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Chapter 11 - Investments

Chapter 11
Investments
SOLUTIONS MANUAL
Discussion Questions
1. [LO 1] Describe how interest income and dividend income are taxed. What are the
similarities and differences in their tax treatment?
Because they are cash method taxpayers, individual investors typically are taxed on
interest and dividends when they receive them. However, interest income is taxed using
ordinary rates while qualified dividends are taxed at lower capital gains rates.
2. [LO 1] What is the underlying policy rationale for the current tax rules applicable to
interest income and dividend income?
Interest and dividends are typically taxed annually when received because taxpayers
have the wherewithal to pay the tax at that time. Interest income is taxed at ordinary
rates because it is viewed as a less risky type of income compared to other more risky
forms of income such as the expected appreciation in capital assets. Qualified dividends
are taxed at capital gains rates to mitigate the effect of double taxation on corporate
earnings.
3. [LO 1] Compare and contrast the tax treatment of interest from a Treasury bond and
qualified dividends from corporate stock.
Both the interest from Treasury bonds and dividends are taxed by cash method taxpayers
in the year they are received. However, interest is taxed using ordinary rates while
qualified dividends are taxed at lower capital gains rates. An additional difference
between these types of income relates to their state income tax treatment. The interest
from Treasury bonds is exempt from state income taxes while dividends are subject to
state income taxes.
4. [LO 1] How are Treasury notes and Treasury bonds treated for federal and state income
tax purposes?
Generally, interest from Treasury bonds and notes is taxed annually as it is received at
ordinary rates for federal income tax purposes. However, interest from Treasury bonds
and Treasury notes is exempt from state income taxes.
Treasury bonds and Treasury notes are issued at maturity value, at a discount, or at a
premium, depending on prevailing interest rates. Treasury bonds and Treasury notes pay
a stated rate of interest semiannually. When Treasury bonds and Treasury notes are
either issued or subsequently purchased at either a premium or discount, special rules
apply. Specifically, taxpayers may elect to amortize the premium to reduce the amount of
interest currently reported. To the extent taxpayers amortize the premium, they reduce
the tax basis in the related bond or note. If a portion of the premium is unamortized
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Chapter 11 - Investments

(either because the election to amortize the premium was not made or because the bond
is sold prior to maturity), the unamortized premium remains part of the tax basis of the
bond or note and affects the amount of capital gain or loss taxpayers recognize when the
bond or note is sold or when it matures.
Original issue discount must be amortized and included in gross income in addition to
any interest payments taxpayers actually receive. Also, the tax basis of a bond or note is
increased by the amount of original issue discount amortized into income. In contrast,
market discount is not amortized into income unless taxpayers elect to do so. Rather, the
market discount that would have been amortized into income (on an annual basis using a
straight line method) if the taxpayer had elected to amortize the market discount into
income is treated as ordinary income when the bond or note is sold or when it matures.
5. [LO 1] Why would taxpayers generally prefer the tax treatment of market discount to the
treatment of original issue discount on corporate bonds?
Taxpayers generally would prefer market discount to original issue discount on bonds
because the ordinary income related to market discount is deferred until bonds are sold
or until they mature. In contrast, taxpayers must report ordinary income from the
amortization of original issue discount yearly until the bonds are sold or until they
mature.
6. [LO 1] In what ways are U.S. savings bonds treated more favorably for tax purposes than
corporate bonds?
U.S. Savings Bonds compare favorably with corporate bonds because any interest related
to the original issue discount on savings bonds is deferred until the savings bonds are
cashed in. In comparison, any original issue discount on corporate bonds must be
amortized and included in the investors annual tax returns.
Also, interest from savings bonds used to pay for qualifying educational expenses may be
excluded entirely from income whereas interest from corporate bonds must eventually be
reported.
7. [LO 1] {Research, Planning} When should investors consider making an election to
amortize market discount on a bond into income annually? [Hint: see 1278(b)]
A taxpayer may elect under 1278(b) to amortize market discount on a bond into income
currently (as ordinary income) rather than wait to recognize the accrued market discount
as ordinary income when the bond is sold or matures.
Generally, this election makes sense when the taxpayers current marginal tax rate is
expected to be significantly lower than the future marginal rate when the bond is sold or
matures.

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Chapter 11 - Investments

8. [LO 1] Why might investors purchase interest-paying securities rather than dividendpaying stocks?
Non-tax considerations may play a role. For example, investors may be willing to give
up the tax rate benefit from receiving qualified dividend income in exchange for the
certainty of receiving predicable interest payments. In addition, risk preferences might
cause investors to prefer one investment over another. FDIC insurance guarantees the
security of an investment in savings accounts and certificates of deposit up to a threshold
amount; whereas, no guarantees exist for stock investments.

9. [LO 1] Compare and contrast the tax treatment of dividend-paying stocks and growth
stocks.
Qualified dividends from dividend paying stocks and long-term capital gains from growth
stocks are both taxed at favorable capital gains rates. However, dividends are taxed
when received in contrast to the appreciation in growth stocks which is taxed only when
growth stocks are sold. All else equal, growth stocks will have a higher after-tax rate of
return because the tax is deferred into the future while dividend paying stocks are taxed
annually.
10. [LO 1] Do after-tax rates of return for investments in either interest or dividend paying
securities increase with the length of the investment? Why or why not?
After-tax rates of return do not increase for interest or dividend paying securities with the
length of the investment period because they are both taxed annually.
11. [LO 2] What is the definition of a capital asset? Give three examples of capital assets.
In general, a capital asset is any asset other than an asset used in a trade or business
(i.e., equipment, buildings, inventory, etc.), or accounts or notes receivable generated
from the sale of services or property by a trade or business.
Also, any property that is used for personal rather than business purposes is a capital
asset. Examples of capital assets include investment assets such as corporate or
governmental bonds, corporate stock, stocks in mutual funds, and land held for
investment. Personal assets such as automobiles, personal residences, golf clubs, book
collections, and televisions are also capital assets.
12. [LO 2] Why does the tax law allow a taxpayer to defer gains accrued on a capital asset
until the taxpayer actually sells the asset?
Taxpayers are allowed to defer accrued gains on capital assets until the date of sale
because the investment doesnt provide the wherewithal (i.e., cash) to pay the tax on the
accrued gains until after it is sold. When the taxpayer sells the asset, the investment
should provide the cash necessary to pay the taxes due on the gain.
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Chapter 11 - Investments

13. [LO 2] Why does the tax law provide preferential rates on certain capital gains?
Preferential tax rates apply to gains on the sale of certain capital assets (e.g., capital
assets held for more than one year). Among other things, these preferential rates are
meant to encourage taxpayers to invest in those assets and to hold those assets for the
long term. The government believes this will help the national economy by stimulating
the demand for risky investments.
14. [LO 2] Cameron purchases stock in Corporation X and in Corporation Y. Neither
corporation pays dividends. The stocks both earn an identical before-tax rate of return.
Cameron sells stock in Corporation X after three years and he sells the stock in
Corporation Y after five years. Which investment likely earned a greater after-tax return?
Why?
The gain from the sale of the Corporation Y stock should earn a greater after-tax return
because the tax was deferred for 5 years while the tax on the gain from the sale of
Corporation X stock was deferred for 3 years. The longer the tax is deferred, the less it
costs on an after-tax basis. The lower the tax cost, the higher the after-tax return, all else
equal.
15. [LO 2] What is the deciding factor in determining whether a capital gain is a short-term
or long-term capital gain?
The deciding factor is the amount of time an asset has been held by the taxpayer. When a
capital asset that has been held for more than one year is sold, it generates a long-term
capital gain. When it has been held for one year or less it generates a short term capital
gain when sold.
16. [LO 2] What methods may taxpayers use to determine the adjusted basis of stock they
have sold?
Taxpayers can use the FIFO method to determine basis in the stock. That is, the first
stock purchased (i.e., the stock the taxpayer has held for the longest time) is treated as
though it is the first stock sold. Taxpayers can also use the specific identification method
of determining the basis of the stock sold.
17. [LO 2] What tax rate applies to net short-term capital gains?
Net short-term capital gains are taxed at the taxpayers ordinary tax rates.
18. [LO 2] What limitations are placed on the deductibility of capital losses for individual
taxpayers?

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Chapter 11 - Investments

Individual taxpayers with a net capital loss for the year may deduct up to $3,000 of the
capital loss against ordinary income. Taxpayers can deduct up to $3,000 ($1,500 if
married filing separately) of net capital losses against ordinary income. Net capital
losses in excess of $3,000 ($1,500 if married filing separately) retain their short or longterm character and are carried forward.
19. [LO 2] What happens to capital losses that are not deductible in the current year?
Individual capital losses that are not deducted in the current year are carried forward
indefinitely and treated as though they were incurred in the subsequent year.
20. [LO 2] Are all long-term capital gains taxable at the same maximum rate? If not, what
rates may apply to long-term capital gains?
Long-term capital gains may be taxed at one of five different rates (0, 15, 20, 25, or 28
percent). Unrecaptured 1250 gains from the sale of depreciable real estate investments
are taxed at a 25% maximum rate, gains from collectibles held for more than one year
are taxed at a 28% maximum rate, and recognized gains from the sale of qualified small
business stock held for more than five years is taxable at a 28% maximum rate. The
remaining long-term capital gains are taxed at 0, 15, or 20 percent depending on the
taxpayers ordinary income tax rate as follows:
Ordinary Tax Bracket
Capital Gains Tax Rate
10% or 15%
0%
25%, 28%, 33%, or 35%
15%
39.6%
20%
21. [LO 2] {Planning}This year, David, a taxpayer in the highest tax rate bracket, has the
option to purchase either stock in a Fortune 500 company or qualified small business
stock in his friends corporation. All else equal, which of the two will he prefer from a
tax perspective if he intends to hold the stock for six years? Which would he prefer if he
only plans to hold the stock for two years?
If David holds the stock in his friends corporation for more than five years, 100% of his
gain will be excluded. In contrast, gains from the sale of stock in the Fortune 500
company would be taxed at the prevailing maximum capital gains rate (maximum of 20%
currently). Thus, David would prefer to purchase stock in his friends corporation if
taxes are the only consideration.
If the stocks are only held for two years, the stock in his friends corporation would not
be treated as qualified small business stock and he would be indifferent, from a tax
perspective, between purchasing the two stocks.

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Chapter 11 - Investments

22. [LO 2] What is a wash sale? What is the purpose of the wash sale tax rules?
A wash sale is a tax term that applies to transactions in which a taxpayer purchases the
same stock or substantially identical stock to the stock they sold at a loss within a 61day period centered on the date of the sale.
A wash sale occurs when an investor sells or trades stock or securities at a loss and
within 30 days either before or after the day of sale buys substantially identical stocks or
securities. Because the day of sale is included, the 30 days before and after period
creates a 61-day window during which the wash sale provisions may apply.
The purpose of the wash sale tax rules is to prevent taxpayers from accelerating losses on
securities that have declined in value without actually changing their investment in the
securities. The 61-day period ensures that taxpayers cannot deduct losses from stock
sales while essentially continuing their investment in the stock.
23. [LO 2] Nick does not use his car for business purposes. If he sells his car for less than he
paid for it, does he get to deduct the loss for tax purposes? Why or why not?
Personal-use of assets falls within the category of capital assets. When a taxpayer sells a
personal-use asset, the gain from the sale of the personal-use asset is taxable even
though it was not purchased for its appreciation potential. If a taxpayer sells a car for
less than he paid for it, the loss from the sale of the personal-use asset is not deductible,
and therefore never becomes part of the netting process.
Hence losses recognized on assets used for personal purposes are not deductible.
However, if Nick sold the car for more than he purchased it, he would be taxed on the
capital gain.
24. [LO 2] Describe three basic tax planning strategies available to taxpayers investing in
capital assets.
When a taxpayer holds capital assets for more than one year before selling, she is
actually utilizing two basic strategies. First, she defers recognizing capital gains thereby
reducing the present value of the capital gains tax due when the asset is sold. Second, by
converting the capital gain into a long-term capital gain, the gain is taxed at a
preferential maximum tax rate of 0/15/20% (depending on her income) instead of her
ordinary rate.
A third strategy is to sell investments with built-in losses. Selling loss assets reduces
taxes by providing up to a $3,000 deduction against ordinary income and by reducing the
amount of capital gains that would otherwise be subject to tax during the year. This is
particularly beneficial for a taxpayer with short-term capital gains that would be taxed
at high ordinary rates absent offsetting capital losses.

