Lesson 15.2: Taxation of Income Versus the Sale of Capital Assets

Question 1

If an investor swaps identical issues of stock to establish a loss that is disallowed, the transaction is known as ???

Answer 1

** A Wash Sale**

The wash sale rule disallows claiming a tax loss on the sale of stock if the investor purchases a substantially identical security within 30 days either before or after the date of such sale.

Question 2

If a high-income taxpayer is subject to the AMT, which preference items must be added to adjusted gross income to calculate his tax liability?

Answer 2

Interest on a private-purpose municipal bond

The interest received on private-purpose municipal bonds is considered a tax preference item for the AMT. The interest on GO bonds and income received on corporate securities are never considered preference items under the AMT. In the real world, it is not only those with high incomes that are caught by the AMT, but the exam is not likely to go that deep.

Question 3

One of the benefits of owning a home is the tax treatment of a sale of a primary residence. Under current IRS regulations,

Answer 3

As long as the requirements are met, a married couple is permitted to exclude the first $500,000 of gain on the sale of a primary residence. The exclusion for singles is $250,000. Years ago, the gain was deferred if the proceeds were reinvested in a new home, but that no longer applies.

Question 4

You have a client whose income from a real estate limited partnership is $11,000. During the same year, your client has net capital losses of $2,000 and losses from an oil and gas drilling program of $6,000. The effect of this investment activity would be to increase the client’s taxable income by ???

Answer 4

$3,000

The $11,000 passive income is offset by the $6,000 of passive loss, giving the client $5,000 of passive income. Because capital losses up to $3,000 are deductible from taxable income, we can deduct the $2,000 in net losses, giving a net increase to taxable income of $3,000.

Question 5

Your customer redeemed 200 of her 500 Kapco common shares without designating which shares were redeemed. Which of the following methods does the IRS use to determine which shares she redeemed?

Answer 5

FIFO

When a customer does not choose a method, the IRS uses FIFO (first-in, first-out). This will likely result in shares with the lowest cost basis being redeemed first, which creates a greater taxable gain.

Question 6

Sally Sherman purchased 100 shares of Chocolate Manufacturers Corporation (CMC) for $19 per share on February 12. She received a 10% stock dividend on May 18. She sold all of her CMC at $13 per share in June of the same year. What were her tax results?

Answer 6

$470 short-term loss

Sally paid $1,900 for 100 shares and sold 110 shares for $1,430 (13 at 110). Because the transactions all took place in less than a year, the transaction was a short-term loss.

Question 7

For tax purposes, the sale of an investment at a profit will result in ???

Answer 7

Capital Gain

Realizing a profit when selling an investment generates a capital gain, while dividend and interest income are taxed as ordinary income.

Question 8

Tax preference items

Answer 8

The alternative minimum tax (AMT) is designed to ensure that certain high-income taxpayers do not avoid all income tax. This is done by adding back to the taxpayer’s ordinary income, items such as accelerated depreciation and excess intangible drilling costs. The term used to describe these items used to arrive at the taxpayer’s alternative minimum taxable income (AMTI) is tax preference items.

The proper term is tax preference items. Those would include the following:

Deductions taken for accelerated (but not straight-line) depreciation

Excess intangible drilling costs

Capital gains on incentive stock options

Otherwise tax-exempt interest from specified private activity bonds

Question 9

Earned income includes:

Answer 9

salary and bonus but not income as an owner of a limited partnership

Question 10

Passive income is derived from:

Answer 10

rental property, limited partnerships, and enterprises in which an individual is not actively involved.

Question 11

Items that must be added back into taxable income for calculation of the alternative minimum tax (AMT) include:

Answer 11

accelerated depreciation on property placed in service after 1986; local taxes and interest on investments that do not generate income; and incentive stock options exceeding the fair market value of the employer’s stock.

Question 12

What offers the opportunity to realize a capital gain rather than ordinary income?

Answer 12

Stock dividends, unlike cash dividends, are not taxable in the year of receipt. Instead, they reduce the owner’s cost basis and, when sold at a price above that cost basis, are treated as a capital gain rather than ordinary income. Deferred annuities never generate anything but ordinary income, and qualified withdrawals from Section 529 plans result in no taxation on the earnings. If they are not qualified, there is ordinary income tax plus a penalty.

