False

 5. Qualified dividends are always taxed at a 15 percent preferential rate.   

True    False 6. The capital gains (losses) netting process for taxpayers without 25 or 28 percent capital gains requires

them to (1) net short-term and long-term gains, (2) net short-term and long-term losses, and (3) net the outcome to yield a final gain or loss to place on the tax return.   True    False

 7. Two advantages of investing in capital assets are (1) gains are generally deferred and (2) gains are

generally taxed at preferential rates.   True    False

 8. Dave and Jane file a joint return. They sell a capital asset at a $150,000 loss. Even though they have no

capital gains, $6,000 of the loss can still be deducted in the current year.   True    False

 9. Unrecaptured §1250 gain is taxed at the 28 percent preferential capital gains rate.   

True    False 10. Losses associated with personal-use assets, sales to related parties, and wash sales are not currently

deductible.   True    False

 11. Capital loss carryovers for individuals are carried forward indefinitely.   

True    False 12. Investors must consider complicit taxes as well as explicit taxes in order to make correct investment

choices.   True    False

 13. All life insurance proceeds given to the beneficiary at the time of death of the insured are excluded from

gross income.   True    False

 14. §529 plans are limited to a yearly contribution of $2,000 for each beneficiary and can only be used to pay

for qualified educational costs incurred from kindergarten through 12th grade.   True    False

15. With tax-exempt investment income, an investor's before-tax rate of return is greater than her after-tax rate of return.   True    False

 16. High-marginal rate taxpayers generally prefer municipal bonds and low-marginal rate taxpayers generally

prefer taxable corporate bonds.   True    False

 17. Nondeductible investment expenses (other than investment interest expenses) are carried forward

indefinitely.   True    False

 18. Taxpayers may make an election to include long-term capital gains and qualified dividends in net

investment income and deduct more investment interest expense currently if they are willing to subject these sources of income to ordinary tax rates.   True    False

 19. Investment expenses and investment interest expense are for AGI deductions.   

True    False 20. When electing to include long-term capital gains and qualified dividends in net investment income,

taxpayers must include all long-term capital gains and dividends recognized for that year.   True    False

 21. The investment interest expense deduction is limited to the amount of net investment income for the

year.   True    False

 22. Generally, losses from rental activities are considered to be active losses.   

True    False 23. Passive losses that exceed passive income are deferred until the taxpayer generates passive income to

offset these passive losses.   True    False

 24. A loss from a passive activity is fully deductible as long as the taxpayer has sufficient tax basis in the

activity.   True    False

 25. A passive activity is any activity that involves a trade or business or rental activity in which the taxpayer

does not materially participate.   True    False

 26. To qualify under the passive activity rental real estate exception, the taxpayer must (1) own at least 15

percent of the property and (2) participate in the process of making management decisions.   True    False

 27. If Jim invested $100,000 in an annual-dividend paying stock today with a 7 percent return, what

investment time period will give Jim the greatest after-tax return?   A. 1 yearB. 5 yearsC. 10 yearsD. 20 yearsE. All yield the same after-tax return

28. Which of the following types of interest income is not taxed as it is earned?   A.  interest from savings accountsB. original issue discounts on corporate bondsC.  accrued market discount on bondsD.  interest from money market accountsE. All of these

 29. Nontax factors investors should consider when choosing between investments include:   

A. before-tax rates of returnB.  after-tax rates of returnC.  liquidity needsD. A and BE. A and C

 30. What rate should be used when calculating the after-tax future value of investments with a constant rate

of return that is taxed annually?   A.  annual before-tax rate of returnB.  annual after-tax rate of returnC. marginal tax rateD. preferential tax rateE. average tax rate

 31. If Tom invests $60,000 in a taxable corporate bond that provides a 5 percent before-tax return, how much

will Tom's investment be worth in either 8 or 20 years from now when the bond matures? Assume Tom's marginal tax rate is 35 percent.   A. $88,647; $159,198B. $92,782; $178,414C. $79,621; $121,716D. $77,495; $113,750E. None of these

 32. One primary difference between corporate and U.S. Treasury bonds is:   

A. Treasury bonds always pay interest periodicallyB. Corporate bonds always pay interest periodicallyC.  Interest from Treasury bonds is exempt from federal taxationD.  Interest from corporate bonds is exempt from state taxationE. None of these

 33. The amount of interest income a taxpayer recognizes when he redeems a U.S. savings bond is:   

A.  the excess of the taxpayer's basis in the bonds over the bond proceedsB.  the bond proceedsC.  the excess of the bond proceeds over the taxpayer's basis in the bondsD.  the taxpayer's basis in the bondsE. None of these

 34. Which of the following is not a tax advantage of a Series EE Saving Bond?   

A.  taxes are paid as the original issue discount on the bond is amortizedB.  interest earned is exempt from state taxationC.  taxes are deferred until the bond is cashed in at maturityD.  interest is exempt from federal taxation when used for qualifying educational expensesE. None of these

 35. When a bond is purchased in the secondary bond market at a discount, the amount of discount treated as

interest income when the bond is sold prior to maturity is the:   A. market premiumB. market discountC.  accrued market premiumD.  accrued market discountE. None of these

36. If Adam invested $25,000 in a stock paying annual dividends equal to 5% of his investment, what would the value of his investment be 10 years from now assuming that he reinvested his after-tax dividends each year? Assume Adam's marginal ordinary tax rate is 15%.   A. $26,940B. $40,722C. $37,905D. $101,139E. None of these

 37. When selling stocks, which method of calculating basis provides the greatest opportunity for minimizing

gains or increasing losses?   A. LIFOB. FIFOC. Weighted averageD. Specific identificationE. None of these

 38. Long-term capital gains can be taxed at a maximum rate of:   

A. 15 percent.B. 25 percent.C. 28 percent.D. A and C.E. Depending on the asset sold, the maximum rate could be 15, 25, or 28 percent.

