Chapter16InvestmentandPersonalFinancialPlanning

Chapter 16
Questions and Problems for Discussion
1.

a. Interest on U. S. Treasury bonds is taxable income for federal purposes but tax-exempt for
state purposes.
b. Interest on a State bond is tax-exempt for federal purposes but may be taxable income or
tax-exempt for state purposes, depending on the taxpayers state of residence.
c.

The stated interest paid on a corporate bond is taxable income for both federal and state
purposes.

d. The stated interest paid on a corporate bond and the amortization of the original issue
discount (OID) is taxable income for both federal and state purposes.
e. Dividends on preferred stock are taxable income for both federal and state purposes.
Qualified dividend income is taxed at a preferential federal rate.
f.

Ordinary dividends paid by mutual funds can consist of ordinary taxable income, qualified
dividend income, and capital gain distributions. Qualified dividend income and capital gain
distributions are taxed at a preferential federal rate.

2.

The lapse of a term life insurance policy has no income tax consequences.

3.

Mrs. SD probably should not move her savings into a tax-deferred annuity. The value of the tax
deferral offered by the annuity is a function of the investors marginal rate: the higher the rate,
the greater the value of the deferral. Because Mrs. SD is in the lowest tax bracket, the value of
deferral may be too small to offset any implicit tax or transaction costs associated with the
annuity. The value of tax deferral also depends on the length of time the investor can postpone
receiving taxable income. If Mrs. SD must liquidate her annuity in just a few years to fund her
move to a retirement home, the value of the brief deferral period is minimal. Moreover, she may
be required to pay a monetary penalty to the annuity company for a premature liquidation (as the
term is defined in the contract). This additional transaction cost would almost certainly negate
the benefit of tax deferral.

4.

Ms. B would recognize capital gain on the sale of GG stock even though she immediately
repurchases the shares; the wash sale rule applies only to realized losses. However, she can
maximize the value of her $12,000 net capital loss by deducting $3,000 this year and each of the
next three years. These deductions reduce AGI and result in an annual tax savings of $1,050
($3,000 35%). At a 6 percent discount rate, NPV of this stream of savings is $3,857. In
contrast, if Ms. B implements her strategy to sell GG stock, the $12,000 capital loss offsets a
$12,000 capital gain that would be taxed at 15 percent three years hence. At a 6 percent
discount rate, NPV of this $1,800 tax savings is only $1,512. Consequently, Ms. B should not sell
any GG stock.

5.

Under state law, limited partners are prohibited from active involvement in the partnership
business. Consequently, they cannot materially participate in that business, and their interest in
the partnership is a passive activity.

6.

If Mrs. K materially participates in TKs business, she should be employed by the corporation
and receiving a salary reflecting the value of her services.

7.

Investors with passive activity losses should be willing to pay a premium for profitable rental real
estate (as compared to other investments with the same risk and before-tax rate of return)
because they can use the losses to shelter the real estate income from tax. Consequently, the
market value of the real estate should increase.

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Chapter16InvestmentandPersonalFinancialPlanning
8.

All three limitations permit taxpayers to claim a current deduction to the extent of a certain type
of income. Investment interest expense is deductible to the extent of net investment income.
Capital losses are deductible to the extent of capital gains. Passive activity losses are deductible
to the extent of passive activity income.

9.

a. Mr. and Mrs. FBs 60 percent equity interest represents legal control of FB Inc. Because the
owner of this equity can control corporate policy (including dividend payments), the value of
Mr. and Mrs. FBs gift to their son is more than $6 million (i.e., the value should reflect a
control premium).
b. The owner of a 10 percent minority interest can do little to influence corporate policy.
Consequently, the value of the investors gift to her son is less than $1 million (i.e., the value
should reflect a minority discount).