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Chapter 11 - Investments

25. [LO 2] {Planning} Clark owns stock in BCS Corporation that he purchased in January of
the current year. The stock has appreciated significantly during the year. It is now
December of the current year, and Clark is deciding whether or not he should sell the
stock. What tax and nontax factors should Clark consider before making the decision on
whether to sell the stock now?
Tax factors:
Clark should consider the rate at which the gain will be taxed. If he sells the stock in
December of the current year, the gain is a short-term gain that will likely be taxed at his
marginal ordinary income rate. If he waits until he has held the stock for more than a
year, the gain will be taxed at a maximum of 0/15/20% (depending on income).
Clark should also assess his other capital gains and losses incurred during the year. The
gain he recognizes on the sale will enter the netting process. Thus, if he has a large short
term capital loss, he may want to sell the stock this year to absorb the loss.
Nontax factors:
If Clark decides to hold the stock, there is risk that the value will decline. Likewise, the
stock may appreciate in value if Clark decides to wait to sell. Clark should assess his
risk of loss and appreciation potential of the stock before selling.
26. [LO 2] Under what circumstances would you expect the after-tax return from an
investment in a capital asset to approach that of tax-exempt assets assuming equal beforetax rates of return?
The after-tax return from capital assets approaches the after-tax return of tax-exempt
assets (assuming equal pre-tax rates of return) the longer the taxpayer holds the capital
asset. The longer the taxpayer holds the capital asset before selling, the less the tax costs
in present value terms. In the extreme, a taxpayer who holds an appreciated capital asset
until death escapes income tax on the gain entirely. In this circumstance, the pretax and
after tax return on the capital assets would be the same just as it is with tax exempt
assets.
27. [LO 3] Why does the federal government exempt municipal bond interest from federal
income tax?
The federal government exempts municipal bond interest income from tax to subsidize
state and local governments. The tax benefits associated with municipal bonds allows
state and local governments to borrow at lower rates than they would otherwise have to
pay.

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Chapter 11 - Investments

28. [LO 3] Why do taxpayers have an incentive to purchase municipal bonds from within
their own states?
The states typically exempt municipal bond interest from bonds issued within the state
from state income tax. As a result, taxpayers should prefer to purchase municipal bonds
issued by governmental entities within their own state holding other factors constant.
29. [LO 3] What is an implicit tax and how does it affect a taxpayers decision to purchase
municipal bonds?
The price of tax-advantaged assets like municipal bonds is bid up in competitive markets
relative to the price of similar assets, like corporate bonds, without tax advantages. The
higher price paid for tax-advantaged assets reduces the rate of return on these assets
relative to other similar assets without tax advantages. This difference in rates of return
represents an implicit tax on tax-advantaged assets.
A taxpayer would have to calculate weather her implicit tax rate is greater than or less
than her individual marginal tax rate (explicit rate) before deciding to purchase
municipal bonds. If her explicit tax rate exceeds her implicit tax rate on municipal
bonds, she will prefer municipal bonds over taxable bonds all else being equal.
30. [LO 3] How do taxpayers explicit marginal tax rates affect their decision to purchase
municipal bonds?
When deciding whether to purchase municipal bonds, taxpayers often must compare the
rate of return from municipal bonds with the after-tax rate of return from similar taxable
bonds. Taxpayers must factor in their own explicit marginal tax rates when computing
their after-tax rate of returns for taxable bonds. Taxpayers with low marginal tax rates
prefer explicitly taxed investments like corporate bonds because the explicit taxes they
actually pay are less than the implicit taxes they avoid on tax-favored assets like
municipal bonds.
31. [LO 3] Is there a natural clientele for municipal bonds? Why or why not?
Yes there is. Taxpayers with high marginal rates are the natural clientele for municipal
bonds. Although they pay implicit taxes due to lower returns on municipal bonds, the
explicit taxes they save by avoiding taxable bonds are greater than the implicit taxes they
pay.
32. [LO 3] In what sense can life insurance be viewed as an investment?
Some life insurance policies allow for a build-up in the cash surrender value of the policy
over time. Policy holders are frequently permitted to borrow against the cash surrender
value of the policy or may receive the cash surrender value if they choose to terminate
the policy.

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Chapter 11 - Investments

33. [LO 3] How are life insurance proceeds taxed when paid after the insured individuals
death?
Life insurance proceeds distributed after the death of the insured individual are tax
exempt.
34. [LO 3] How are life insurance proceeds taxed if a policy is cashed out early?
In this instance, the policy holder is taxed at ordinary rates on the difference between
their investment in the policy and the amount they receive.
35. [LO 3] List the important nontax issues to consider when purchasing life insurance as an
investment.
Life insurance products, when compared to other investment alternatives, tend to be
weighed down by high fees and commissions. In addition, beneficiaries may find it
difficult to plan for cashing in their investments if they decide to wait until the insured
party dies.
36. [LO 3] How are state-sponsored 529 educational savings plans taxed if investment
returns are used for educational purposes? Are the returns taxed differently if they are not
ultimately used to pay for education costs?
Investment returns from state sponsored 529 plans are never taxed if used to pay for
qualified higher education expenses. If distributed investment returns are used for any
other purpose, the distributee will pay tax on the investment returns in the year received
at ordinary rates. In many instances, the distributee will also be required to pay an
additional 10% penalty tax in addition to the normal tax on the investment returns.
37. [LO 3] {Planning} Why would someone saving for college consider investing in
something other than a 529 plan?
529 plans offer a fixed menu of investments choices. An individual saving for education
costs with a desire for greater investment options may decide to invest elsewhere.
38. [LO 4] Are dividends and capital gains considered to be investment income for purposes
of determining the amount of a taxpayers deductible investment interest expense for the
year?
Long-term capital gains and dividends that qualify for the preferential 20% (or lower)
tax rate are not considered to be investment income for purposes of determining the
investment interest expense deduction unless the taxpayer makes an election to tax this
income at ordinary rates. If the taxpayer makes this election, the dividends and longterm capital gains count as investment income for this purpose. Dividends and capital
gains that are not eligible for the preferential rate are included in investment income in
determining the deductibility of investment interest expense.

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Chapter 11 - Investments

39. [LO 4] How is the amount of net investment income determined for a taxpayer with
investment expenses and other noninvestment miscellaneous itemized deductions?
Investment expenses and miscellaneous itemized deductions are subject to the 2% of AGI
limitation. So, when the two types of expenses are added together, only the amount in
excess of 2% of AGI is deductible. The amount in excess of 2% of AGI is first considered
to be the investment expenses. If these expenses are fully deductible, the remaining
miscellaneous itemized deduction consists of the non-investment expenses. This sequence
maximizes the deductibility of the investment expenses. The sequence is unfavorable for
the taxpayer because maximizing the deductible investment expenses minimizes net
investment income which minimizes the investment interest expense deduction.
40. [LO 4] What limitations are placed on the deductibility of investment interest expense?
What happens to investment interest expense that is not deductible because of the
limitations?
Investment interest expense is deductible, as an itemized deduction, to the extent of net
investment income. Net investment income is investment income minus deductible
investment expenses. Investment interest expense that is not deductible because of the net
investment income limitation is carried forward and treated as though it is incurred in
the next year. Unused investment interest expense can be carried forward indefinitely.
41. [LO 4] When taxpayers borrow money to buy municipal bonds, are they allowed to
deduct interest expense on the loan? Why or why not?
Interest expense incurred on loans used to purchase municipal bonds is not deductible.
The interest income from the municipal bonds is not included in income; therefore, the
interest expense incurred to produce the tax exempt income is not deductible.
42. [LO 5] What types of losses may potentially be characterized as passive losses?
Losses from limited partnerships, and from rental activities, including rental real estate,
are generally considered passive losses. In addition, losses from any other activity
involving the conduct of a trade or business in which the taxpayer does not materially
participate are also treated as passive losses. Material participation is defined as
regular, continuous, and substantial.
43. [LO 5] What are the implications of treating losses as passive?
Passive losses may not be used to offset portfolio income or active income. Passive
losses can only be used to offset passive income. Passive losses that are limited will be
suspended until taxpayers have passive income or until the activity producing the passive
loss is sold.

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Chapter 11 - Investments

44. [LO 5] What tests are applied to determine if losses should be characterized as passive?
In general, losses from trade or business activities are passive unless individuals are
material participants in the activity. Regulations provide seven separate tests for
material participation, and individuals can be classified as material participants by
meeting any one of the seven tests. The seven tests are as follows:
1. The individual participates in the activity more than 500 hours during the year.
2. The individuals activity constitutes substantially all of the participation in such
activity by the individuals including non-owners.
3. The individual participates more than 100 hours during the year, and the
individuals participation is not less than any other individuals participation in the
activity.
4. The activity qualifies as a significant participation activity (more than 100 hours
spent during the year) and the aggregate of all significant participation activities is
greater than 500 hours for the year.
5. The individual materially participated in the activity for any five of the preceding 10
taxable years.
6. The individual materially participated for any three preceding years in any personal
service activity (personal services in health, law, accounting, architecture, etc.)
7. Taking into account all the facts and circumstances, the individual participates on a
regular, continuous, and substantial basis during the year.
45. [LO 5] {Planning} All else being equal, would a taxpayer with passive losses rather have
wage income or passive income?
A taxpayer in this situation would prefer passive income because the taxpayers passive
losses could be applied currently against the passive income to reduce the amount of tax
paid currently. If the taxpayer had received wage income, the passive losses would have
been suspended, and the tax benefits associated with the passive losses would be
deferred.
46. [LO 1,2,3] {Planning} Laurie is thinking about investing in one or several of the
following investment options:
Corporate bonds
529 plan
Dividend-paying stock
Life insurance
Savings account
Treasury bonds

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Chapter 11 - Investments

Growth stock
a. Assuming all seven options earn similar returns before taxes, rank Lauries investment
options from highest to lowest according to their after-tax returns.
b. Which of the investments employ the deferral and/or conversion tax planning
strategies?
c. How does the time period of the investment affect the returns from these alternatives?
d. How do these alternative investments differ in terms of their nontax characteristics?
Investment

Part a
AT RoR
Rank

Corporate
Bonds

529 plan

2
(used for
education)

Part b
Tax planning
strategy
None
Conversion
Deferral if
proceeds not used
for education.

Dividend
Paying
Stock

Conversion

Life
Insurance

1
(if held until
death)

Conversion

Savings
Account

7(likely
wouldnt earn
same return as
other

Part c
Time period
No effect
No effect if
proceeds used for
education.
Returns increase
with holding
period if
proceeds not
used for
education.
No effect

No effect if policy
held until death
of insured.
Otherwise
returns increase
with holding
period.
No effect

None

Part d
Nontax
characteristics
Rate higher than
savings but may
be more risky.
Limited choices
of investments.
Not asset of
student for
financial aid
purposes. 10%
penalty if not
used for
education.
Consistent
income stream.
Equity investment
subject to market
risk.
High
commissions and
fees.

Safe investment;
likely low beforetax return.

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Chapter 11 - Investments

Treasury
Bonds
Growth
Stock

investments)
5
(but no state
taxes)
3

None for
federal/conversio
n for state.
Deferral and
conversion.