 39. In 2012, Cory recently sold his qualified small business stock for $90,000 after holding it for ten years.

His basis in the stock is $40,000. Assuming his marginal tax rate is 35 percent, how much tax will he owe on the sale?   A. $3,750B. $7,000C. $7,500D. $14,000E. None of these

 40. In X8, Erin had the following capital gains (losses) from the sale of her investments: $2,000 LTCG,

$25,000 STCG, ($9,000) LTCL, and ($15,000) STCL. What is the amount and nature of Erin's capital gains and losses?   A. $3,000 net short-term capital gain.B. $3,000 net long-term capital loss..C. $4,000 net short-term capital gain.D. $4,000 net long-term capital loss.E. None of these.

 41. The netting process for capital gains (losses) with 15 percent, 25 percent, and 28 percent capital assets

helps maximize the tax benefit of:   A.  current year net loss in the 25 percent rate groupB. net short-term capital lossesC.  long-term capital loss carryoversD. A and CE. B and C

 42. When the wash sale rules apply, the realized loss is:   

A.  recognized at time of saleB. not recognized at time of sale and does not affect basis of newly acquired stockC.  recognized at time of sale and added to basis of the newly acquired stockD. not recognized at time of sale and added to basis of the newly acquired stockE. not recognized at time of sale and subtracted from the basis of the newly acquired stock

43. The maximum amount of net capital losses individuals may deduct against their ordinary income per year is:   A. $3,000B. $5,000C. Zero, losses are not deductibleD. There is no maximum. All losses are allowed to be deducted.E. None of these

 44. In the current year, Norris, an individual, has $50,000 of ordinary income, a Net Short Term Capital Loss

(NSTCL) of $10,000 and a Net Long Term Capital Gain (NLTCG) of $2,800. From his capital gains and losses, Norris reports:   A.  an offset against ordinary income of $10,000B.  an offset against ordinary income of $3,000 and a NSTCL carryforward of $7,000C.  an offset against ordinary income of $2,800 and a NSTCL carryforward of $7,200D.  an offset against ordinary income of $3,000 and a NSTCL carryforward of $7,200E. an offset against ordinary income of $3,000 and a NSTCL carryforward of $4,200

 45. Ms. Fresh bought 1,000 shares of Ibis Corporation stock for $5,000 on January 15, 2010. On December

31, 2012 she sold all 1,000 shares of her Ibis stock for $4,500. Based on a hot tip from her friend, she bought 1,000 shares of Ibis stock on January 23, 2013 for $3,000. What is Ms. Fresh's recognized loss on her 2012 sale and what is her basis in her 1,000 shares purchased in 2013?   A. $ - 0 - LTCL and $3,500 basisB. $200 LTCL and $3,300 basisC. $300 LTCL and $3,200 basisD. $400 LTCL and $3,100 basisE. $500 LTCL and $3,000 basis

 46. Kevin bought 200 shares of Intel stock on January 1, 2012 for $50 per share with a brokerage fee of $100.

Then, Kevin sells all 200 shares for $75 per share on December 12, 2012. The brokerage fee on the sale was $150. What is the amount of the gain/loss Kevin must report on his 2012 tax return?   A. $4,500B. $4,750C. $5,000D. $5,250E. None of these

 47. If an individual taxpayer's marginal tax rate is 35 percent and he holds the following assets for more than

a year, which gains will be taxed at the highest rate at the time of sale?   A. gains from investment landB. gains from personal-use propertyC. gains from a coin collectionD. gains from the sale of qualified small business stock held for 3 yearsE. gains attributable to tax depreciation taken on real property

 48. The longer the holding period on growth stocks, ____________ the after-tax rate of return.   

A.  the lesserB.  the greaterC.  there is no difference between

 49. Tom, from Nebraska, and Jill, from Missouri, recently got married. To earn a decent return on all their

wedding gifts, they decide to invest in some municipal bonds issued by the state of Missouri. Assuming they both qualify as Missouri residents, the bond interest Tom and Jill earn will be subject to the following taxes:   A.  federal income taxes onlyB.  federal and Missouri state income taxesC. Missouri state income taxes onlyD. Nebraska state income taxes onlyE. None of these

50. Which of the following portfolio investments is incorrectly characterized (Investment-Income Type-Timing of Taxation-Tax Rate)?   A. Growth stock-appreciation in capital assets-current-capital gainsB. Municipal bonds-tax-exempt income-never-zeroC. Savings account-taxable interest-current-capital gainsD. A and CE. A and B

 51. When 529 plan distributions are not used for qualified higher education expenses, these distributions are

subject to an additional penalty of:   A. 5%B. 10%C. 15%D. 25%E. None of these

 52. Kevin has the option of investing in a municipal bond that provides a 4.5 percent return or a taxable

bond that provides a 7 percent return. Assuming Kevin's marginal tax rate is 35 percent, what investment should he choose and why?   A. Taxable bond; provides a 4.55 percent return versus 4.5 percent return for the municipal bondB. Taxable bond; provides a 7 percent return versus 4.5 percent return for the municipal bondC. Taxable bond; provides a 4.55 percent return versus 2.9 percent return for the municipal bondD. Municipal bond; provides a 4.5 percent return versus 4.2 percent return for the taxable bondE. None of these