10. This strategy wastes one spouses lifetime transfer tax exclusion. Mr. and Mrs. T should each
bequeath property with a value equal to the current year exclusion to their offspring and only the
remainder of his or her property to the surviving spouse. This strategy eliminates any estate tax
when the first spouse dies and allows each spouse to use his or her lifetime transfer tax
exclusion to transfer property to younger-generation family members.
11. Mr. and Mrs. B can spend their after-tax income or save (invest) it. They can spend their wealth
(accumulated income), give it away during their life, or hold it until death, at which point it will
pass to another owner.
Application Problems
1.

a. Ms. Ss tax is $2,937 ($19,580 15% preferential rate on qualified dividend income).
b. The tax is $2,937. Ms. S is in constructive receipt of the dividend income even though it was
automatically reinvested in additional BenBow shares.

2.

a. Mr. Lays tax is $7,711 ($22,030 35%).

b. Mr. Lays tax is $6,813 ($6,139 [$17,540 35%] + $674 [$4,490 15% preferential rate]).
c.

Mr. Lays tax is $4,689 ($2,422 [$6,920 35%] + $2,267 [$15,110 15% preferential rate]).

3.

Mr. Ss basis in his 620 Carmel shares is $9,160 ($9,300 cost basis $140 return of capital).

4.

a. $753 ($2,690 interest 28%).

b. $753 ($2,690 interest 28%).
c.

$753 ($2,690 interest 28%).

d. $753 ($2,690 interest 28%).

e. Mrs. Nunns federal tax is -0- (municipal bond interest is tax-exempt).
5.

a. $188 ($2,690 interest 7%)

b. Mrs. Nunns state tax is -0- (federal bond interest is tax-exempt).
c.

$188 ($2,690 interest 7%)

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Chapter16InvestmentandPersonalFinancialPlanning
6.

Mrs. Zs before-tax income from the Pennsylvania bond

Virginia income tax at 6%
Federal tax savings from deduction of Virginia tax
($204 35%)
After-tax income

$3,400
(204)
71
$3,267

$3,267 $50,000 investment = 6.534% after-tax rate of return

7.

a. $74,800 before-tax cash flow - $24,684 tax cost ($74,800 interest income 33%) = $50,116
after-tax cash flow.
b. -0- before-tax cash flow - $24,684 tax cost ($74,800 interest income 33%) = ($24,684)
after-tax cash flow.
c.

8.

-0- before-tax cash flow - $24,684 tax cost ($74,800 interest income 33%) = ($24,684)
after-tax cash flow.

a. $100,000 redemption proceeds - $93,100 cost basis = $6,900 interest income.

b. $100,000 redemption proceeds - $100,000 adjusted basis ($72,900 cost + $27,100
amortized OID) = -0- interest income.

9.

a. Mrs. Ulm must recognize $1,512 OID interest income in 2005 and $1,480 OID interest
income in 2006. Her long-term capital gain on the sale of the bond is computed as follows.
Amount realized on sale
Adjusted basis ($80,000 + amortized OID)
Long-term capital gain

$84,180
(82,992)
$1,188

b. Mrs. Ulm does not recognize the accrued market discount as income. However, when she
sells the bond, she must recognize the $2,992 accrued market discount (based on the
bonds yield to maturity) as ordinary income and the $1,188 remaining gain as long-term
capital gain.
Amount realized on sale
$84,180
Adjusted basis
(80,000)
Realized gain
$4,180
Ordinary income (accrued discount)
(2,992)
Long-term capital gain
$1,188
10. a. Amount realized (4,052 shares $18)
Adjusted basis (cost + reinvested dividends)
Mr. Dales recognized gain
b. Amount realized (800 shares $18)
Adjusted basis ($14 cost of 800 original shares)
Mr. Dales recognized gain
c.

Amount realized (800 shares $18)

Adjusted basis ($58,393 [800 shares 4,052 shares])
Mr. Dales recognized gain

$72,936
(58,393)
$14,543
$14,400
(11,200)
$3,200
$14,400
(11,529)
$2,871

11. a. Mrs. Cole recognizes $7,220 ($38,500 cash surrender value $31,280 investment in the
policy) as ordinary income.
b. Mrs. Coles $400,000 accelerated death benefit is excludable from her taxable income.

