CH. 7 - Investments Flashcards
Investment Income
income received from portfolio-type investments. Portfolio income includes capital gains and losses, interest, dividend, annuity, and royalty income not derived in the ordinary course of a trade or business. When computing the deductibility of investment interest expense, however, capital gains and dividends subject to the preferential tax rate are not treated as investment income unless the taxpayer elects to have this income taxed at ordinary tax rates.
What are two key characteristics that affect after-tax rates of return from investments?
- The timing of tax payments and tax benefits
and - the rate at which investment or gains are taxed or deductible expenses or losses generate tax savings.
Portfolio investments
investments producing dividends, interest, royalties, annuities, or capital gains.
Dividend
a distribution to shareholders of money or property from the corporation’s earnings and profits.
Income from portfolio investments may be taxed at ___________ rates or ____________ rates, or they may be _________ from taxation.
ordinary; preferential; exempt
True or false: losses from portfolio investments deferred until the investment is sold and are typically subject to limitations
True
Passive investments
direct or indirect investments (other than through a C corporation) in a trade or business or rental activity in which the taxpayer does not materially participate.
Operating income
the annual income from a trade or business or rental activity.
Operating loss
the annual loss from a trade or business or rental activity
Operating income is always taxed __________ at ________ rates, while operating losses are either __________ __________ at _________ rates or __________ and _________ later at ______ rates, depending on the investors circumstances.
annually; ordinary; deducted; annually; deferred; deducted; ordinary
Certificate of Deposit (CDs)
an interest-bearing debt instrument offered by banks and savings and loans. Money removed from the CD before maturity is subject to a penalty.
Bonds
A loan given to a company or government by an investor. By issuing a bond, the company or government borrows money from the investor who in turn is paid interest on the money they’ve loaned.
Aka “a debt instruments issued for a period of more than one year with the purpose of raising capital by borrowing.”
What are investments that generate interest income?
CDs, savings accounts, corporate bonds, and governmental bonds.
What are investments that generate dividend income?
direct equity investments in corporate stocks and investments in mutual funds and exchange traded funds (ETFs) that invest in corporate stock.
Mutual Funds
a diversified portfolio of securities owned and managed by a regulated investment company.
Exchange traded funds (ETFs)
diversified portfolios of securities owned and managed by a regulated investment company similar to mutual funds except they are traded on exchanges and the shares trade throughout the day like ordinary stock listings.
Maturity value or face value
the amount paid to a bondholder when the bond matures and the bondholder redeems the bond for cash.
What does investment income include?
capital gains and losses, interest, dividend, annuity, and royalty income not derived in the ordinary course of a trade or business.
True or false: it is possible that two investments with identical before-tax rates of return will generate different after-tax rates of return because the investments are taxed differently.
True!
True or false: tax on income from a portfolio investment may be imposed annually but may not be deferred.
False; it CAN BE imposed annually, but it can also be deferred until the taxpayer sells the investment.
passive income generates _________ and _________
operating income and operating losses.
After tax rate of return on investments depends on:
-The before tax rate of return
-When the investment income and gains are taxed
–Taxed annually
–Tax deferred
–Tax-exempt
-When investment losses are deducted
–Deductions annually
–Deductions deferred
-Rates at which investment income or gains/expenses or losses are taxed/deducted
–Ordinary tax rates
–Preferential tax rates
–Zero tax rates
True or false: shareholders are legally entitled to receive dividend payments
False; they are not. They are also not entitled to recover their initial investment.
From an investor’s perspective, debt tends to be (more/less) risky than equity. Why?
less risky.
Because by lending money to banks, governmental agencies, and corporations, investors essentially become debt holders to those entities.
However, investors who purchase stock become shareholders (aka equity holders) in a company, and are therefore more exposed to its ups and downs.
True or false: individual investors are typically taxed on both interest and divident income when they receive it.
True
Interest income is taxed at ______ rates, and dividend income is generally taxed at ________
ordinary rates; lower capital gains rates.
Taxpayers recognize interest income from investments when _______
they receive the interest payments
Bond discount
the result of issuing bonds for less than their maturity value.
Bond premium
the result of issuing bonds for more than their maturity value.
U.S. Savings bond
debt instruments issued by the U.S. Treasury at face value or at a discount, with a set maturity date. Interest earned from U.S. bonds is paid either at maturity or when the bonds are converted to cash before maturity.
Treasury bonds
a debt instrument issued by the U.S. Treasury at face value, at a discount, or at a premium, with a set interest rate and maturity date that pays interest semiannually. Treasury bonds have terms of 30 years.
Treasury notes
a debt instrument issued by the U.S. Treasury at face value, at a discount, or at a premium, with a set interest rate and maturity date that pays interest semiannually. Treasury notes have terms of 2, 5, or 10 years.
Zero-coupon bond
a type of bond issued at a discount that pays interest only at maturity (aka does not pay periodic interest).
What are the two primary differences between holding a corporate bond vs a treasury bond?
- Interest from Treasury bonds are exempt from state taxation while interest from corporate bonds is not
- Treasury bonds always pay interest periodically while corporate bond may or may not.
True or false: taxpayers do not include the actual interest payment they receive from corporate and U.S. Treasury bonds in gross income
false–they have to include it.
If a bond was issued at a discount, taxpayers are _____ to _________ the discount and include the amount of the current year amortization in ______ ________
Taxpayers are required to amortize the discount and include the amount of the current year amortization in gross income in addition to any interest payments the taxpayer actually receives.
Original issue discount (OID)
a type of bond issued for less than the maturity or face value of the bond.
If a bond was issued at a premium, taxpayers…
may elect to amortize the premium. The amount of the current-year amortiization offsets a portion of the actual interest payments that taxpayers must include in gross income.
Amortization
the method of recovering the cost of intangible assets over a specific time period.
If the bond was purchased in the secondary bond market at a discount, the taxpayer….
treats all or some of the market discount as interest *when they sell the bond or the bond matures. If the bond is sold prior to maturity, a ratable amount of the market discount (called accured market discount) is treated as income on the date of the sale.
Market discount
the difference between the amount paid for a bond in a market purchase rather than at original issuance when the amount paid is less than the maturity value of the bond.
Maturity
the amount of time to the expiration date, or maturity date, of a debt instrument. The maturity of a debt instrument is generally the life of the instrument, at which point a payment of the face value is due or the instrument terminates.