 53. What explicit tax rate would keep Jason indifferent between purchasing a municipal bond with a 3.0

percent return and a taxable bond with a 4.5 percent before-tax return? (Round your answer to the nearest percent)   A. 25%B. 30%C. 33%D. 36%E. None of these

 54. Jim decides to purchase a life insurance policy for $75,000 that promises a 9 percent return if Jim dies

after 20 years (normal life expectancy). Jim decides to cash in the policy after five years while still living. Assuming Jim's marginal tax rate is 35 percent, what are his after-tax proceeds? (Round all interim calculations to the nearest whole number)   A. $14,139B. $40,397C. $101,258D. $115,397E. None of these

 55. Maximum yearly contributions per beneficiary to Coverdell Savings Accounts are limited to:   

A. $1,500B. $2,000C. $5,000D. No limit on amount you contribute yearlyE. None of these

56. Emily invested $60,000 into a 529 account on January 1, 20X8 to fund her son's future schooling. Five years later, Emily needs this money to purchase a new car for the family. Her after-tax and penalty proceeds were $76,896. What is Emily's after-tax and penalty rate of return?   A. 5.1%B. 6.1%C. 7.1%D. 8.1%E. None of these

 57. Which of the following is not an example of the conversion tax planning strategy?   

A.  selling corporate bonds to purchase growth stocksB.  selling U.S. Treasury bonds to purchase municipal bondsC.  cashing in a certificate of deposit to purchase a stock paying qualified dividendsD. withdrawing funds from a savings account to purchase a qualified small business stockE. None of these

 58. Life insurance policies have nontax factors that limit their desirability as an investment vehicle. Some of

these factors include:   A. waiting for the insured individual's deathB.  low expense to return ratiosC. high commission costsD. A and BE. A and C

 59. John holds a taxable bond and a municipal bond. Which fees are considered part of John's investment

expense?   A.  attorney and accounting fees on municipal bondB.  safe deposit box rental fees on taxable bondC.  interest expense on taxable bondD. A and BE. B and C

 60. Bill would like some tax benefits for his investment expenses incurred this year. His AGI is $190,000.

Currently, his expenses consist of: (1) $1,000 investment advice fees, (2) $1,500 unreimbursed employee business expenses (a miscellaneous itemized deduction), and (3) $600 tax return preparation fees. How much more, if any, must Bill spend for investment expenses this year before he receives any tax benefit?   A. Zero, Bill is already receiving a benefitB. More than $500C. More than $700D. More than $900E. None of these

 61. When calculating net investment income, gross investment income includes:   

A.  interest incomeB. net short-term capital gainsC. net long-term capital lossesD.  royalty incomeE. All of these

 62. Unused investment interest expense:   

A.  expires after the current yearB.  is carried back two yearsC.  is carried forward twenty yearsD.  is carried forward indefinitelyE. None of these

63. Brandon and Jane Forte file a joint tax return and decide to itemize their deductions. The Forte's income for the year consists of $120,000 in salary, $1,000 interest income, $1,500 nonqualifying dividends, and $1,000 long-term capital gains. The Forte's expenses for the year consist of $3,000 investment interest expense and $900 tax preparation fees. Assuming that the Forte's marginal tax rate is 30%, what is the amount of investment interest expense deduction for the year?   A. Zero; investment interest expense is below two percent of AGI.B. $1,000.C. $2,500.D. $3,000.E. None of these.

 64. Investment expenses treated as miscellaneous itemized deductions do not include:   

A.  expenses incurred to generate tax-exempt incomeB.  investment interest expenseC.  expenses for investment adviceD. A and BE. B and C

 65. Investment interest expense does not include:   

A.  interest expense from loans to purchase municipal bonds.B.  interest expense from loans to purchase corporate bonds.C.  interest expense from loans to purchase stocks.D. A and B.E. B and C

 66. Assume that Joe has a marginal tax rate of 35 percent and decides to make the election to include

long-term capital gains and qualified dividends as investment income. What rate must Joe use when calculating the tax on these two items?   A. 15%B. 25%C. 28%D. 35%E. None of these

 67. Doug and Sue Click file a joint tax return and decide to itemize their deductions. The Click's income for

the year consists of $90,000 in salary, $2,000 interest income, $800 long-term capital loss. The Click's expenses for the year consist of $1,500 investment interest expense. Assuming that the Click's marginal tax rate is 35%, what is the amount of their investment interest expense deduction for the year?   A. $1,200B. $1,500C. $2,000D. $2,300E. None of these

 68. Bob Brain files a single tax return and decides to itemize his deductions. Bob's income for the year

consists of $75,000 of salary, $3,000 long-term capital gain, and $1,500 interest income. Bob's expenses for the year consists of $800 investment advice fees, $700 unreimbursed employee business expenses (a miscellaneous itemized deduction), and $250 tax return preparation fees. What is Bob's actual deduction for miscellaneous itemized deductions?   A. Zero; Bob's investment expenses do not exceed two percent of AGI floor.B. $1,590.C. $1,500.D. $1,750.E. None of these.

69. What is the correct order of the loss limitation rules?   A.  tax basis, at-risk amount, passive loss limitsB.  at-risk amount, tax basis, passive loss limitsC. passive loss limits, at-risk amount, tax basisD.  tax basis, passive loss limits, at-risk amountE. passive loss limits, tax basis, at-risk amount

 70. Sue invested $5,000 in the ABC Limited Partnership and received a 10 percent interest in the partnership.

The partnership had $20,000 of qualified nonrecourse debt and $20,000 of debt she is not responsible to repay because she is a limited partner. Sue is allocated a 10 percent share of both types of debt resulting in a tax basis of $9,000 and an at risk amount of $7,000. During the year, ABC LP generated a ($90,000) loss. How much of Sue's loss is disallowed due to her tax basis or at-risk amount?   A. Zero; all of her loss is allowed to be deducted.B. $2,000 disallowed because of her at- risk amount.C. $2,000 disallowed because of her tax basis.D.  $4,000 disallowed because of her tax basis.E. $4,000 disallowed because of her at-risk amount.