No effect

Safe investment.

Returns increase
with holding
period.

Typically involves
risk; therefore,
should diversify.

Problems
47. [LO 1] Annes marginal income tax rate is 30 percent. She purchases a corporate bond
for $10,000 and the maturity, or face value, of the bond is $10,000. If the bond pays 5
percent per year before taxes, what is Annes annual after-tax rate of return from the bond
if the bond matures in one year? What is her annual after-tax rate of return if the bond
matures in 10 years?
Annes after-tax rate of return from the corporate bond is 3.5% or 5% x (1-.3). Because
interest from the bond is taxed annually and her rate is assumed to be constant, the aftertax rate of return doesnt depend on her investment horizon. Thus, her annual after-tax
rate of return remains at 3.5% if the bond matures in ten years.
48. [LO 1] Matt recently deposited $20,000 in a savings account paying a guaranteed interest
rate of 4 percent for the next 10 years. If Matt expects his marginal tax rate to be 20
percent for the next 10 years, how much interest will he earn after-tax for the first year of
his investment? How much interest will he earn after-tax for the second year of his
investment if he withdraws enough cash every year to pay the tax on the interest he
earns? How much will he have in the account after four years? How much will he have
in the account after seven years?
After one year, Matt will have earned $640 or $20,000 x .04(1-.2) after tax. In the
second year, Matt will earn $660 after tax or $20,640 x .04(1-.2) after tax. After four
years, Matt will have $22,686 or $20,000 x (1 + .04(1-.2))4 in the savings account. After
seven years, Matt will have $24,934 or $20,000 x (1 + .04(1-.2))7 in the savings account.
49. [LO 1] Dana intends to invest $30,000 in either a Treasury bond or a corporate bond. The
Treasury bond yields 5 percent before tax and the corporate bond yields 6 percent before
tax. Assuming Danas federal marginal rate is 25 percent and her marginal state rate is 5
percent which of the two options should she choose? If she were to move to another state
where her marginal state rate would be 10 percent, would her choice be any different?
Assume that Dana itemizes deductions.
When the state rate is 5 percent, Dana would achieve the following returns from the
Treasury bond or the corporate bond:
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Chapter 11 - Investments

The Treasury bond yields $1,125 or $30,000 x [.05 (1-.25)] after tax. The corporate
bond yields $1,282.50 or $30,000 x [.06 (1 - .25 - .05(1-.25))] after tax. Note that the

11-14
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in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 11 - Investments

actual state rate is reduced by 25% to allow for the deductibility of state income taxes on
the federal income tax return. Thus, she should choose the corporate bond.
When the state rate is 10%, Dana would achieve the following returns from the Treasury
bond or the corporate bond:
The Treasury bond would still yield $1,125 or $30,000 x [.05 (1-.25)] after tax because
state rates dont affect after- tax returns from Treasury bonds. The corporate bond yields
$1,215 or $30,000 x [.06 x (1 - .25 - .10(1-.25))] after tax. Again, note that the actual
state rate is reduced by 25% to allow for the deductibility of state income taxes on the
federal income tax return. If Danas state tax rate increases to 10%, corporate bonds are
still superior to Treasury bonds.
50. [LO 1] At the beginning of his current tax year David invests $12,000 in original issue
U.S. Treasury bonds with a $10,000 face value that mature in exactly 10 years. David
receives $700 in interest ($350 every six months) from the Treasury bonds during the
current year and the yield to maturity on the bonds is 5 percent.
a. How much interest income will he report this year if he elects to amortize the bond
premium?
b. How much interest will he report this year if he does not elect to amortize the bond
premium?
a. If David elects to amortize the $2,000 bond premium, he will use the constant
yield method (similar to the effective interest method used to amortize bond
premium under GAAP) to amortize the bond premium semiannually.
Ultimately, he will report $599 of interest income from the bond. The
amortization table below reflects the required calculations:
Column 1
Semiannu
al Period

1
2
Yearly
Total

Column 2
Adjusted Basis
of Bond at
Beginning of
Semiannual
Period
$12,000
$11,950

Column 3
Interest
Received

Column 4
Premium
Amortization
(Column 3
Column 5)

Column 5
Reported
Interest
(Column 2 x .
05 x .5)

$350
$350
$700

$50
$51
$101

$300
$299
$599

b. If David does not elect to amortize the bond, he will simply report the entire
$700 payment he receives as interest income for the year.
51. [LO 1] Seth invested $20,000 in Series EE savings bonds on April 1. By December 31,
the published redemption value of the bonds had increased to $20,700. How much
11-15
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Chapter 11 - Investments

interest income will Seth report from the savings bonds in the current year absent any
special election?
Seth will not report any interest income from the EE savings bonds currently unless he
elects to have the increase in redemption value taxed currently.
52. [LO 1] At the beginning of her current tax year, Angela purchased a zero-coupon
corporate bond at original issue for $30,000 with a yield to maturity of 6 percent. Given
that she will not actually receive any interest payments until the bond matures in 10
years, how much interest income will she report this year assuming semiannual
compounding of interest?
Angela would recognize $1,827 of interest income from OID calculated as follows:
$30,000 x .06 =
$30,900 x .06 =
Total

$900
927
$1,827

53. [LO 1] At the beginning of his current tax year, Eric bought a corporate bond with a
maturity value of $50,000 from the secondary market for $45,000. The bond has a stated
annual interest rate of 5 percent payable on June 30 and December 31, and it matures in
five years on December 31. Absent any special tax elections, how much interest income
will Eric report from the bond this year and in the year the bond matures?
Accrued market discount on bonds is reported as interest income when the bonds are sold
or mature. Therefore, Eric will only report the interest he actually receives or $2,500
[($50,000 .025) x 2]. In the year the bond matures, he will again report $2,500 of
interest income related to the semiannual interest payments received and an additional
$5,000 of interest income related to the market discount on the bonds.
54. [LO 1] Hayley recently invested $50,000 in a public utility stock paying a 3 percent
annual dividend. If Hayley reinvests the annual dividend she receives net of any taxes
owed on the dividend, how much will her investment be worth in four years if the
dividends paid are qualified dividends? (Hayleys marginal income tax rate is 28 percent.)
What will her investment be worth in four years if the dividends are nonqualified?
If Hayley receives qualified dividends, her annual after-tax rate of return will be 2.55%
or 3% (1-.15). On the other hand, if the dividends are nonqualified her annual aftertax rate of return will be 2.16% or 3% (1-.28). As a result, her investment will be
worth $55,298 or 50,000 x (1+.0255)4 if the dividends are qualified. Otherwise, her
investment will be worth $54,462 or $50,000 (1+.0216)4.
55. [LO1] {Planning} Five years ago, Kate purchased a dividend-paying stock for $10,000.
For all five years, the stock paid an annual dividend of 4 percent before tax and Kates

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Chapter 11 - Investments

marginal tax rate was 25 percent. Every year Kate reinvested her after-tax dividends in
the same stock. For the first two years of her investment, the dividends qualified for the
15 percent capital gains rate; however, for the last three years the 15 percent dividend rate
was repealed and dividends were taxed at ordinary rates.
a. What is the current value (at the beginning of year 6) of Kates investment assuming
the stock has not appreciated in value?
b. What will Kates investment be worth three years from now (at the beginning of year
9) assuming her marginal tax rate increases to 35 percent for the next three years?
a. The following formula takes into account the change in dividend tax rates in
the last three years of Kates investment:
$10,000 (1+ (.04 (1-.15))) 2 (1+ (.04 (1-.25))) 3 = $11,683
b. $11,683 (1+ (.04 (1-.35))) 3 = $12,618
56. [LO 2] John bought 1,000 shares of Intel stock on October 18, 2010 for $30 per share
plus a $750 commission he paid to his broker. On December 12, 2013, he sells the shares
for $42.50 per share. He also incurs a $1,000 fee for this transaction.
a.
b.
c.

What is Johns adjusted basis in the 1,000 shares of Intel stock?


What amount does John realize when he sells the 1,000 shares?
What is the gain/loss for John on the sale of his Intel stock? What is the
character of the gain/loss?
a. Johns basis in the 1,000 shares of Intel stock is $30,750. This is the purchase
price of $30,000 (i.e., 30 $1,000) plus the $750 commission paid to the
broker.
b. On the sale, John realizes $41,500. This is the sales price of $42,500 (i.e.,
1,000 $42.50) minus the transaction fee of $1,000.
c. Johns gain on the sale is $10,750 which is the amount realized minus his
adjusted basis (i.e., $41,500 30,750). The gain is a long-term capital gain
because John held the stock for more than a year before selling.

11-17
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Chapter 11 - Investments

57. [LO 2] Dahlia is in the 28 percent tax rate bracket and has purchased the following shares
of Microsoft common stock over the years:
Microsoft common stock
Date Purchased
Shares
7/10/2003
400
4/20/2004
300
1/29/2005
500
11/02/2007
250

Basis
$12,000
$10,750
$12,230
$7,300

If Dahlia sells 800 shares of Microsoft for $40,000 on December 20, 2013, what is her
capital gain or loss in each of the following assumptions?
a.
b.

She uses the FIFO method.


She uses the specific identification method and she wants to minimize her
current year capital gain.
a. Under the FIFO method, the first 400 shares sold have a $12,000 basis, the
next 300 have a $10,750 basis, and the last 100 shares have a basis of $2,446
(100/500 $12,230) for a total basis of $25,196. The resulting capital gain
would be $40,000 less the $25,196 tax basis of the shares sold or $14,804.
b. The shares purchased in 2003 cost $30 per share, the shares purchased in
2004 cost $35.83 per share, the shares purchased in 2005 cost $24.46 per
share, and the shares purchased in 2007 cost $29.20 per share. To minimize
her capital gain, Dahlia should specifically identify the 300 shares purchased
in 2004, then the 400 shares purchased in 2003 and then 100 of the shares
purchased in 2007. Under the specific identification method, the 300 shares
purchased in 2004 have a $10,750 basis, the 400 shares purchased in 2003
have a $12,000 basis, and the 100 shares purchased in 2007 have a basis of
$2,920 (100/250 X $7,300) for a total basis of $25,670. The resulting capital
gain would be the $40,000 sales proceeds less the $25,670 tax basis of the
shares sold or $14,330.

58. [LO 2] {Research} Karyn loaned $20,000 to her co-worker to begin a new business
several years ago. If her co-worker declares bankruptcy on June 22nd of the current year,
is Karyn allowed to deduct the bad debt loss this year? If she can deduct the loss, what is
the character of the loss?
According to IRC Section 166 and Publication 550, taxpayers may deduct non-business
bad debts in the year the amount of the loss can be determined. Because Karyn will not
be able to measure her actual loss until the bankruptcy process is complete, she must
wait to deduct her loss until she knows with certainty the amount of her loss.