Question 13

A married couple has lived in the same home for 40 years and now, with the children all gone, they’ve decided to sell and move to a retirement village. They purchased the home for $80,000 and have accepted a contract for $800,000. The tax consequence of this sale is:

Answer 13

a $220,000 capital gain.

As long as a homeowner has lived in the primary residence at least two of the previous five years, the first $250,000 of profit on a home sale is excluded from tax. In the event it is a married couple, as in this question, the exclusion is doubled to $500,000. The profit on the sale was $720,000 ($800,000 minus the cost of $80,000) and the exclusion of $500,000 reduces the reportable gain to $220,000.

Question 14

A client owns a taxable bond with a coupon rate of 5%. His marginal tax rate is 28%. What is the after-tax yield he will receive on this investment?

Answer 14

The client will earn an after-tax yield of 3.60%, or 5% × (1 − 0.28). Or, you could simply take off the 28% tax from 5% (1.40%) and subtract that from the 5% to arrive at 3.60%.

Question 15

A customer in the 25% tax bracket bought 200 shares of ABC at $93 per share plus commission of $50. Considering the customer’s cost basis, when she sold 100 shares six months later at $96 per share, less commission of $50, her after-tax net was:

Answer 15

Because the purchase and sale were of different lots, you must compute the net proceeds on a per share basis. Dividing the cost of $93 + commission of $0.25 ($50 ÷ 200 shares) gives you a total per share cost of $93.25. Selling for $96.00 – $0.50 ($50 ÷ 100 shares) = $95.50 proceeds per share. $95.50 – $93.25 = $2.25. $2.25 multiplied by 100 shares sold = $225.00. In a 25% tax bracket, this is a taxable short-term gain and 25% of $225.00 = $56.25. Therefore, her after-tax net was $168.75 ($225.00 – 56.25).

Question 16

There are many sources of taxable income to an individual. Included might be money received from which of the following?

I. Sole proprietorship
II. Subchapter S corporation
III. Investments
IV. Life insurance death benefit

Answer 16

I, II, III

An individual can generate income from running a sole proprietorship or being a shareholder in an S corporation (the exam will possibly use the obsolete term Subchapter S). Of course, taxable income can be generated by investments in the form of dividends, interest, and capital gains. The death benefit from a life insurance policy is NOT subject to income tax.

Question 17

The alternative minimum tax (AMT) is assessed against:

Answer 17

high annual income earners and disallows some deductions and exemptions used to calculate adjusted gross income.

The alternative minimum tax (AMT) is assessed against high annual income earners. When calculating adjusted gross income (AGI), some deductions and exemptions are disallowed, resulting in a higher taxable AGI. In the real world, it is not only those with high incomes that are caught by the AMT, but the exam is not likely to go that deep.

Question 18

A client bought 100 shares of a mutual fund on December 28, 2016, for $4,000 and received a capital gains distribution of $2.40 per share on March 6, 2017, which was taken in cash. He sold his 100 shares for $4,300 on June 19, 2017. For tax purposes, this transaction resulted in:

Answer 18

The June sale of the shares purchased in December resulted in a short-term capital gain of $300. The distribution represents a long-term gain of $240, but this question only deals with the client’s transaction.

Question 19

An advisory client of yours discusses a business project she is involved with where the partnership is using accelerated depreciation to maximize losses in the early years. It would be prudent of you to inform the client that:

Answer 19

accelerated depreciation could trigger the alternative minimum tax.

Accelerated depreciation is a tax preference item and could result in requiring this client to pay the AMT. These would be passive losses, and they can only be taken against passive income. There is no limit to the amount of passive loss that can be deducted against passive income. Because the most common way for a company to compute cash flow is net income plus depreciation, the reduction to net income is zeroed out by the increased depreciation added back in.

Question 20

What is not included in taxable income on an individual’s federal income tax return?

Answer 20

Stock dividends (dividends paid as additional shares of stock rather than in cash) adjust the investor’s cost basis and don’t come into play until the stock is sold.

Question 21

Straight-line depreciation is:

Answer 21

NOT a preference item.