 71. Which taxpayer would not be considered a material participant of an activity?   

A.  taxpayer materially participated in the activity for any five of the preceding ten yearsB.  taxpayer participated on a regular, continuous, and substantial basis last yearC. 

taxpayer participated 95 hours last year and participation is not less than any other participants for the year

D.  taxpayer participated in the activity for 995 hours last yearE. None of these

 72. Generally, which of the following does not correctly categorize the type of income?   

A.  rental real estate-passive income/lossB.  salary-active income/lossC. dividends-portfolio income/lossD.  capital losses-passive income/lossE. All of these

 73. Michelle is an active participant in the rental condominium property she owns. During the year, the

property generates a ($15,000) loss; however, Michelle has sufficient tax basis and at-risk amounts to absorb the loss. If Michelle has $115,000 of salary, $10,000 of long-term capital gains, $3,000 of dividends, and no additional sources of income or deductions, how much loss can Michelle deduct?   A. Zero; losses from rental property are passive losses and can only be offset by passive income.B. $4,000.C. $11,000.D. $15,000.E. None of these.

 74. The rental real estate exception favors:   

A.  lower income taxpayers (AGI less than $80,000)B. middle income taxpayers (AGI greater than $80,000 and less than $150,000)C. upper income taxpayers (AGI greater than $150,000)D. A and BE. B and C

 75. On the sale of a passive activity, any suspended losses cannot be used to offset income from:   

A. other passive activitiesB.  capital gainsC.  interest incomeD. wages and tipsE. None of these

76. A taxpayer's at-risk amount in an activity is increased by:   A. a reduction in the amount of debt related to the activity that the taxpayer is responsible for payingB.  cash contributions to the activityC.  cash distributions from the activityD. A and BE. A and C

 77. Compare and contrast how interest income is reported for the following types of bonds: (a) bond

originally issued at a discount, (b) bond originally issued at a premium, (c) bond purchased at a discount in a secondary market (d) bond purchased at a premium in a secondary market.   

 78. What requirements must be satisfied before an investor may receive preferential tax treatment on

dividend income, and what preferential treatment will result?   

 79. Susan Brown has decided that she would like to go back to school after her kids leave home in five years.

To save for her education, Susan would like to invest $25,000 in an investment that provides a high return. If her marginal tax rate is 35 percent, what is Susan's after-tax rate of return for the following investment options?(1) Corporate bond issued at face value with 10 percent stated interest rate payable annually.(2) Dividend-paying stock with an annual qualifying dividend equal to 10% of her investment.(3) Growth stock with an annual growth rate of 8 percent and no dividends paid.(4) Municipal bond yielding a 6 percent annual return.(5) 529 plan with 7 percent annual return.(Round your interim calculations to the nearest whole number)   

 80. On January 1, 20X1, Fred purchased a corporate bond with a face value of $50,000 from the secondary

market at a premium. The bond has a coupon rate of 8 percent and matures in five years. The market rate of the bond is a 6 percent annual before-tax return compounded semiannually. If Fred was trying to minimize interest income, what is the least amount of interest income Fred may report on his 20X1 tax return?   

81. What impact does an investment time horizon have on the after-tax returns from a portfolio producing interest and dividend income annually?   

 82. On December 1, 20X7, George Jimenez needed a little extra cash for the upcoming holiday season,

and sold 250 shares of Microsoft stock for $50 per share less a broker's fee of $200 for the entire sale transaction. Prior to the sale, George held the following blocks of Microsoft stock (associated broker's fee paid at the time of purchase):

   If his goal is to minimize his current capital gain, how much capital gain will George report from the sale?   

 83. What are the rules limiting the amount of capital losses a taxpayer may deduct in a given year? Name at

least three.   

84. Henry, a single taxpayer with a marginal tax rate of 35 percent, sold the following assets during the year:

   *The original purchase price of the rental home was $75,000. The current tax basis reflects $25,000 of tax depreciation taken.What tax rate(s) will apply to Henry's capital gains or losses?   

 85. Scott Bean is a computer programmer and incurred the following transactions last year.

   What is the Net Short-Term Capital Gain/Loss reported on the 2012 Schedule D? What is the Net Long-Term Capital Gain/Loss reported on the 2012 Schedule D? What amount of capital gain is subject to the preferential capital gains rate?   

86. Mr. and Mrs. Smith purchased 100 shares of stock for $45 per share on June 30, 20X6. On March 30, 20X8, the Smith family decides to sell these shares for $30 generating a loss of $15 per share. On April 15, 20X8, the Smith family realized they made a mistake and repurchased 100 shares for $35 per share. Can the Smith family deduct a long-term or short-term capital loss from the sale on March 30, 20X8? If not, will the Smiths ever receive a tax benefit for their loss?   

 87. What is the tax treatment for qualified small business stock acquired in 2012 and held for more than five

years and what is the tax treatment if held for less than five years?   

 88. When considering tax-favored investments, taxpayers must not only look at explicit taxes but also

at implicit taxes to properly compare them with other less favorably taxed investments. Generally speaking, how do explicit and implicit taxes affect the investment decisions of high and low marginal rate taxpayers?   