11-18
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in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 11 - Investments

59. [LO 2] Sue has 5,000 shares of Sony stock that has an adjusted basis of $27,500. She
sold the 5,000 shares of stock for cash of $10,000, and she also received a piece of land
as part of the proceeds. The land was valued at $20,000 and had an adjusted basis to the
buyer of $12,000. What is Sues gain or loss on the sale of 5,000 shares of Sony stock?
Sues gain on the sale is $2,500, which is the amount realized of $30,000 ($10,000+
$20,000) less her adjusted basis of $27,500. Note that the value of the land is included in
her amount realized along with the cash she received.
60. [LO 2] Matt and Meg Comer are married. They do not have any children. Matt works as
a history professor at a local university and earns a salary of $54,000. Meg works parttime at the same university. She earns $21,000 a year. The couple does not itemize
deductions. Other than salary, the Comers only other source of income is from the
disposition of various capital assets (mostly stocks).
a. What is the Comers tax liability for 2013 if they report the following capital gains
and losses for the year?
Short-term capital gains
$9,000
Short-term capital losses
($2,000)
Long-term capital gains
$15,000
Long-term capital losses
($6,000)
b. What is the Comers tax liability for 2013 if they report the following capital gains
and losses for the year?
Short-term capital gains
Short-term capital losses
Long-term capital gains
Long-term capital losses

$1,500
$0
$15,000
($10,000)

a. Salary
$75,000
Net short-term capital gain
7,000
Net long-term capital gain
9,000
AGI
$91,000
Standard deduction
(12,200)
Personal exemption
(7,800)
Taxable income
$71,000
Less preferentially taxed income
(9,000)
Income taxed at ordinary rates
$62,000 tax $1,785 + $6,623 =
$8,408
Income subject to capital gains rates $9,000 tax ($9,000 0%) = $0
Total tax liability = $8,408+ $0 = $8,408

11-19
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Chapter 11 - Investments

b. Short-term capital gains


Short-term capital losses
Net short-term capital gain

$1,500
$0
$1,500

Long-term capital gains


$15,000
Long-term capital losses
($10,000)
Net long-term capital gains $5,000
Salary
$75,000
Long-term capital gains
5,000
Short-term capital gains
1,500
AGI
$81,500
Standard deduction
(12,200)
Personal exemption
(7,800)
Taxable income
$61,500
Less preferentially taxed income
(5,000)
Income taxed at ordinary rates
$56,500 tax $1,785 + $5,798 =
$7,583
Income subject to capital gains rates $5,000 tax ($5,000 0%) = $0
Total tax liability = $7, 583 + $0 = $7,583
61. [LO 2] Grayson is in the 25 percent tax rate bracket and has the sold the following stocks
in 2013:
Stock A
Stock B
Stock C
Stock D
Stock E
a.
b.
c.
d.

Date Purchased
1/23/1989
4/10/2013
8/23/2011
5/19/2003
8/20/2013

Basis
$7,250
14,000
10,750
5,230
7,300

Date Sold
7/22/2013
9/13/2013
10/12/2013
10/12/2013
11/14/2013

Amount Realized
$4,500
17,500
15,300
12,400
3,500

What is Graysons net short-term capital gain or loss from these transactions?
What is Graysons net long-term gain or loss from these transactions?
What is Graysons overall net gain or loss from these transactions?
What amount of the gain, if any, is subject to the preferential rate for certain
capital gains?

a. Graysons net short-term capital loss is $300, which is the net of the short-term
gains and losses for the year. This $300 loss is the short-term capital gain of
$3,500 from Stock B (i.e. $17,500 14,000) less the short-term capital loss of
$3,800 from Stock E (i.e. $3,500 7,300).
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Chapter 11 - Investments

b. Graysons net long-term capital gain is $8,970, which is the net long-term gain
less the long-term loss for the year. This is the net of the long-term capital gain of
$11,720 (i.e. $4,550 from Stock C ($15,300 10,750) and $7,170 from Stock D
($12,400 5,230)) less the long-term capital loss of $2,750 from Stock A ($4,500
7,250).
c. Graysons net capital gain is $8,670, which is the net short-term loss offset
against the net long-term capital gain for the year because the signs are opposite.
This $300 short-term capital loss (from part a) is netted against the $8,970 net
long-term capital loss (from part b).
d. Graysons entire net capital gain of $8,670 will be taxed at a preferential 15
percent tax rate.
62. [LO 2] George bought the following amounts of Stock A over the years:
Stock A
Stock A
Stock A

Date Purchased
11/21/1987
3/18/1993
5/22/2002

Number of Shares
1,000
500
750

Adjusted Basis
$24,000
9,000
27,000

On October 12, 2013, he sold 1,200 of his shares of Stock A for $38 per share.
a.

How much gain/loss will George have to recognize if he uses the FIFO
method of accounting for the shares sold?
b.
How much gain/loss will George have to recognize if he specifically identifies
the shares to be sold by telling his broker to sell all 750 shares from the 5/22/2002
purchase and 450 shares from the 11/21/1987 purchase?
a. George will recognize $18,000 of long-term capital gain. This is the amount
realized of $45,600 (i.e. $38 per shares multiplied by 1,200 shares) less the
adjusted basis of $27,600. The adjusted basis is calculated under the FIFO
method. This means the 1,200 shares sold were the first 1,200 purchased.
Therefore the 1,200 sold were the 1,000 shares purchased on 11/21/1987 (basis of
$24,000) and 200 of the shares purchased on 3/18/1993 (basis of $3,600 which is
calculated by taking the $9,000 total basis divided by 500 shares purchased
multiplied by the 200 shares sold).
b. Georges long-term capital gain is $7,800. This is the amount realized of $45,600
(i.e. $38 per shares multiplied by 1,200 shares) less the adjusted basis of $37,800.
The adjusted basis is calculated under the specific identification method. George
identified that the shares sold were the 750 purchased on 5/22/2002 (basis of
$27,000) and 450 of the shares purchased on 11/21/1987 (basis of $10,800 or

11-21
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Chapter 11 - Investments

$24,000 total basis divided by 1,000 shares purchased multiplied by the 450 shares
sold).
63. [LO 2] During the current year, Ron and Anne sold the following assets:
Capital
Market
Tax
Holding Period
Asset
Value
Basis
L stock
$50,000
$41,000
> 1 year
M stock
28,000
39,000
> 1 year
N stock
30,000
22,000
< 1 year
O stock
26,000
33,000
< 1 year
Antiques
7,000
4,000
> 1 year
Rental home
300,000*
90,000
> 1 year
*$30,000 of the gain is 25 percent gain (from accumulated
depreciation on the property).
a. Given that Ron and Anne have taxable income of only $20,000 (all ordinary) before
considering the tax effect of their asset sales, what is their gross tax liability for 2013
assuming they file a joint return?
b. Given that Ron and Anne have taxable income of $400,000 (all ordinary) before
considering the tax effect of their asset sales, what is their gross tax liability for 2013
assuming they file a joint return?
a. Ron and Annes netting process is reflected in the following table:
Description
Stock N
Stock O
Step 1:
Antiques
Unrecaptured
1250 Gain
Remaining
Gain from
Rental
Property
Stock L
Stock B
Step 2:
Steps 4 and 5:
Step 6: N/A

ShortTerm

Long-term
Overall

LongTerm
28%

LongTerm
25%

LongTerm
0/15/20%

$8,000
$(7,000
)
$1,0
00
$3,000
$30,000

$3,000
$30,000

$180,000

$180,000

$9,000
$(11,000)
$211,000

$9,000
$(11,000)
$178,000

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Chapter 11 - Investments

Step 7
Step 8
Summary

$3,000
$1,000

$3,000

$30,000
$30,000

$178,000

Ron and Annes ordinary income will increase from $20,000 to $21,000 due to their
$1,000 net short-term capital gain. Ron and Annes gross tax liability of $31,133 is
computed as follows:
Amount and
Type of
Income
$17,850;
ordinary

Applicabl
e
Rate
10%

Tax
$1,785

$3,150;
ordinary

15%

$473

$30,000; 25%
rate capital
gain
$3,000 28%
rate capital
gains
$18,500;
0/15/20% rate
capital gains

15%

$4,500

15%

$450

0%

$0

$159,500

15%

$23,92
5

Gross tax
liability

Explanation
$17,850 10%
The first $17,850 of Ron and Annes $21,000 of
ordinary income is taxed at 10% (see MFJ tax
rate schedule for this and other computations).
$3,150 15%.
Ron and Annes remaining $3,150 of ordinary
income (21,000 17,850) is taxed at 15%.
$30,000 15%
$3,000 15%
$18,500 0%
$18,500 ($72,500 - $21,000 ordinary income $30,000 25% capital gain - $3,000 28% capital
gain) of 0/15/20% rate capital gain fits into the
remaining 15% bracket so it is taxed at 0%.
$159,500 15%
All of the remaining $159,500 ($178,000 $18,500) of 0/15/20% capital gain is in an
ordinary income bracket greater than 15% and
less than 39.6% so it is all taxed at 15%.

$31,13
3

b. The netting process used to determine Ron and Annes gross tax liability for the year
is unchanged from the process used in part a.
Ron and Annes ordinary income will increase from $400,000 to $401,000 due to
their $1,000 net short-term capital gain. Ron and Annes gross tax liability of
$151,836 is computed as follows:
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Chapter 11 - Investments

Amount and
Type of
Income
$17,850;
ordinary

Applicabl
e
Rate
10%

Tax
$1,785

Explanation
$17,8500 10%
The first $17,850 of Ron and Annes $401,000 of
ordinary income is taxed at 10% (see MFJ tax
rate schedule for this and other computations).
$54,650 15%.
The next $54,650($72,500- $17,850) of Ron and
Annes $401,000 of ordinary income is taxed at
15%.
$73,900 25%
The next $73,900 ($146,400-$72,500) of Ron and
Annes $401,000 of ordinary income is taxed at
25%.
The next $76,650 ($223,050-$146,400) of Ron
and Annes $401,000 of ordinary income is taxed
at 28%
The next $175,300 ($398,350-$223,050) of Ron
and Annes $401,000 or ordinary income is taxed
at 33%.
$2,650 35%
$2,650 ($401,000 - $398,350) taxed in 35%
ordinary income bracket.
$3,000 28%

$54,650;
ordinary

15%

$8,197.5

$73,900;
ordinary

25%

$18,475

$76,650;
ordinary

28%

$21,462

$175,300

33%

$57,849

$2,650;
ordinary

35%

$927.5

$3,000; 28%
rate capital
gains
$30,000; 25%
rate capital
gains
$16,000;
0/15/20% rate
capital gains

28%

$840

25%

$7,500

$30,000 25%

15%

$2,400

$162,000;
0/15/20% rate
capital gains

20%

$32,400

$16,000 15%
$16,000 ($450,000 - $401,000 ordinary income $30,000 25% capital gain - $3,000 28% capital
gain) of 0/15/20% rate capital gain fits into the
remaining 35% bracket so it is taxed at 15%.
$162,000 20%
All of the remaining $162,000 ($178,000 $16,000) of 0/15/20% capital gain is in the
39.6% ordinary income bracket so it is taxed at
20%.

Gross tax
liability

$151,83
6
11-24

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Chapter 11 - Investments

64.

[LO 2] In 2013, Tom and Amanda Jackson (married filing jointly) have $200,000 of
taxable income before considering the following events:
a) On May 12, 2013, they sold a painting (art) for $110,000 that was inherited from
Grandma on July 23, 2011. The fair market value on the date of Grandma's death
was $90,000 and Grandma's adjusted basis of the painting was $25,000.
b) Applied a long-term capital loss carryover from 2012 of $10,000.
c) Recognized a $12,000 loss on 11/1/13 sale of bonds (acquired on 5/12/03).
d) Recognized a $4,000 gain on 12/12/13 sale of IBM stock (acquired on 2/5/13).
e) Recognized a $17,000 gain on the 10/17/13 sale of rental property (the only
1231 transaction) of which $8,000 is reportable as gain subject to the 25 percent
maximum rate and the remaining $9,000 is subject to the 15 percent maximum
rate (the property was acquired on 8/2/07).
f) Recognized a $12,000 loss on 12/20/13 sale of bonds (acquired on 1/18/13).
g) Recognized a $7,000 gain on 6/27/13 sale of BH stock (acquired on 7/30/04).
h) Recognized an $11,000 loss on 6/13/13 sale of QuikCo stock (acquired on
3/20/06).
i) Received $500 of qualified dividends on 7/15/13.
Complete the required capital gains netting procedures and calculate the Jacksons
2013 tax liability.
LT
ST

(d)

4,000

(f) (12,000)

(8,000)

28%

25%

(a) 20,000

(e) 8,000

(b) (10,000)

$10,000

$8,000

0/15/20%
(c) (12,000)
(e)

9,000

(g)

7,000

(h)

(11,000)

($7,000)

11-25
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Chapter 11 - Investments

(7,000)
(8,000)

7,000

$3,000
$8,000

8,000

$ 0

(3,000)
(5,000)

$ 0

$ 0

$3,000

$ 0

2013 Taxable Income:


TI b/4

$200,000

Qual. Dividend

500

LTCG 25%

3,000

Taxable Inc

$203,500

11-26
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Chapter 11 - Investments

2013 Tax Liability:


Ordinary Income:

$28,457.50 + 28% ($200,000-146,400) =

Capital Gains:

+ 25% $3,000 =

Dividends:

+ 15% $500 =

750.00
75.00

Total tax liability


65.