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Chapter16InvestmentandPersonalFinancialPlanning
12. Mr. F is entitled to a tax-free return of his $50,000 investment in the annuity contract. The
taxable portion of each $1,300 monthly payment is computed as follows.
$50,000 investment $312,000 expected return = .16026 exclusion ratio
Monthly payment
Exclusion ratio
Tax-free return of investment

$1,300
.16026
$208

Taxable annuity payment ($1,300 $208)

$1,092

13. a. Mr. Fs total annuity payments for the year

Unrecovered investment
Taxable payments

$15,600
(1,875)
$13,725

b. Unrecovered investment at beginning of year

Tax-free recovery from January payment
Unrecovered investment at date of death

$1,875
(208)
$1,667

The $1,092 taxable portion of the January payment is included in gross income, and the
$1,667 unrecovered investment is reported as an itemized deduction on Mr. Fs final Form
1040.
14. Mr. L is treated as selling his Drago stock on the last day of the year for an amount realized of
zero. Therefore, he recognizes a $14,400 long-term capital loss (unrecovered basis in the
worthless stock).
15. Mrs. B can treat the nonbusiness bad debt as a $10,000 short-term capital loss. Note that the
debt is not a business debt because she did not incur the debt for her business purposes. Her
loan was an investment in Mr. Js business.
16. a. The exchange of common stock for common stock in the same corporation is nontaxable.
Thus, CVF does not recognize its $162,000 realized gain.
b. The exchange of Jarvis common stock for U. S. bonds is taxable. Thus, CVF must recognize
its $92,500 realized gain.
c.

The exchange of Jarvis common stock for Newton common stock is taxable because it was
not pursuant to a corporate reorganization. Thus, CVF must recognize its $55,000 realized
gain.

d. The exchange of Jarvis common stock for Newton common stock is nontaxable because it
was pursuant to a corporate reorganization. Thus, CVF does not recognize its $55,000
realized gain.
17. a. CVFs basis in the 1,300 shares of Jarvis voting common stock is $225,000, which is the
substituted basis of the 2,000 shares surrendered in the exchange.
b. CVFs basis in its U.S. bonds is $317,500, which is the cost of the bonds.
c.

CVFs basis in its 900 shares of Newton stock is $280,000, which is the cost of the stock.

d. CVFs basis in its 900 shares of Newton stock is $225,000, which is the substituted basis of
the 2,000 shares of Jarvis stock surrendered in the exchange.
18. a. Mrs. Beard can deduct $3,000 of the capital loss.
b. Mrs. Beard can deduct $6,780 of the capital loss ($3,780 capital gain + $3,000).
c.

Mrs. Beard can deduct the entire $12,290 capital loss against her $15,610 capital gain.

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Chapter16InvestmentandPersonalFinancialPlanning
19. a. Mr. Alms AGI is $58,850 ($61,850 salary - $3,000 net capital loss).
b. Mr. Alms AGI is $68,500 ($61,850 salary + $6,650 net capital gain ($12,250 capital gain $5,600 capital loss).
c.

Mr. Alms AGI is $60,350 ($61,850 salary - $1,500 net capital loss ($8,000 capital gain
distribution - $5,600 capital loss - $3,900 capital loss carryforward).

20. a. Mr. and Mrs. Revel recognized a $6,100 net long-term capital loss of which they can deduct
$3,000 against other sources of income. Therefore, their AGI is $203,200.
b. Mr. and Mrs. Revel recognized a $380 net long-term capital gain. Their AGI is $206,580.
c.

Mr. and Mrs. Revel recognized a $9,800 net capital loss of which they can deduct $3,000
against other sources of income. Their AGI is $203,200.

d. Mr. and Mrs. Revel recognized a $4,100 net short-term capital loss of which they can deduct
$3,000 against other sources of income. Their AGI is $203,200.
21. a. Mr. and Mrs. Revel have a $3,100 long-term capital loss carryforward.
b. No carryforward.
c.

Mr. and Mrs. Revel have an $1,800 short-term capital loss carryforward and a $5,000 longterm capital loss carryforward.

d. Mr. and Mrs. Revel have a $1,100 short-term capital loss carryforward.
22. Ordinary taxable income
Capital transactions:
Net short-term capital gain
Long-term capital gain
Long-term capital loss
Net long-term capital gain
Taxable income

$421,000
14,300
$64,000
(12,900)
51,100
$486,400

Tax on $435,300 ordinary income (single)

$131,429
Tax on $51,100 long-term capital gain at 15%
7,665
Mr. Js tax

$139,094

23. a. $4,395 ($29,300 long-term capital gain 15%)

b. $5,695 ($2,895 [$19,300 LTCG 15%] + $2,800 [$10,000 collectibles gain 28%])
c.