Question 22

Tax preference items are used for the purpose of computing the alternative minimum tax. They include all of the following:

Answer 22

I. excess intangible drilling costs.
II. certain incentive stock options.
III. accelerated depreciation.

In the case of the ISO, it is a preference item to the extent that the fair market value of the employer’s stock is in excess of the strike price of the option. As a test-taking tip, when you see two opposites as answer choices, it is likely that one of them is the correct answer. In this case, we have straight-line and accelerated depreciation, only one of which is a preference item.

Question 23

One of your clients invested $10,000 into a mutual fund. The client elected to reinvest all dividends. As a consequence of this:

Answer 23

the investor’s cost basis is increased by the amount of the reinvested dividends.

Because the reported dividends are taxed each year, when the shares are ultimately liquidated, they have already been taxed. So, the investor’s cost basis is increased by the amount of the reinvestment. Reinvested dividends are purchased at the NAV; mutual fund shares are never purchased below the NAV.

Question 24

Taxation is an important part of investment planning. In general, it is correct to state that a taxpayer’s effective tax rate:

Answer 24

is lower than the marginal tax rate.

The marginal tax rate is the rate you pay on each additional dollar you receive as income. The effective tax rate, however, is the overall rate of tax you pay on your total taxable income. Because income tax in the U.S. is progressive, as your earnings increase, so does the tax rate. Because the effective tax rate is the average rate, with very rare exceptions, it will always be lower than the marginal rate. Only the marginal tax rates are shown in the IRS tables. When money is spent on a tax-deductible basis, whether it is a donation to a charity or a contribution to a retirement plan, it is the marginal rate that is used to calculate the tax savings.

Question 25

One of your clients buys 300 shares of RIF common stock in March at $25 per share. Three months later, the client purchases 200 shares of RIF at $30 per share. One month later, RIF pays a dividend of $1 per share. Then, five months later, another purchase of RIF is made—this time 400 shares at $35 per share. If the client were to sell all RIF at $30 per share, what is the client's **capital gain or loss**?

Answer 25

The investor's total cost is $27,500 for the 900 shares purchased. The proceeds of the sale are $27,000 (900 × $30). That results in a capital loss of $500. **The cash dividend has nothing to do with capital gain or loss.**

Question 26

The main purpose of dividend reinvestment in a mutual fund accumulation plan is to:

Answer 26

**compound the growth of a mutual fund investment.** Reinvesting dividends compounds the growth of the fund with periodic purchases of new shares. Taxes are due on dividends whether or not they are reinvested. Capital gains or losses will occur whether or not dividends are reinvested. The purchase of additional shares with reinvested dividends may increase the capital gain or loss in proportion to the dividends reinvested. **Avoiding commissions or sales charges is not the main rationale for reinvesting dividends, even though sales charges are not applied to reinvested dividends.**

Question 27

A U.S. citizen purchases a bond issued by the government of Sweden. The interest payments received are taxed at which of the following levels? I. Federal II. State III. Local

Answer 27

**I, II, III** Interest on foreign bonds is taxed in the United States by **federal, state, and local governments.**

Question 28

A loss derived from a **limited partnership** may be offset against income from:

Answer 28

**other limited partnerships.** **A limited partner may use only passive income to offset the loss derived from a limited partnership**. A passive loss cannot be used to offset dividends received from common stocks. Passive loss from partnerships may be used to offset passive gains from partnerships, not gains from municipal bonds.

Question 29

A number of his clients have reached the age where they are contemplating selling their homes and moving into an assisted living facility. The profit made on the sale of their homes will be used to defray the costs of their new residence. Under current tax laws:

Answer 29

When a primary residence that has been lived in for **at least two of the past five years is sold at a profit, the first $250,000 for an individual and the first $500,000 for a married couple is not subject to taxation.** Everything in excess of that is taxed as capital gain on Schedule D of Form 1040.

Question 30

An investor would have to pay the alternative minimum tax when:

Answer 30

**it exceeds the investor's regular income tax.** A taxpayer must pay the alternative minimum tax (AMT) in **any year that it exceeds regular tax liability**. Tax-preference items are re-input in figuring the AMT, but the AMT is paid only if that amount is higher than the regular income tax.