$43,465.50

$44,290.50

[LO 2] For 2013, Sherri has a short-term loss of $2,500 and a long-term loss of $4,750.
a.
How much loss can Sherri deduct in 2013?
b.
How much loss will Sherri carryover to 2014 and what is the character of the
loss carryover?
a. Sherri has a $2,500 short-term capital loss and a $4,750 long-term capital loss.
Because both are losses they cannot be netted. Individual taxpayers can offset
$3,000 of capital loss against ordinary income, with short-term losses being offset
first.
b. Individual taxpayers can offset $3,000 of capital loss against ordinary income,
with short-term losses being offset first. Therefore, Sherri can deduct the $2,500
short-term capital loss and $500 of the long-term capital loss in 2013. The
remaining $4,250 of the long-term capital loss (i.e. $4,750 less the $500 deducted
currently) is carried forward indefinitely.

66.

[LO 2] Three years ago, Adrian purchased 100 shares of stock in X Corp. for $10,000.
On December 30 of year 4, Adrian sells the 100 shares for $6,000.
a.

Assuming Adrian has no other capital gains or losses, how much of the loss is
Adrian able to deduct on her year 4 tax return?
b.
Assume the same facts as in part a, except that on January 20 of year 5, Adrian
purchases 100 shares of X Corp. stock for $6,000. How much loss from the sale
on December 30 of year 4 is deductible on Adrians year 4 tax return? What basis
does Adrian take in the stock purchased on January 20 of year 5?
a. Adrian has a $4,000 long-term capital loss. She can offset $3,000 of the capital
loss against ordinary income. The remaining $1,000 of the capital loss (i.e.
$4,000 less the $3,000 deducted currently) is carried forward indefinitely.
b. Adrian has a realized $4,000 long-term capital loss on the sale of the 100 shares.
However, she has purchased substantially identical stock within the 61 day period
(30 days before the sale until 30 days after the sale); therefore, her loss is limited
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Chapter 11 - Investments

by the wash sale rules. Since Adrian purchased 100 shares the loss is not
currently recognized. The loss is added to the basis of the new shares purchased.
Thus, the basis of the 100 new shares of stock is $10,000 (i.e. the $6,000 purchase
price plus the unrecognized loss of $4,000).

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Chapter 11 - Investments

67. [LO 2] Christopher sold 100 shares of Cisco stock for $5,500 in the current year. He
purchased the shares several years ago for $2,200. Assuming his marginal ordinary
income tax rate is 28 percent, and he has no other capital gains or losses, how much tax
will he pay on this gain?
Christophers long-term capital gain is $3,300 ($5,500 amount realized less his
$2,200 tax basis). Since Christophers marginal rate on ordinary income is above
15% and below 39.6% his long-term capital gains rate is 15%. Therefore, he will
pay 15% of $3,300 or $495 in capital gains tax.
68. [LO 2] Christina, who is single, purchased 100 shares of Apple Inc. stock several years
ago for $3,500. During her year-end tax planning, she decided to sell 50 shares of Apple
for $1,500 on December 30. However, two weeks later, Apple introduced the iPhone 5,
and she decided that she should buy the 50 shares (cost of $1,600) of Apple back before
prices skyrocket.
a.

What is Christinas deductible loss on the sale of 50 shares? What is her basis
in the 50 new shares?
b.
Assume the same facts, except that Christina repurchased only 25 shares for
$800. What is Christinas deductible loss on the sale of 50 shares? What is her
basis in the 25 new shares?
a. Christina has engaged in a wash sale because she bought identical stock within
30 days of selling Apple stock. Therefore, her $250 ($1,500 less $1,750) loss is
disallowed. The basis of Christinas 50 shares of new Apple stock is $1,850
($1,600 purchase price plus $250 of disallowed loss).
b. Christina has engaged in a partial wash sale because she bought 25 shares of
identical stock within 30 days of selling Apple stock. Therefore, she may deduct
$125 or 50% of her $250 ($1,750 less $1,500) loss; the remaining $125 is
disallowed. The basis of Christinas 25 shares of new stock is $925 ($800
purchase price plus $125 of disallowed loss).
69. [LO 2] {Research}Arden purchased 300 shares of AMC common stock several years ago
for $1,500. On April 30, Arden sold the shares of AMC common for $500 and then
purchased 250 shares of AMC preferred stock two days later for $700. The AMC
preferred stock is not convertible into AMC common stock. What is Ardens deductible
loss from the sale of the 300 shares of AMC common stock?
Section 1.1233-1(d) of the Income Tax Regulations indicates that common and preferred
stock of the same company are not considered "substantially identical property" for
purposes of applying the wash sale rules as long as the preferred stock is not convertible
into common stock. Thus, Arden may deduct $1,000 dollars of loss from the sale of the
AMC stock in the current year.

11-29
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Chapter 11 - Investments

70. [LO 2] {Planning} Shaun bought 300 shares of Dental Equipment, Inc. several years ago
for $10,000. Currently the stock is worth $8,000. Shauns marginal tax rate this year is
25 percent, and he has no other capital gains or losses. Shaun expects to have a marginal
rate of 30 percent next year, but also expects to have a long-term capital gain of $10,000.
To minimize taxes, should Shaun sell the stock on December 31 of this year or January 1
of next year (ignore the time value of money)?
If Shaun sells the stock in the current year, he may deduct his $2,000 capital loss against
his ordinary income. Given that his tax rate in the current year is 25 percent, this will
produce a tax benefit of 25 percent of $2,000 or $500. On the other hand, if he waits
until the following year to recognize the $2,000 capital loss, he must apply the loss
against his $10,000 long-term capital gains taxed at a 15 percent rate. If he waits, his
loss would produce a tax benefit of only 15 percent of $2,000 or $300. Therefore, Shaun
should sell his stock in the current year.
71. [LO 2] {Planning} Irene is saving for a new car she hopes to purchase either four or six
years from now. Irene invests $10,000 in a growth stock that does not pay dividends and
expects a 6 percent annual before-tax return (the investment is tax deferred). When she
cashes in the investment after either four or six years, she expects the applicable marginal
tax rate on long-term capital gains to be 25 percent.
a.
b.

What will be the value of this investment four and six years from now?
When Irene sells the investment, how much cash will she have after taxes to
purchase the new car (four and six years from now)?

a. Her investment will be worth $12,625 or $10,000 X (1+.06)4 after 4 years; and
$14,185 or $10,000 X (1+.06)6 after 6 years.
b. After 4 years, Irene will pay taxes of 25 percent on her investment returns of
$2,625 leaving her with investment returns after taxes of $1,969 or [(1-.25) X
$2,625]. This, combined with her original $10,000 investment, will leave her
with $11,969 to purchase the car.
After 6 years, Irene will pay taxes of 25 percent on her investment returns of
$4,185 leaving her with investment returns after taxes of $3,139 or [(1-.25) X
$4,185]. This, combined with her original $10,000 investment, will leave her
with $13,139 to purchase the car.
72. [LO2] {Planning} Komiko Tanaka invests $12,000 in LymaBean, Inc. LymaBean does
not pay any dividends. Komiko projects that her investment will generate a 10 percent
before-tax rate of return. She plans to invest for the long term.
a. How much cash will Komiko retain, after-taxes, if she holds the investment for 5
years and then she sells it when the long-term capital gains rate is 15 percent?
b. What is Komikos after-tax rate of return on her investment in part (a)?

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Chapter 11 - Investments

c. How much cash will Komiko retain, after-taxes, if she holds the investment for 5
years and then sells when the long-term capital gains rate is 25 percent?
d. What is Komikos after-tax rate of return on her investment in part (c)?
e. How much cash will Komiko retain, after taxes, if she holds the investment for 15
years and then she sells when the long-term capital gains rate is 15 percent?
f. What is Komikos after-tax rate of return on her investment in part (e)?
a.

$12,000 (1.10)5 = $19,326


(12,000)
$7,326
15
= 1,099

amount received
basis in stock
long-term capital gain
percent
tax on gain

Cash retained = $19,326 1,099 taxes = $18,227


b.

($18,227/12,000)1/5 1 = 8.7 percent

c.

$12,000 (1.10)5 =

$19,326
(12,000)
$7,326
25%
= $1,832

amount received
basis in stock
long-term capital gain
tax on gain

Cash retained = $19,326 1,832 taxes = $17,494


d.

($17,494/12,000)1/5 1 = 7.83 percent

e.

$12,000 (1.10)15 = $50,127


(12,000)
$38,127
15%
= $5,719

amount received
basis in stock
long-term capital gain
tax on gain

Cash retained = $50,127 5,719 taxes = $44,408


f.

($44,408/12,000)1/15 1 = 9.11 percent

73. [LO 2] {Research} Becky recently discovered some high-tech cooking technology that
has advantages over microwave and traditional ovens. She received a patent on the
technology that gives her exclusive rights to the technology for 20 years. Becky would
prefer to retain the patent, but she doesnt want to deal with the manufacturing and
marketing of the technology. She was able to reach a compromise. A little over a year
after she secured the patent, Becky signed a contract with DEF Company giving DEF
control to manufacture and market the technology. In exchange, Becky is to receive a
royalty based on the sales of the technology. For tax purposes, Becky is not sure how to

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Chapter 11 - Investments

treat her arrangement with DEF. If the exchange with DEF is treated as a sale, she will
recognize long-term capital gain because the patent is a capital asset held for more than a
year. If the exchange is not treated as a sale, Becky will recognize ordinary income as
she receives the royalties. (Hint: IRC 1235)
a.

Is it possible for Becky to treat the exchange with DEF as a sale even though
she never relinquishes actual title of the patent? If so, what requirements must she
meet to treat the contract as a sale for tax purposes?
b.
Does your answer to the question above change if Beckys contract with DEF
gave DEF Company control over the income from the patent for the next 10 years
of the patents remaining 19-year life?
a. Section 1235 allows certain contracts outlining an exchange to be treated as sales
if the exchange meets the following two criteria:
(1) The exchange results in a transfer of property consisting of all substantial
rights to a patent, and (2) the transferor is a holder of the patent.
The first criteria (all substantial rights to a patent) require the transferor (i.e.,
Becky) to permanently give up all rights to control creation of income from the
patent. The transferees (DEF) control cannot be limited geographically or by
industry. Also the rights cannot be for a shorter period than the life of the patent.
The second criterion requires the taxpayer to be an individual or a partner in a
partnership. This restricts corporations from getting the beneficial sales
treatment of the patent.
In this case, Becky would qualify for capital gain treatment on the exchange with
DEF. Thus, she would be taxed on the gain from the exchange at the preferential
capital gains rates instead of the ordinary income rates applicable to royalty
income.
b. In this case, Becky would not meet the first criteria to qualify for sale treatment
because she no longer transferred all substantial rights to the patent to DEF.
Consequently, she would be required to treat the royalties as ordinary income
rather than long-term capital gain.
74. [LO 3] {Planning} The Johnsons recently decided to invest in municipal bonds because
their marginal tax rate is 40 percent. The return on municipal bonds is currently 3.5
percent and the return on similar taxable bonds is 5 percent. Compare the after-tax
returns of the municipal and taxable bonds.
a.
b.