 89. Richard purchased a life insurance policy at a cost of $65,000. His two sons, Dale and Drew, were named

the beneficiaries. His policy promises a return of 7.5 percent per year if Richard dies after his normal life expectancy of 25 years. Due to a recent recession, Richard must cash out his policy after 15 years. How much cash will Richard receive after-taxes and what is his after-tax rate of return? Assume Richard's marginal tax rate is 30%.   

 90. Compare and contrast the advantages and disadvantages of Coverdell Educational Savings Plans and 529

Plans.   

91. Phil and Emily Brooks have three sons, Jason, 16, Tom, 12, and Adam, 10. They create a Colorado 529 plan for each of their sons by investing $10,000 in three different plans. Each of these investments yields a constant return of 6.5 percent. When they turned 18, Jason and Adam withdrew the funds in their 529 plans and used the money for higher education expenses while Tom withdrew the funds in his 529 plan to start a new business. Assuming that each of the sons have a 15 percent marginal tax rate when they turn 18, how much money will each of the three boys have after paying all applicable taxes due? (Round all interim and final calculations to the nearest whole number)   

 92. What are the tax and nontax consequences associated with purchasing a whole life insurance policy on

your life?   

 93. How are individual taxpayers' investment expenses and investment interest expense treated for tax

purposes?   

 94. Sarantuya, a college student, feels that now is a good time to buy stocks. However, because she doesn't

have any savings, she decides to borrow $15,000 at an annual interest rate of 8 percent. She must make an interest-only payment each year for five years plus repay the entire principal in year five. On August 1, 20X8 when Sarantuya obtained the loan, Sarantuya invested $10,000 in several individual stocks and used the remaining $5,000 to pay her tuition for the year. Assuming Sarantuya's net investment income this year is greater than her investment interest expense this year, how much investment interest expense can she deduct in 20X8?   

95. Dan and Sue Hill file a joint tax return and elect to itemize their deductions. For 20X7, the Hills received the following income items: (1) $150,000 salary, (2) $3,000 long-term capital gain, and (3) $1,500 interest income. Other than these amounts, no other events or transactions affected their AGI in 20X7. During the same year, the Hills incurred the following expenses: (1) $500 accounting fees, (2) $4,000 investment expenses, and (3) $10,000 additional miscellaneous expenses. Assuming the Hills have a marginal tax rate of 30 percent, what is the tax benefit they receive from the investment expenses they paid?   

 96. How can electing to include long-term capital gains and qualifying dividends in the computation of net

investment income be beneficial to taxpayers?   

 97. Kerri, a single taxpayer who itemizes deductions on Schedule A, incurs $15,000 of interest expense

on funds borrowed to acquire taxable bonds. Kerri also has $20,000 of taxable interest income for the year. Assume Kerri is in a 30% marginal tax bracket. How much of the interest expense can she deduct? Assuming the same facts except that the $20,000 of investment income is a qualifying dividend rather than taxable interest income, what should Kerry do if she wants to minimize her current year tax liability?   

 98. The Crane family recognized the following types of investment income during 20X6: (1) $1,500 qualified

dividends, (2) $3,000 long-term capital gains, and (3) $850 taxable interest. Additionally, the Crane family has $500 in investment expenses and their other miscellaneous itemized deductions exceed 2% of their AGI for the year. The Crane family paid $3,333 in investment interest expense during 20X6. What is the best option for the Crane family if they want to maximize their deduction in 20X6 for investment interest expense? Show all possibilities.   

99. Describe the three main loss limitations that taxpayers must overcome before deducting losses allocated to them from a specific activity.   

 100.Given that losses from passive activities can only offset income from passive activities unless the passive

activity is sold, what types of activities are not considered to be passive? Name at least three ways a taxpayer may be treated as an active participant in an activity.   

 101.Roy, a resident of Michigan, owns 25 percent of a fourplex in the nearby college town of Ann Arbor

with three other friends. The fourplex is rented to students who attend the University of Michigan. Roy's responsibility is to approve new tenants each year and take care of any maintenance issues. During the year, the rental property generated a $25,000 loss which was split equally among Roy and his three friends. Assuming Roy's only source of income was $145,000 of salary, how much of the rental loss can Roy deduct this year and what amount must be carried forward?   

 102.Judy, a single individual, reports the following items of income and loss:

   Judy owns 100% of the rental property and actively participates in the rental of the property. Calculate Judy's AGI.   

103.On January 1, 20X8, Jill contributed $18,000 of cash to the XYZ limited partnership for a 25 percent limited partnership interest. On April 6, 20X8, XYZ, limited partnership distributed $2,000 to Jill. For the year ended December 31, 20X8, Jill received the following income/loss allocations from her partnership investments: (1) XYZ, limited partnership allocated a $5,000 loss to Jill (2) ABC limited partnership allocated $2,300 of income to Jill. How much of the $5,000 loss from XYZ limited partnership can Jill deduct in 20X8?   