$5,945 ($2,070 [$13,800 LTCG 15%] + $3,875 [$15,500 unrecaptured Section 1250 gain
25%])

d. $6,816 ($840 [$5,600 LTCG 15%] + $476 [$1,700 collectibles gain 28%] + $5,500
[$22,000 unrecaptured Section 1250 gain 25%])
24. Amount realized
Adjusted basis
Gain realized

$685,000
(544,700)
$140,300

Tax on unrecaptured Section 1250 gain

($51,900 25%)
Tax on Section 1231 gain treated as LTCG
($88,400 15%)
Tax on gain realized

$12,975
13,260
$26,235

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Chapter16InvestmentandPersonalFinancialPlanning
25. a. Ordinary taxable income
Capital transactions:
Long-term capital gain on Seta stock sale
Excluded gain (50 percent)
Gain on qualified small business stock sale
Other long-term capital gain
Taxable income
Tax on $191,000 ordinary income (HH)
Tax on $33,700 capital gain at 28%
Tax on $8,600 capital gain at 15%
Ms. EJs tax

$191,000
$67,400
(33,700)
33,700
8,600
$233,300
$45,985
9,436
1,290
$56,711

b. In this case, Ms. EJ did not hold the Seta stock for more than five years, and her long-term
capital gain on sale is not eligible for the 50 percent exclusion.
Ordinary taxable income
Capital transactions:
Long-term capital gain on Seta stock sale
Other long-term capital gain

$191,000
$67,400
8,600
76,000
$267,000

Taxable income
Tax on $191,000 ordinary income (HH)
Tax on $76,000 capital gain at 15%
Ms. EJs tax

$45,985
11,400
$57,385

26. Mr. EF recognized the following losses on sale of his LLG stock.
Sale of Section 1244 stock issued to Mr. EF:
Amount realized (500 shares $16)
Adjusted basis (cost)
Ordinary loss

$8,000
(45,000)
$(37,000)

Sale of stock purchased by Mr. EF:

Amount realized (1,000 shares $16)
Adjusted basis (cost)
Capital loss

$16,000
(40,000)
$(24,000)

a. Salary
Ordinary loss on LLP stock sale
Limited net capital loss deduction
Mr. EFs AGI

$80,000
(37,000)
(3,000)
$40,000

b. Salary
Ordinary loss on LLP stock sale
Capital gain on sale of marketable securities
Capital loss on LLP stock sale
Net capital loss
Limited net capital loss deduction
Mr. EFs AGI

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$80,000
(37,000)
$20,000
(24,000)
(4,000)
(3,000)
$40,000

Chapter16InvestmentandPersonalFinancialPlanning
27. a. Ms. Reids deduction for her $3,900 investment interest expense is limited to $1,100. (If Mrs.
Reid treats her $1,100 qualified dividend income as investment income, the dividend will not
be taxed at the 15% preferential rate.)
b. Ms. Reids deduction for her $3,900 investment interest expense is limited to $690.
c.

Ms. Reid can deduct her entire $3,900 investment interest expense.

28. a. If Mr. and Mrs. MS do not elect to treat any long-term capital gain as investment income,
their tax is $10,103.
Salaries
Interest income (investment income)*
Short-term capital gain (investment income)*
Long-term capital gain
AGI
Itemized deductions: Investment interest*
Other

$84,000
963
600
7,200
$92,763
$1,563
12,500
(14,063)
(6,800)
$71,900

Exemption amount ($3,400 2)

Taxable income
Tax on $64,700 ordinary income (MFJ)
Tax on $7,200 long-term capital gain at 15%
Mr. and Mrs. MSs tax