Which type of bond should the Johnsons select?


What type of bond should the Johnsons select if their marginal tax
rate was 20 percent?
c.
At what marginal tax rate would the Johnsons be indifferent between
investing in either taxable or municipal bonds?
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Chapter 11 - Investments

a. Assuming the Johnsons marginal rate is 40 percent, their after-tax rate of return
from taxable bonds would be 3 percent or 5 percent x (1-.40). Because this is less
than the 3.5 percent rate of return from municipal bonds, they should purchase
municipal bonds.
b. If the Johnsons marginal rate is 20 percent the after-tax rate of return from
taxable bonds would be 4 percent or 5 percent x (1-.20). Under this assumption,
the Johnsons should buy taxable bonds.
c. To discover the marginal tax rate at which the neighbors would be indifferent
between investing in either type of bond, solve the following equation for t: 5
percent x (1-t) = 3.5 percent. It turns out that t equals 30 percent. In other
words, the after-tax rates of return for both bonds are equal if the Johnsons have
a marginal tax rate of 30 percent.
75. [LO 3] Lynette VanWagoner purchased a life insurance policy to insure her mother Idon.
Idon is currently 64. Insurance companies predict that women in her condition will live,
on average, to be 81 years old. Lynette makes a one-time payment of $100,000 to
purchase a life insurance policy on Idons life. The policy provides for a $1,000,000
death benefit and a cash surrender value equal to the original $100,000 premium plus a 7
percent annual rate of return on the premium.
a.
b.

How much will Lynette receive after taxes if Idon dies in 14 years?
How much will Lynette receive after taxes if Idon dies in seven
years?

c.

How much will Lynette receive after taxes if Lynette decides to cash
in the policy after four years when Idon is still living and Lynettes marginal tax
rate is 28 percent?

a. If Lynette receives the life insurance proceeds after Idons death, she will receive
$1,000,000 after taxes without regard to the number of years Idon lives after the
policy is purchased because death benefits from life insurance policies are tax
free.
b. Again, if Lynette receives the life insurance proceeds after Idons death, she will
receive $1,000,000 after taxes without regard to the number of years Idon lives
after the policy is purchased because death benefits from life insurance policies
are tax free.
c. If Lynette decides to cash in the policy four years after purchasing it, she will
receive $131,080 or 100,000 (1.07)4 before taxes. Comparing the $131,080
proceeds to her original $100,000 investment, Lynettes taxable earnings will be
$31,080. Given her assumed tax rate of 28 percent, she will pay $8,702 or (.28
$31,080) in tax leaving her with $122,378 or ($131,080 - $8,702) after taxes.

11-33
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Chapter 11 - Investments

76. [LO 3] Ben recently made a one-time investment of $20,000 in the Florida 529
educational savings plan for his three-year-old son, Mitch. Assume the plan yields a
constant 6 percent return for the next 15 years.
a.

How much money will be available for Mitch after taxes when he
begins college at age 18?
b.
Assume, instead, that when Mitch turns 18, he decides to forego
college and spend his time as a traveling artist. If Mitchs parents give him the
amount in the 529 plan to pursue his dreams, how much will he keep after taxes if
his marginal tax rate is 10 percent?
a. Because earnings inside a 529 plan compound tax free, the 529 plan Ben set up
for Mitch will be worth $47,931 or $20,000 (1+.06)15 after fifteen years. If this
amount is distributed to Mitch and he uses it to pay for qualified higher education
expenses, neither he nor Ben will owe any tax on the distribution.
b. If Mitch becomes a traveling artist, he will pay taxes and penalties on the
earnings portion of the $47,931 distribution. Because the original investment in
the account was $20,000, the earnings portion of the $47,931 distribution would
be $27,931. This amount will be subject to Mitchs ordinary 10 percent tax rate
plus a 10 percent penalty rate. Thus, Mitch will pay $5,586 or $27,931 x 20
percent in taxes and penalties leaving him with $42,345 to pursue his dreams as a
traveling artist.
77. [LO 4] Rich and Shauna Nielson file a joint tax return, and they itemize deductions.
Assume their marginal tax rate on ordinary income is 25 percent. The Nielsons incur
$2,000 in miscellaneous itemized deductions, excluding investment expenses. They also
incur $1,000 in noninterest investment expenses during the year. What tax savings do
they receive from the investment expenses under the following assumptions:
a.
b.

Their AGI is $90,000.


Their AGI is $130,000.

a. The Nielsons have $3,000 of miscellaneous itemized deductions including


investment expenses. These deduction are only deductible to the extent they
exceed 2 percent of AGI. If AGI is $90,000, 2 percent of AGI is $1,800 and
$1,200 of the $3,000 is deductible. The deductible portion is first treated as
investment expense and then noninvestment miscellaneous itemized deductions.
In this situation, all $1,000 of the investment expenses are deductible ($200 of the
other miscellaneous itemized deductions are deductible). The tax benefit of the
investment expenses is $250 (i.e., $1,000 deduction 25 percent marginal tax
rate).
b. If AGI is $130,000, 2 percent of AGI is $2,600. In this case only $400 of the
miscellaneous itemized deductions are deductible. Because the deductible
portion
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Chapter 11 - Investments

is first considered to be the investment expenses, all $400 of the deductible


miscellaneous itemized deductions are considered to be investment expenses. The
tax benefit from the $400 deductible investment expense is $100 (i.e., $400 25
percent).
78. [LO 4] Mickey and Jenny Porter file a joint tax return, and they itemize deductions. The
Porters incur $2,000 in employment-related miscellaneous itemized deductions. They
also incur $3,000 of investment interest expense during the year. The Porters income for
the year consists of $150,000 in salary, and $2,500 of interest income.
a. What is the amount of the Porters investment interest expense deduction for the
year?
b. What would their investment interest expense deduction be if they also had a
($2,000) long-term capital loss?
a. The $3,000 of investment interest expense is deductible to the extent of net
investment income. In this problem, investment income and net investment income
are $2,500 because there are no investment expenses. Consequently, $2,500 of
the investment interest expense is deductible and $500 is carried forward to next
year.
b. If the Porters also have a $2,000 long-term capital loss, their net investment
income remains $3,000 for purposes of determining the investment interest
expense deduction. Capital losses are not included in the calculation of net
investment income. Consequently, $2,500 of the investment interest expense is
deductible and $500 is carried over to next year.
79. [LO 4] {Planning} On January 1 of year 1, Nick and Rachel Sutton purchased a parcel of
undeveloped land as an investment. The purchase price of the land was $150,000. They
paid for the property by making a down payment of $50,000 and borrowing $100,000
from the bank at an interest rate of 6 percent per year. At the end of the first year, the
Suttons paid $6,000 of interest to the bank. During year 1, the Suttons only source of
income was salary. On December 31 of year 2, the Suttons paid $6,000 of interest to the
bank and sold the land for $210,000. They used $100,000 of the sale proceeds to pay off
the $100,000 loan. The Suttons itemize deductions and are subject to a marginal ordinary
income tax rate of 35 percent.
a. Should the Suttons treat the capital gain from the land sale as investment income
in year 2 in order to minimize their year 2 tax bill? If so, how much?
b. How much does this cost or save them in year 2?
a. In year one, the Suttons incurred $6,000 of investment interest expense but did not
have any investment income so the investment interest expense is not deducted
and is carried over to year 2. In year 2, the Suttons incurred another $6,000 of
investment interest expense. Combined with the carryover from year 1, the
Suttons had $12,000 of investment interest expense they could potentially deduct
11-35
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Chapter 11 - Investments

in year 2. In year 2, the Suttons have $60,000 of long-term capital gain. None of
this long-term capital gain is investment income unless the Suttons elect to have
some of it taxed at ordinary rates.
If the Suttons dont elect to tax any of the capital gain as ordinary income, they
would not be able to deduct any of the investment interest expense and they would
owe taxes of $9,000 (i.e., $60,000 x 15 percent). The Suttons would have a
$12,000 investment expense carry forward to next year.
If the Suttons elect to include $12,000 of the long-term capital gain in investment
income and have it taxed at ordinary rates, the Suttons would owe tax of $4,200
($12,000 x 35 percent) on this portion of the capital gain and they would owe
$7,200 of taxes on the rest of the capital gain (i.e., $48,000 x 15 percent). The
$12,000 investment interest expense deduction would save the Suttons $4,200 in
taxes (i.e., $12,000 x 35 percent). The end result is that if the Suttons make the
election, they will owe $7,200 in taxes (i.e., $4,200 + $7,200 - $4,200). They will
not however have an investment interest expense carry forward. Making the
election would make sense for the Suttons if they did not expect to have any
investment income for the foreseeable future.
b. In terms of the year 2 tax bill only, making the election to tax some of the longterm capital gain at ordinary rates saves the Suttons $1,800 in taxes (i.e., $9,000
- $7,200).
80. [LO 4] {Research} George recently received a great stock tip from his friend, Mason.
George didnt have any cash on hand to invest, so he decided to take out a $20,000 loan
to facilitate the stock acquisition. The loan terms are 8 percent interest with interest-only
payments due each year for five years. At the end of the five-year period the entire loan
principal is due. When George closed on the loan on April 1, 2012, he decided to invest
$16,000 in stock and to use the remaining $4,000 to purchase a four-wheel recreation
vehicle. George is unsure how he will treat the interest paid on the $20,000 loan. In
2013, George paid $1,200 interest expense on the loan. For tax purposes, how should he
treat the 2013 interest expense? (Hint: visit www.irs.gov and consider IRS Publication
550)
IRS Publication 550 indicates that if you borrow money for personal purposes as well
as for investment, you must allocate the debt among those purposes. This means that
only interest expense paid on the portion of debt that was used for the investment in the
stocks can be deducted as investment interest. The interest paid on the loan allocated to
the personal portion isnt deductible to the taxpayer.
Therefore, in determining the deductibility of the $1,200 interest expense paid by George
during 2013, George would allocate 80 percent (i.e., $16,000 / 20,000) of the interest
expense to the purchase of the stock and 20 percent (i.e., $4,000 / 20,000) of the interest
expense to the purchase of the 4-wheeler. Consequently, George would have $960 of

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in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 11 - Investments

investment interest expense (80 percent x $1,200) and he would have $240 (i.e., 20
percent x $1,200) of nondeductible personal interest.
81. [LO5] Larry recently invested $20,000 (tax basis) in purchasing a limited partnership
interest. His at-risk amount is also $20,000. In addition, Larrys share of the limited
partnership loss for the year is $2,000, his share of income from a different limited
partnership was $1,000, and he had $3,000 of dividend income from the stock he owns.
How much of Larrys $2,000 loss from the limited partnership can he deduct in the
current year?
Before considering his $2,000 loss, Larrys tax basis is $20,000 and his at-risk amount is
$20,000. Therefore the basis and at-risk hurdles do not apply. However, Larry still may
not deduct $1,000 of the $2,000 loss because he only has $1,000 of passive income for
the year. Therefore, Larry has a $1,000 passive activity loss carryover.
82. [LO5] Rubio recently invested $20,000 (tax basis) in purchasing a limited partnership
interest. His at-risk amount is $15,000. In addition, Rubios share of the limited
partnership loss for the year is $22,000, his share of income from a different limited
partnership was $5,000, and he had $40,000 in wage income and $10,000 in long-term
capital gains.
a. How much of Rubios $22,000 loss can he deduct considering only the tax
basis limitation?
b. How much of the loss from part a. can Rubio deduct under the at-risk
limitations?
c. How much of Rubios $22,000 loss from the limited partnership can he deduct
in the current year considering all limitations?
a. Rubios initial tax basis in the limited partnership is $20,000. Rubios
$22,000 loss reduces his tax basis to zero leaving him with a $2,000 loss
carryover because of the tax basis loss limitation.
b. Rubios initial at-risk amount in the limited partnership is $15,000. Rubios
$22,000 loss reduces his at-risk amount to zero leaving him with a $5,000 atrisk carryover ($20,000 loss allowed under the tax basis limitation less the
$15,000 amount Rubio has at risk).
c. After applying the tax basis and at-risk limitations, Rubio can potentially
deduct $15,000 of loss. However, because Rubio is a limited partner this loss
is considered a passive loss. Therefore, Rubio may only deduct this loss in the
current year to the extent he has passive income. Because Rubio has only
passive income of $5,000 (from another limited partnership), he may only
deduct $5,000 of the $15,000 loss leaving him with a $10,000 passive activity
loss that can be carried forward indefinitely.