Chapter 11 Key  1. FALSE 2. FALSE 3. TRUE 4. TRUE 5. FALSE 6. FALSE 7. TRUE 8. FALSE 9. FALSE 10. TRUE 11. TRUE 12. FALSE 13. TRUE 14. FALSE 15. FALSE 16. TRUE 17. FALSE 18. TRUE 19. FALSE 20. FALSE 21. TRUE 22. FALSE 23. TRUE 24. FALSE 25. TRUE 26. FALSE 27. E 28. C 29. E 30. B 31. D 32. A 33. C 34. A 35. D 36. B 

37. D 38. E 39. B 40. A 41. E 42. D 43. A 44. E 45. A 46. B 47. C 48. B 49. E 50. D 51. B 52. A 53. C 54. C 55. B 56. A 57. E 58. E 59. B 60. C 61. E 62. D 63. C 64. D 65. A 66. D 67. A 68. E 69. A 70. B 71. C 72. D 73. C 74. D 

75. E 76. B (D) Bond purchased at a premium in a secondary market-actual interest payments received in gross income and may elect to use the market premium to offset the interest payments on a yearly basis. If no election is made, the premium is included with the tax basis of the bond and will affect the amount of gain or loss recognized when the bond is sold or redeemed.(C) Bond purchased at a discount in a secondary market-actual interest payments received in gross income and accrued market discount is treated as interest income when the bond has been sold or has reached maturity.(B) Bond originally issued at a premium-actual interest payments received in gross income and may elect to include the current year amortization from the premium to offset the interest payments included in gross income.77. (A) Bond originally issued at a discount-actual interest payments received in gross income and current year amortization amount from discount included in gross income.

 78. A dividend must be a qualified dividend to get preferential treatment. Qualified dividends are paid by domestic or certain qualified foreign corporations. The investor must have held the dividend-paying stock for more than 60 days during the 121 day period that begins 60 days before the ex-dividend date. Generally, qualified dividends are taxed at the preferential capital gains rate of 15 percent. When taxpayers are subject to marginal ordinary rates of 15% or less, qualified dividends are taxed at zero percent. 7%(5) 529 plan6%(4) Municipal bond[($34,973/$25,000)1/5 - 1] = 6.94%$36,733 - $1,760 = $34,973$11,733 x .15 = $1,760$36,733 - $25,000 = $11,733$25,000 x (1 + .08)5 = $36,733(3) Growth stock.10 x (1 - .15) = 8.5%(2) Dividend-paying stock.10 x (1 - .35) = 6.5%79. (1) Corporate bond

Interest income reported - $4,000 - $755.26 = $3,244.74Election of yearly premium amortized - $755.26Yearly interest income - $4,000Step 3: Total Interest Income

   Step 2: Amortization TablePV = $54,265FV - $50,000I - .06 x .5 = 3%N - 5 x 2 = 10PMT - $50,000 x .08 x.5 = $2,000Step 1: Find premium of bondFeedback: See computation below:80. $3,244.74

 81. Interest and dividends are a type of portfolio income desired by investors that prefer current cash flow. Since interest and dividend income is generally taxed on an annual basis as it is received, an investor's time horizon will not affect the after-tax rate of return; however, it will affect the future after-tax value of the investment. 

   Feedback: See computation below:82. Using the specific identification method, George will report only $842 of gain instead of $3,342 of gain he would have reported using the FIFO method.

83. First, a maximum of $3,000 of net capital loss may be applied against ordinary income annually. Any amount of capital loss over $3,000 or any capital loss not used because of insufficient ordinary income is carried forward indefinitely. Second, while capital gains on personal assets are required to be reported, capital losses on personal-use assets are not deductible. Third, capital losses on sales to related parties are not deductible. Fourth, capital losses from wash sales are not currently deductible. A wash sale occurs when an investor sells stock or other securities at a loss and within 30 days either before or after the day of sale buys substantially identical stocks or securities. 

   Step 9: Not required.Step 8: Not required.Step 7: $2,000 net gain in 28 percent group [$5,000 gain on stamps + (3,000) short term loss from Step 1].Step 6: Move the ($3,000) loss from Step 1 into the 28 percent group.Step 5: $50,000 net 15 percent gain [$25,000 ABC stock + $25,000 rental home].Step 4: The $25,000 gain on the ABC stock, and the $25,000 of gain from the rental home that is not attributed to tax depreciation are placed in the 15 percent group. $25,000 of the gain from the rental property attributed to tax depreciation is placed in the 25 percent group, and the $5,000 gain on the stamp collection is placed in the 28 percent group.Step 3: from the text and proceed to Step 4.Step 2: $80,000 overall net long-term capital gain, so ignore.Step 1: ($3,000) net short-term capital loss [$3,000 + ($6,000)].Feedback: See computations below:84. A $2,000 long-term capital gain taxed at 28%, $25,000 long-term capital gains taxed at 25% and $50,000 long-term capital gain taxed at 15%.

   Feedback: See calculations below85. $1,500 net short-term capital loss is reported on Schedule D, $9,000 net long-term capital gain is reported on Schedule D, and $7,500 of net capital gain is subject to the preferential capital gains rates.

 86. The Smith family will have a ($1,500) long-term capital loss. They had held the original stock for over a year; thus, the loss would be categorized as long-term. However, the loss cannot be deducted on the 20X8 tax return. The wash sale rules disallow the deduction because the Smith family sold and purchased similar stock in the same company within 30 days of selling the original shares. However, the loss is added to the basis of the newly acquired stock. Thus, the basis of the new stock is $5,000 or $3,500 (100 shares x $35) plus $1,500 (the disallowed loss). 87. Qualified business stock is considered a capital asset. Thus, preferential treatment is provided under certain circumstances. If stock acquired in 2012 is held by an investor for more than five years, 50 percent of the gain - will be excluded from income. If the stock has been held by an investor for less than five years, the entire gain is taxed; however, the gain will be taxed at a maximum 15% rate. 88. High marginal taxpayers tend to seek more tax-favored investments relative to taxable investments. The reason for this is that the explicit tax that these taxpayers avoid is greater than the implicit tax they are paying when purchasing tax-favored investments. Despite the fact that before-tax returns are generally higher for taxable investments, the high marginal tax rate applicable to less favorably taxed investments will tend to decrease after-tax returns below the returns on tax-favored investments. On the other hand, low marginal rate taxpayers will generally prefer less favorably taxed investments because the implicit taxes they avoid by not purchasing tax-favored investments tends to be greater than the explicit taxes they pay, if any, on the less tax favored investments they actually purchase. 