Question 31

The alternative minimum tax is designed to ensure that certain high-income taxpayers do not avoid all income tax through the use of various tax preference items. Those preference items are added back to the taxpayer's ordinary income on IRS Form 6251 and would include:

Answer 31

**interest received from specified private-purpose municipal revenue bonds.** The Internal Revenue Code provides that interest on specified private activity bonds is an item of tax preference. Therefore, this interest must be added to a taxpayer's regular taxable income in order to compute the taxpayer's AMT income. Read the choices carefully. It is accelerated (not straight line) depreciation and excess intangible drilling costs that are preference items. In the real world, it is not only those with high incomes that are caught by the AMT, but the exam is not likely to go that deep.

Question 32

Investors who buy shares in state-specific municipal bond funds may be subject to:

Answer 32

**capital gains tax.** Interest received from municipal bonds and municipal bond funds is generally income tax free on a federal basis but taxable in states other than the state of issue. State-specific funds avoid that problem. These investments are subject to capital gains taxes if sold at prices above investors' cost.

Question 33

The term earned income would include:

Answer 33

**a bonus paid as a result of your division exceeding its goals.** The IRS defines earned income as wages, salaries, tips, and other taxable employee pay, such as bonuses. The death benefit from a variable annuity policy is taxed as ordinary income but is not earned. The death benefit from a variable life insurance policy is generally free of income tax, so it cannot be earned income. Under the TCJA of 2017, alimony received from a divorce decree dated January 1, 2019 or later is not earned income.

Question 34

Which of the following statements about **capital gains** are true? I. The minimum holding period required to qualify for long-term capital gains treatment is **1 day longer than 12 months.** II. The highest federal income tax rate on long-term capital gains **is less than** the highest federal income tax rate on ordinary income. III. If an investor holds stock for 12 months or less and has no other transactions, any gain on the sale of the stock **is taxed at the same rate as ordinary income.**

Answer 34

**I, II, III** If an investor holds stock for more than 12 months and sells it for a gain, the gain will be treated as a long-term capital gain. The advantage of long-term capital gains is that the maximum tax rate on long-term capital gains is lower than the maximum rate on ordinary income. If an investor holds stock for 12 months or less, though, any gain will be considered a short-term capital gain and will be taxed at the same rate as ordinary income.

Question 35

Investors looking **to minimize the effects of taxation** on their investments would probably receive the least benefit from:

Answer 35

**a corporate bond** Investors receive interest income from corporate bonds. **That income is fully taxable at ordinary income rates.** Real estate ownership has certain tax benefits, such as depreciation and a deduction for operating expenses. Index funds are known for their high tax efficiency, and investors in growth stocks anticipate long-term capital gains, which are taxed at a lower rate than ordinary income.

Question 36

If a client has realized a capital gain from the sale of a municipal bond, to reduce tax liability, the capital gain can be offset against a capital loss in which of these? I. GOs II. Equity securities III. Corporate bonds IV. REITs

Answer 36

**I, II, III, IV** A realized capital gain on a security may be offset by a capital loss realized from the sale of any type of security, including municipal bonds, equities, corporate bonds, or REITs.

Question 37

If an employed client has $12,000 of capital gains and $15,000 of capital losses in the most recent taxable year, how much unused loss, if any, is carried forward by the client to the following tax year?

Answer 37

In this question, the client had $12,000 of capital gains and $15,000 of capital losses. Step 1: Offset the capital gains with the capital losses ($15,000 – $12,000). This leaves $3,000 remaining in capital losses. Step 2: Note that the client can apply up to a maximum of $3,000 of any remaining losses against ordinary income. Once all $3,000 in remaining losses is used to reduce ordinary income,** this would leave $0 to carry forward to the next year.** Therefore, the reason you would not carry $3,000 to the next year is that it would be used to reduce ordinary income for the current year. It can be safely assumed than an employed client of a broker-dealer makes at least $3,000 per year.

Question 38

It would be **least likely** for dividends paid on what investment to meet the requirements to be considered qualified?

Answer 38

**Bond mutual funds** Qualified dividends are those eligible for reduced income tax rates. Those rates can be as low as 0% and as high as 23.8%, with most falling within the 15% to 20% bracket. We don't expect the exam to test on the requirements for a dividend to be considered qualified or how you reach that 23.8% rate. Dividends on bond funds and money market funds are not qualified because the majority of those dividends represent interest earned by the fund and the tax break does not apply to earnings from interest.