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Chapter 11 - Investments

83. Molly Grey (single) acquired a 30 percent limited partnership interest in Beau Geste LLP
several years ago for $48,000. At the beginning of year 1, Molly has tax basis and an atrisk amount of $20,000. In year 1, Beau Geste incurs a loss of $180,000 and does not
make any distributions to the partners.

In year 1, Mollys AGI (excluding any income or loss from Beau Geste) is
$60,000. This includes $10,000 of passive income from other passive activities.

In year 2, Beau Geste earns income of $30,000. In addition, Molly contributes an


additional $30,000 to Beau Geste during year 2. Mollys AGI in year 2 is $63,000
(excluding any income or loss from Beau Geste). This amount includes $8,000 in
income from her other passive investments.

a. Based on the above information, determine the following amounts:

At-risk amount at the end of year 1

At-risk amount at the end of year 2

Losses allowed under the at-risk rules in year 2

Total suspended passive losses at the end of year 1

Total suspended at-risk losses at the end of year 2

Deductible losses in year 1

Year 2 AGI after considering Beau Geste events

b. Briefly describe actions Molly Grey could undertake in year 2 to utilize any
suspended passive losses from year 1.
To determine the required amounts, Molly must determine her at-risk basis for each
year.
At-Risk Amount:
Initial year 1 amount:
Allowed loss:
End of year 1 at-risk amount

$ 20,000
(20,000)
$ -0-

Given in problem
See below

Contribution for year 2


$ 30,000
BG Income (30% x $30,000)
9,000
Allowed loss:
(34,000)
End of year 2 at-risk amount $ 5,000

Given in problem
Given in problem
See below

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Chapter 11 - Investments

At-risk allowed loss calculation:


Year
Total Loss
At-Risk Allowed
1

$ 54,000

34,000

At-Risk Disallowed

$ 20,000

$ 34,000

34,000

-0-

Passive activity loss allowed calculation:


Year
At-Risk Allowed
PAL Allowed

PAL Disallowed

$20,000

$10,000

$10,000

34,000
10,000

17,000

27,000

In year 1, Molly has at-risk amount of $20,000 before losses from Beau Geste and therefore
is only allowed $20,000 of losses under the at-risk rules. This loss then must pass the passive
activity loss rules. Since Molly has $10,000 of passive activity income from other sources in
year 1, she may deduct $10,000 of the $20,000 loss allowed under the at-risk rules under the
passive activity loss rules. This leaves $10,000 suspended under the passive activity loss
rules for year 1.
In year 2, Mollys at-risk amount increases by the amount of her contribution ($30,000) and
by the income generated by Beau Geste to $39,000 before considering any losses from Beau
Geste. This additional at-risk amount will allow Molly to use up to $39,000 of losses
suspended by the at-risk rules in previous years. As a result, the $34,000 of losses suspended
in year 1 now flow to the passive activity loss rules. In addition to the $34,000 loss freed
from the at-risk rules, Molly must also consider whether she can use the $10,000 loss that
was suspended under the passive activity loss rules in year 1. Since she has $17,000 ($9,000
from Beau Geste and $8,000 from other sources) of passive income she may deduct $17,000
of the total $44,000 losses in year 2. This leaves $27,000 of losses that remain suspended
under the passive activity loss rules at the end of year 2.
Mollys AGI for year 2 is determined as follows:
Year 2 AGI:
AGI before Beau Geste:
+ Year 2 passive income from Beau Geste
- Year 2 allowed passive losses
= Year 2 AGI

$63,000
9,000
17,000
$55,000

a. Based on the above calculations the following amounts:

At-risk amount at the end of year 1:

$-0-

At-risk amount at the end of year 2

$5,000

Losses allowed under the at-risk rules in year 2

$34,000

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Chapter 11 - Investments

Total suspended passive losses at the end of year 1

$10,000

Total suspended at-risk losses at the end of year 2

$-0-

Deductible losses in year 1

$10,000

Year 2 AGI after considering Beau Geste events

$55,000

b. Meredith could a) sell her entire interest in Beau Geste; or b) acquire an additional
passive income generator (e.g., rental property).
84. [LO 5] Anwar owns a rental home and is involved in maintaining it and approving
renters. During the year he has a net loss of $8,000 from renting the home. His other
sources of income during the year were a salary of $111,000 and $34,000 of long-term
capital gains. How much of Anwars $8,000 rental loss can he deduct currently if he has
no sources of passive income?
Because Anwar meets the definition of an active participant and has adjusted gross
income of less than $150,000, before considering his rental loss, he may deduct $2,500 of
the loss against his other income. His $2,500 deduction is computed as follows:
Description

Amount

(1) Maximum deduction available


before phase-out

$25,000

(2) Phase-out of maximum deduction

$22,500

Explanation

[($145,000 AGI
100,000) x .5]

(3) Maximum deduction in current year

$2,500

(1) (2)

(4) Rental loss in current year

$8,000

(5) Rental loss deductible in current


year

$2,500

Lesser of (3) or (4)

Passive loss carry forward

$5,500

(3) (4)

Comprehensive Problems
85. [LO 1, 2, 3] {Planning} As noted in the chapter, Nick inherited $100,000 with the
stipulation that he invest it to financially benefit his family. Nick and Rachel decided
they would invest the inheritance to help them accomplish two financial goals:
purchasing a Park City vacation home and saving for Leas education.

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Chapter 11 - Investments

Initial Investment
Investment Horizon

Vacation Home
$50,000
5 years

Leas Education
$50,000
18 years

The Suttons have a marginal income tax rate of 30 percent (capital gains rate of 15
percent), and have decided to investigate the following investment opportunities.
5 Years

Corporate bonds
Dividend-paying stock
(no appreciation)
Growth stock
Municipal bond
Qualified tuition
program

Annual
After-Tax
Rate of
Return

18 Years

Annual
After-Tax
Rate of
Return

5.75%

4.75%

3.50%
Future
Value is
$65,000
3.20%

3.50%
Future Value is
$140,000

5.75%

5.50%

3.10%

Complete the two annual after-tax rates of return columns for each investment and
provide investment recommendations for the Suttons.
Considering after-tax rates of return alone, the computations below suggest that the
Suttons should invest in growth stocks to save for the vacation home and invest in a
qualified tuition program for their daughters education. Before making a final decision,
the Suttons should also consider relevant nontax factors including differences in risk
across the investments.
5 Years
(home)
Corporate Bonds
Dividend-Paying
Stock, pref. rate
15%
(no appreciation)
Growth Stock
Municipal Bond
Qualified Tuition
Program

18 Years
(education)

Annual After
Tax Rate of
Return

5.75%

Annual
After Tax
Rate of
Return
4.025%

4.75%

3.325%

3.50%

2.975%

3.50%

2.975%

FV is
$65,000
3.20%

4.65%
3.20%

FV is
$140,000
3.10%

5.30%
3.10%

5.75%

3.60%*

5.50%

5.5 %

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Chapter 11 - Investments

or 3.84% **
Growth Stock Calculations:
FV of Growth Stock After-Tax in 5 Years: 65,000 [.15 (65,000 -50,000)] = $62,750
Annual After-tax rate of return= [($62,750/50,000)1/5 1] = 4.65%
FV of Growth Stock After-Tax in 18 Years: 140,000 [.15 (140,000 -50,000)] =
$126,500
Annual After tax rate of return= [($126,500/50,000)1/18 1] =5.3%
Qualified Tuition Program Calculations:
FV of QTP in 5 Years: 50,000 (1+.0575)5 = $66,126
FV of QTP After-Tax in 5 Years: 66,123 [.4 (66,126 -50,000)] = $59,676
* The appreciation is subject to tax at 40 percent (30 percent + penalty of 10 percent)
Annual After Tax Rate of Return= [($59,676/50,000)1/5 1] = 3.6%
FV of QTP in 18 Years: 50,000 (1+.055)18 = $131,073
FV of QTP After-Tax in 18 Years if Funds Not Used for Education: 131,073 [.4
(131,073 - 50,000)] = $98,644
** If not used for educational purposes the appreciation is subject to tax at 40 percent
(30 percent + penalty of 10 percent)
Annual After Tax Rate of Return= [($98,644/50,000)1/18 1] = 3.84%
86.[Tax Forms] [LO 1, 2, 3, 4] During 2013, your clients, Mr. and Mrs. Howell, owned the
following investment assets:
Investment Assets

Date
Acquired

Purchase
Price

Brokers
Commission
Paid at Time
of Purchase
$100
$300

300 shares of IBM common


11/22/10
$10,350
200 shares of IBM common
4/3/11
$43,250
3,000 shares of Apple
preferred
12/12/11
$147,000
$1,300
2,100 shares of Cisco
common
8/14/12
$52,500
$550
420 Shares of Vanguard
mutual fund
3/2/13
$14,700 No load fund*
*No commissions are charged when no load mutual funds are bought and sold.
Because of the downturn in the stock market, Mr. and Mrs. Howell decided to sell most
of their stocks and mutual fund in 2013 and to reinvest in municipal bonds. The following
investment assets were sold in 2013:
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Chapter 11 - Investments

Investment Assets

Date Sold

Sale
Price

Brokers
Commission
Paid at Time of
Sale@
$100

300 shares of IBM common


5/6/13
$13,700
3,000 shares of Apple
preferred
10/5/13
$221,400
$2,000
2,100 shares of Cisco
common
8/15/13
$63,250
$650
451 Shares of Vanguard
mutual fund
12/21/13
$15,700 No load fund*
*No commissions are charged when no load mutual funds are bought and sold.
The Howells broker issued them a Form 1099 showing the sales proceeds net of the
commissions paid. For example, the IBM sales proceeds were reported as $13,600 on the
Form 1099 they received.
In addition to the sales reflected in the table above, the Howells provided you with the
following additional information concerning 2013:

The Howells received a Form 1099 from the Vanguard mutual fund reporting a $900
long-term capital gain distribution. This distribution was reinvested in 31 additional
Vanguard mutual fund shares on 6/30/13.

In 2008, Mrs. Howell loaned $6,000 to a friend who was starting a new multilevel
marketing company called LD3. The friend declared bankruptcy in 2013, and Mrs.
Howell has been notified that she will not be receiving any repayment of the loan.

The Howells have a $2,300 short-term capital loss carryover and a $4,800 long-term
capital loss carryover from prior years.

The Howells did not instruct their broker to sell any particular lot of IBM stock.

The Howells earned $3,000 in municipal bond interest, $3,000 in interest from
corporate bonds, and $4,000 in qualified dividends.