[($154,129/$65,000)1/15 - 1] = 5.92%Step 5: After-tax rate of return$192,327 - $38,198 = $154,129Step 4: After-tax proceeds$127,327 x .30 = $38,198Step 3: Tax on cash surrender value$192,327 - $65,000 = $127,327Step 2: Gain[$65,000 * (1 + .075)15] = $192,327Step 1: Cash surrender value receivedFeedback: See calculations below:89. Richard's after tax proceeds are $154,129 and his after-tax rate of return is 5.92%

 • The $2,000 contribution limit phases out at higher levels of AGI (No phase-out of 529 plan contributions)• Yearly contributions limited to $2,000 per beneficiary (the median contribution limit for state sponsored 529 plans is well over $200,000)• Coverdell Education Savings Plan Disadvantages (529 Plan Advantages)• Flexibility in determining where to invest funds (Investors are limited to investments offered by 529 plans)• Distributions may be used to pay for kindergarten through 12th grade (Distributions from 529 may only be used to pay for higher education expenses)90. Coverdell Educational Savings Plan Advantages (529 Plan Disadvantages)

 $14,591 - $1,148 = $13,443$4,591 x .25 (15% marginal rate + 10% penalty) = $1,148$14,591 - $10,000 = $4,591[$10,000 x (1 + .065)6] = $14,591Tom[$10,000 x (1 + .065)8] = $16,550Adam[$10,000 x (1 + .065)2] = $11,342JasonFeedback: See computations below:91. Jason will have $11,342, Adam will have $16,550, and Tom will have 13,443.

92. A whole life insurance policy can be used as a tax-favored investment. The amount paid out at time of death will be tax-exempt to the beneficiary of the policy. Also, the cash surrender value of the policy will grow free of tax as long as the invested premiums generate positive returns. If the owner of the policy elects to receive the cash surrender value before his death, he must pay taxes on his investment gains (i.e., the difference between the cash surrender value of the policy and the amount invested in the policy). Regarding nontax consequences, purchasing life insurance policies can result in high commissions and fees. These costs will reduce the before-tax return of life insurance relative to other investments. Overall, life insurance is a relatively tax favorable investment if held until time of death, but the costs associated with life insurance may overwhelm the tax benefits. Investment interest expense: This is a specific expense that relates to the interest on loans taxpayers obtain to purchase portfolio investments. The amount a taxpayer is able to deduct depends on whether the taxpayer itemizes deductions for the year. The deduction for investment interest expense is limited to the taxpayer's net investment income for the year. Any investment interest expense in excess of a taxpayer's net investment income may be carried forward indefinitely until the taxpayer has enough net investment income to use the deduction.93. Investment expense: This is any expense incurred to acquire or manage investments, excluding interest. Investments expenses are treated as miscellaneous itemized deductions subject to the 2% of AGI floor. Thus, investment expenses result in tax deductions if investors itemize and if such expenses exceed the 2 percent of AGI floor. These expenses are only deductible in the year incurred.

 Nondeductible personal interest: $500 x .33 = $167Investment interest expense: $500 x .67 = $333Step 3: Use percentages from Step 2 to allocate the correct interest expense that is allowed to be deductibleTuition: $5,000/$15,000 = 33%Individual stocks: $10,000/$15,000 = 67%Step 2: Proportion amount of loan used for investment and personal use.[$15,000 x .08 x (5/12)] = $500Step 1: Interest expense for 20X8.Feedback: See calculations below:94. Sarantuya is allowed to deduct up to $333 in investment interest expense.

 Because the total $11,400 miscellaneous itemized deduction is greater than the $4,000 of investment expenses, the Hills receive a tax benefit for all $4,000 of their investment expenses. Given their marginal tax rate of 30%, the tax benefit is equal to $4,000 x 30% or $1,200.$14,500 - $3,090 = $11,410Step 3: Calculate amount of miscellaneous itemized deductions in excess of the AGI floor$154,500 x .02 = $3,090Step 2: Calculate the 2% AGI floorMiscellaneous itemized expenses: $500 + $4,000 + $10,000 = $14,500AGI: $150,000 + $3,000 + $1,500 = $154,500Step 1: Calculate AGI and calculate total miscellaneous expensesFeedback: See calculations below:95. Tax savings of $1,200 for the Hills related to their investment expenses.

 96. If taxpayers elect to include long-term capital gains and qualifying dividends in net investment income, these income items must be taxed at ordinary rates rather than at the preferential capital gains rates. This detriment may be more than offset by the additional investment interest expense that becomes deductible as net investment income is increased by virtue of making the election. Taxpayers considering this election should compare the current benefit of making this election with the loss of future benefits from taking the investment interest expense deduction in the future. Fortunately, the election doesn't require all capital gains and qualifying dividends to be taxed at ordinary rates. Instead, taxpayers can elect to include only the amount of long-term capital gains and qualifying dividends that will provide the greatest current benefit. 

*Kerri only wants to elect to treat an amount of the qualifying dividend as investment income ($15,000) so as to allow her to deduct all of the investment interest expense. This allows her to deduct all $15,000 of the investment interest expense and still be able to tax $5,000 of the qualifying dividend @ 15% rather than all $20,000 of the qualifying dividend @ 30%.

   Second question:

   First question:Feedback: See calculations below:97. She can deduct $15,000 of investment interest expense. If the investment income is a qualifying dividend, she should elect to treat $15,000 of the qualifying dividend as investment income.