Assume the Howells have $130,000 of wage income during the year.

a. Go to the IRS web site (www.IRS.gov) and download the most current version of
Form 8949 and Schedule D. Use Form 8949 and page 1 of Schedule D to compute
net long-term and short-term capital gains. Then, compute the Howells tax liability
for the year (ignoring the alternative minimum tax and any phase-out provisions)
assuming they file a joint return, they have no dependents, they dont make any

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Chapter 11 - Investments

special tax elections, and their itemized deductions total $25,000. Assume that asset
bases are not reported to the IRS.
b. Are there any tax planning recommendations related to the stock sales that you should
have shared with the Howells before their decision to sell?
c. Assume the Howells short-term capital loss carryover from prior years is $82,300
rather than $2,300 as indicated above. If this is the case, how much short-term and
long-term capital loss carryover remains to be carried beyond 2013 to future tax
years?
a. The Howells Form 8949 and Schedule D for the year would be completed as follows:

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Chapter 11 - Investments

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Chapter 11 - Investments

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Chapter 11 - Investments

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Chapter 11 - Investments

The Howells net capital gain is then included with their other income for the year in
calculating their final tax liability for the year.
Description
Wage Income
Interest Income
Qualified Dividends
Net Capital Gains
from Schedule D
Adjusted Gross Income
Total Itemized
Deductions
Personal Exemptions
Taxable Income

Amount
130,000
3,000
4,000
71,700
208,700
(25,000)

Explanation
Given
Given
Given
See Schedule D above
The effect of investment
advice fees and investment
interest expense already
included in this number

(7,800)
175,900

The Howells 2013 tax liability would be $28,515. This is calculated by determining
ordinary income of $100,200 which is $175,900 of taxable income minus $71,700 net
long-term capital gain that will be taxed at 15% and minus $4,000 qualified dividends
that will be taxed at 15%. The tax on $100,200 is $16,908 and the 15% tax on long-term
capital gains and qualified dividends of $75,700 is $11,355. This results in a total 2013
tax liability of $28,263.
b. Mr. and Mrs. Howell should have told their broker to sell the 200 shares of IBM
acquired on 4/3/11 first, using the specific identification method. Because these
shares have a much higher tax basis than the shares acquired on 11/22/10, the
Howells could have reported a capital loss on the sale of the IBM stock, which could
have been used to offset the gains from the sale of the Apple and Cisco stock.
However, at this point in time, its too late to implement this strategy. Mr. and Mrs.
Howell should have consulted with their tax advisor prior to the sale.
c. If we assume the Howells short-term capital loss carryover into 2013 was $82,300
rather than $2,300 as originally assumed, a number of things change. First, the net
short-term capital loss for the year increases to $88,200. When netted against the net
long-term capital gain for the year of $79,900, a net short-term capital loss for the
year of $8,300 remains. $3,000 of this loss can be used to reduce ordinary income,
and the remaining $5,300 constitutes a short-term capital loss carryover to future tax
years.
87. [Tax Forms] WAR (We Are Rich) has been in business since 1980. WAR is an accrual
method sole proprietorship that deals in the manufacturing and wholesaling of various
types of golf equipment. Hack & Hack CPAs have filed accurate tax returns for WARs
owner since WAR opened its doors. The managing partner of Hack & Hack (Jack) has
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Chapter 11 - Investments

gotten along very well with the owner of WAR Mr. Someday Woods (single).
However, in early 2013, Jack Hack and Someday Woods played a round of golf and Jack,
for the first time ever, actually beat Mr. Woods. Mr. Woods was so upset that he fired
Hack & Hack and has hired you to compute his 2013 taxable income. Mr. Woods was
able to provide you with the following information from prior tax returns. The taxable
income numbers reflect the results from all of Mr. Woods activities except for the items
separately stated. You will need to consider how to handle the separately stated items for
tax purposes. Also, note that the 20082012 numbers do not reflect capital loss
carryovers.
Ordinary taxable
income
Other items not
included in
ordinary taxable
income
Net gain (loss) on
disposition of
1231 assets
Net long-term
capital gain (loss)
on disposition of
capital assets

2008
$4,000

2009
$2,000

$3,000

10,000

($15,000)

$1,000

2010
$94,000

2011
$170,000

2012
$250,000

($6,000)
($7,000)

($7,000)

In 2013, Mr. Woods had taxable income in the amount of $460,000 before considering the
following events and transactions that transpired in 2013:
a. On January 1, 2013, WAR purchased a plot of land for $100,000 with the intention of
creating a driving range where patrons could test their new golf equipment. WAR
never got around to building the driving range; instead, WAR sold the land on
October 1, 2013, for $40,000.
b. On August 17, 2013, WAR sold its golf testing machine, Iron Byron and replaced it
with a new machine Iron Tiger. Iron Byron was purchased and installed for a
total cost of $22,000 on February 5, 2009. At the time of sale, Iron Byron had an
adjusted tax basis of $4,000. WAR sold Iron Byron for $25,000.
c. In the months October through December 2013, WAR sold various assets to come up
with the funds necessary to invest in WARs latest and greatest inventionthe three
dimple golf ball. Data on these assets are provided below:

Asset
Somedays black
leather sofa
(used in office)
Somedays

Placed in
Service (or
purchased)

Sold

Initial
Basis

Accumulated
Depreciation

Selling
Price

4/4/12

10/16/13

$3,000

$540

$2,900

3/1/11

11/8/13

$8,000

$3,000

$4,000

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Chapter 11 - Investments

office chair
Marketable
securities
Land held for
investment
Other investment
property

2/1/10

12/1/13

$12,000

$0

$20,000

7/1/12

11/29/13

$45,000

$0

$48,000

11/30/11

10/15/13

$10,000

$0

$8,000

d. Finally, on May 7, 2013, WAR decided to sell the building where they tested their
plutonium shaft, lignite head drivers. WAR purchased the building on January 5,
2001, for $190,000 ($170,000 for the building, $20,000 for the land). At the time of
the sale, the accumulated depreciation on the building was $50,000. WAR sold the
building (with the land) for $300,000. The fair market value of the land at the time of
sale was $45,000.
Part 1: Compute Mr. Woodss taxable income after taking into account the transactions
described above.
Part 2: Compute Mr. Woodss tax liability for the year.
Part 3: Complete Mr. Woodss Form 8949, Schedule D, and Form 4797 (use the most
current version of these schedules) to be attached to his Form 1040. Assume that asset
bases are not reported to the IRS.
Part 1: Mr. Woodss taxable income is determined as follows:
This table determines the gains, losses and character for each of the dispositions.

Land

Sales
Price
$40,000

Adjusted
Basis
$100,000

Gain/Loss
$(60,000)

Character
Ordinary Loss

Iron Byron
Sofa
Chair

25,000
2,900
4,000

4,000
2,460
5,000

21,000
440
(1,000)

$18,000 = 1245 Ordinary


Income; $3,000 = 1231
1245 Ordinary income
1231 loss

Marketable
Securities
Land - Investment
Investment Property

20,000
48,000
8,000

12,000
45,000
10,000

8,000
3,000
(2,000)

LTCG
LTCG
LTCL

255,000
45,000

120,000
20,000

135,000
25,000

Building
Land -Bldg

$50,000 Unrecaptured 1250


gain; $85,000 1231 gain
1231 gain

Once the gains and losses have been characterized, they are netted in the 1231 netting
process as follows:

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Chapter 11 - Investments

1231 Netting
Step 1 - depreciation recapture
1245 Iron Byron
$18,000
1245 Sofa
440
$18,440

Notes on netting:

Ordinary Income

Step 2 - 1231 G/L netting


Gains Iron
Byron
$3,000
Building
85,000
Land
25,000
Losses - Chair
(1,000)
$112,000
Unrecaptured
1250 Gain Bldg 50,000
(Reclassify unrecaptured 1250 gains before regular
1231 gains)
$6,000 will be Ordinary Income
$44,000 Unrecaptured 1250 LTCG at 25%
0/15/20% LTCG

Step 3 - Lookback rule


$50,000
$112,000

The capital gains and loss netting process follows the 1231 netting process as follows:
Capital G/L netting
Short term

28%

Long term
25%
$ 44,000

0/15/20%
112,000

8,00
0
3,00
0
(2,000
)
121,000

121,000

(5,000)

(5,000)
5,000

LTCL carryforward

$
$

44,000
(5,000)
39,000

Net LTCG

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Chapter 11 - Investments

Mr Woodss taxable income is calculated as follows:


Taxable Income:
Taxable income before transactions
Ordinary loss - land
Recapture
Ordinary income from lookback
LTCG @ 25%
LTCG @ 0/15/20%
Taxable income

$460,000
(60,000)
18,440
6,000
39,000
121,000
$584,440

Part 2: Mr. Woodss tax liability is calculated as follows:


Tax Liability:
Calculate Ordinary income
Tax on ordinary income
Tax on 25% Gain
Tax on 0/15/20% Gain (taxed at
20%)
Tax liability

$424,440
$124,718
9,750
24,200
$158,668

Part 3: Mr. Woodss Form 8949, Schedule D, and Form 4797 would be completed as follows:

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Chapter 11 - Investments

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Chapter 11 - Investments

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Chapter 11 - Investments

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Chapter 11 - Investments

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Chapter 11 - Investments

88. Fizbo Corporation is in the business of breeding and racing horses. Fizbo has taxable
income of $5,000,000 other than from these transactions. It has nonrecaptured 1231
losses of $10,000 from 2009 and $13,000 from 2007.

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Chapter 11 - Investments

Consider the following transactions that occur during 2013:


a. A building with an adjusted basis of $300,000 is totally destroyed by fire. Fizbo
receives insurance proceeds of $400,000, but does not plan to replace the building.
The building was built 12 years ago at a cost of $420,000 and was used to provide
lodging for employees.
b. Fizbo sells four acres of undeveloped farmland (used for grazing) for $50,000. Fizbo
purchased the land 15 years ago for $15,000.
c. Fizbo sells a racehorse for $250,000. The racehorse was purchased four years ago for
$200,000. Total depreciation taken on the racehorse was $160,000.
d. Fizbo exchanges equipment that was purchased three years ago for $300,000 for
$100,000 of IBM common stock. The adjusted basis of the equipment is $220,000. If
straight-line depreciation had been used, the adjusted basis would be $252,000.
e. On November 1, Fizbo sold XCON stock for $50,000. Fizbo had purchased the stock
on December 12, 2012 for $112,000.
Part 1: After ALL netting is complete, what is Fizbos total amount of income from these
transactions to be treated as ordinary income or loss? What is its capital gain or
loss?
Part 2:What is Fizbos taxable income for the year after including the effects of these
transactions?
Part 1: Fizbos ordinary income/loss and capital gains/losses are as follows:
This table determines the gains, losses and character for each of the dispositions.
Asset
Amount
Adjusted Gain/(Loss) Character
Realized
Basis
Building
$400,000
$300,000 $100,000
$20,000 is 291 gain
$80,000 is 1231 gain
Farm land
50,000
15,000
35,000
$35,000 1231 gain
Racehorse1
250,000
40,000
210,000
160,000 1245 recapture
50,000 1231 gain
Equipment
100,000
220,000
(120,000)
1231 loss
XCON Stock 50,000
112,000
(62,000)
STCL
Once the gains and losses have been characterized, they are netted in the 1231 netting
process as follows:

1231 Netting:
Step 1: recapture:
291 from building
1245 from racehorse

$20,000
160,000
$180,000

Ordinary income

1In the racing business, racehorses are considered to be analogous to equipment for a
manufacturing business.
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2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution
in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 11 - Investments

Step 2: net 1231 gains and losses:


G: Building
$80,000
Farm land
35,000
Racehorse
50,000
Equipment
(120,000)
Net 1231 Gain
$45,000
Step 3: Lookback losses: Ordinary income = $10,000

1231 = $35,000

The 1231 gains are combined with the other capital gains and losses:
Capital Gain/Loss Netting:
1231
$35,000
Capital loss from stock
(62,000)
Net capital loss
$(27,000)
Ordinary income:
Depreciation recapture
Lookback
Total

$180,000
10,000
$ 190,000

Capital gain/loss:

$ (27,000)

Part 2: Fizbos taxable income is determined as follows:


Taxable income before transactions
$5,000,000
Ordinary income
190,000
Taxable income
$5,190,000
Note that Fizbo may not reduce its taxable income by the net capital loss. Corporations
capital losses are limited to their capital gains.

11-59
2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution
in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.