Option 5 is superior to options 3 and 4 because it subjects the minimum amount of long-term capital gain to ordinary rates while maintaining the net investment interest carried forward at 0. Other combinations of long-term capital gain and qualifying dividends totaling $2,983 would also be acceptable.Investment interest expense carried forward: $0Investment interest expense allowed to deduct: $3,333Net investment income: $2,983 + $850 - $500 = $3,333Option 5: Election to include only $2,983 of long-term capital gains in net investment incomePay higher tax rate on excess $1,517 electedInvestment interest expense carried forward: $0Investment interest expense allowed to deduct: $3,333Net investment income: $1,500 + $3,000 + $850 - $500 = $4,850Option 4: Election to include all qualified dividends and all long-term capital gains in investment incomePay higher tax rate on excess $17 electedInvestment interest expense carried forward: $0Investment interest expense allowed to deduct: $3,333Net investment income: $3,000 + $850 - $500 = $3,350Option 3: Election to include all long-term capital gains in investment incomeInvestment interest expense carried forward: $3,333 - $1,850 = $1,483Investment interest expense allowed to deduct: $1,850Net investment income: $1,500 + $850 - $500 = $1,850Option 2: Election to include all qualified dividends in investment incomeInvestment interest expense carried forward: $3,333 - 350 = $2,983Investment interest expense allowed to deduct: $350Net investment income: $850 - $500 = $350Option 1: No electionFeedback: See calculations below:98. Elect to include only $2,983 of long-term capital gain in net investment income.

 Passive loss limits - limits the amount of loss from any passive activity (activities in which the taxpayer does not materially participate) to the taxpayer's passive income for the year. Limited partnerships and rental activities are generally considered to be passive activities. Losses limited by the passive activity loss rules are carried forward until the taxpayer generates passive income or until the taxpayer disposes of the activity producing the passive losses.At-risk amount-limits the amount of deductible loss to the amount the taxpayer has at risk in the activity. Generally, the taxpayer's at risk amount corresponds to his tax basis except that debt allocated to the taxpayer and included in tax basis is not included in the taxpayer's amount at risk if he is not responsible for repaying the debt. However, an exception to this general rule is qualified nonrecourse financing that is included in the taxpayer's amount at risk. Losses limited by the taxpayer's amount at risk are carried forward and deducted when the taxpayer's amount at risk becomes positive again.99. Tax basis - limits the amount of deductible loss to the tax basis the taxpayer has in the activity. Thus, losses from an activity may not reduce the tax basis in that activity below zero. Losses in excess of the taxpayer's basis are carried forward until the taxpayer's basis becomes positive again.

7. Taking into account all the facts and circumstances, the individual participates on a regular, continuous, and substantial basis during the year.6. The individual materially participated for any three preceding years in any personal service activity (personal services in health, law, accounting, architecture, etc).5. The individual materially participated in the activity for any five of the preceding 10 taxable years.4. The activity qualifies as a "significant participation activity" (more than 100 hours) and the aggregate of all "significant participation activities" is greater than 500 hours for the year.3. The individual participates more than 100 hours during the year, and the individual's participation is not less than any other individual's participation in the activity.2. The individual's activity constitutes substantially all of the participation in such activity by all individuals including non-owners.1. The individual participates in the activity more than 500 hours during the year.100. To be considered an active participant in an activity, a taxpayer must materially participate in the activity. An individual will qualify as a material participant in an activity if any one of the seven tests below is satisfied:

 Carried forward: $6,250 - $2,500 = $3,750Deducted for current year: $2,500Step 3: Rental loss allowed to be deducted for current year and amount carried forward$25,000 - [($145,000 - $100,000) x .5] = $2,500Step 2: Maximum deduction for current year$25,000/4 = $6,250Step 1: Portion of rental loss to RoyFeedback: See calculations below:101. Current year deduction - $2,500 and carried forward amount - $3,750

   Feedback: See calculations below:102. $105,000

 Jill has sufficient tax basis and amount at-risk in XYZ to deduct her $5,000 loss allocation from XYZ; however, she must assess how much passive income she has from other sources that she may offset with her $5,000 passive loss from XYZ. Because she is a limited partner in XYZ and ABC, her losses and income from these activities are considered to be passive. The only passive income she has is $2,300 from ABC. Thus, she would only be allowed to deduct $2,300 of her $5,000 loss from XYZ this year and must carry forward $2,700 of the remaining loss until she generates additional passive income in the future or sells her interest in XYZ.Feedback: See calculations below:103. $2,300 of loss from XYZ is deducted in 20X8.

Chapter 11 Summary  Category # of Questions

AACSB: Analytic 33

AACSB: Reflective thinking 70

AICPA BB: Critical Thinking 103

Blooms: Analyze 78

Blooms: Apply 4

Blooms: Remember 24

Blooms: Understand 42

Learning Objective: 11-01 Explain how interest income and dividend income are taxed. 21

Learning Objective: 11-02 Compute the tax consequences associated with the disposition of capital assets; including the netting process for calculating gains and losses.

26

Learning Objective: 11-03 Describe common sources of tax-exempt investment income and explain the rationale for exempting some investments from taxation.

21

Learning Objective: 11-04 Calculate the deduction for portfolio investment-related expenses; including investment expenses and investment interest expense.

21

Learning Objective: 11-05 Understand the distinction between portfolio investments and passive investments and apply tax basis; at-risk; and passive activity loss limits to losses from passive investments.

18

Level of Difficulty: 1 Easy 24

Level of Difficulty: 2 Medium 65

Level of Difficulty: 3 Hard 14

Spilker - Chapter 11 103