$9,023
1,080
$10,103

b. If Mr. and Mrs. Poe elect to treat $2,837 of their long-term capital gain as investment income,
their tax is $9,677.
Salaries
Interest income (investment income)*
Short-term capital gain (investment income)*
Long-term capital gain ($2,837 investment income)*
AGI
Itemized deductions: Investment interest*
$4,400
Other
12,500

$84,000
963
600
7,200
$92,763
(16,900)
(6,800)
$69,063

Exemption amount ($3,400 2)

Taxable income
Tax on $64,700 ordinary income (MFJ)
Tax on $4,363 long-term capital gain at 15%
Mr. and Mrs. MSs tax

$9,023
654
$9,677

Mr. and Mrs. Poe minimize their current year tax by electing to treat $2,837 of their long-term
capital gain as investment income. However, a comparison of current year tax liabilities ignores
the present value of any future tax savings generated by the carryforward of nondeductible
investment interest expense that results if Mr. and Mrs. Poe do not make the election.

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Chapter16InvestmentandPersonalFinancialPlanning
29. a. Mr. Ds tax savings from the loss was $5,250 ($15,000 short-term capital gain offset by
$15,000 capital loss 35%).
b. Mr. Ds tax savings from the loss was $2,250 ($15,000 long-term capital gain offset by
$15,000 capital loss 15%).
c.

Mr. Ds tax savings from the loss was $4,200 ($15,000 28 percent rate gain offset by
$15,000 capital loss 28%).

d. Mr. Ds NPV of the tax savings from the loss was $4,773.
Tax savings in 2007 ($3,000 deduction 35%)
Present value of annual tax savings in 2008-2011
($1,050 3.546 discount factor at 5%)
NPV
30. Grocery store net profit
Adjustment for one-half of SE tax
Dividends and interest income
Passive activities: Rental loss deductible up to $25,000)
LP interest (nondeductible loss)
Mr. and Mrs. Morriss AGI
31. a. Salary
Business income from VP
Passive activities: BL (nondeductible loss)
Mr. Kellys AGI

$1,050
3,723
$4,773
$44,000
(3,109)
1,080
(6,470)
-0$35,501

$62,300
19,000
-0$81,300

b. Salary
Business loss from BL.
Passive activities: VP
Mr. Kellys AGI
c. Salary
Business income from VP
Business loss from BL.
Mr. Kellys AGI

$62,300
(25,000)
19,000
$56,300
$62,300
19,000
(25,000)
$56,300

d. Salary
Passive activities: VP income
$19,000
BL deductible loss (19,000)

$62,300
-0$62,300

Mr. Kellys AGI

32. a. Salary
Interest and dividends
AGI before real estate rental loss
Real estate rental loss (deductible up to $25,000)
Ms. TNs AGI
b. Salary
Interest and dividends
AGI before real estate rental loss
Real estate rental loss (deductible up to
$25,000 [50% $17,800 excess AGI])
Ms. TNs AGI
c.

Salary
Interest and dividends

$59,000
4,400
$63,400
(25,000)
$38,400
$113,400
4,400
$117,800
(16,100)
$101,700
$168,250
4,400

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Chapter16InvestmentandPersonalFinancialPlanning
Ms. TNs AGI

$172,650

33. Net profit from sole proprietorship

Adjustment for one-half of SE tax
Interest and dividends
Passive activities: Rent house
ABCD (deductible loss)

$75,000
(5,299)
1,500
$9,500
(9,500)
-0$71,201

Ms. Adamss AGI

Because Ms. Adamss tax for the year is the same with or without the $9,500 rent income, the
tax cost of the rent income is zero.
34. Salary
Capital transactions:
Gain on sale of partnership interest
Loss on securities sale
Net capital gain
Passive activities: Partnership income
S corporation loss*

$85,000
$14,000
(12,000)
2,000
$2,100
(13,900)
(11,800)
$75,200

Mr. Ds AGI

Mr. D can deduct the entire S corporation loss because he has $16,100 passive activity income
from other sources. The $14,000 gain on sale of the partnership interest is characterized as both
capital gain and passive activity income, a dual characterization that allows Mr. D to deduct both
his capital loss on the securities sale and his passive activity loss.
35. a. Mr. Zeplin can transfer $276,000 ($12,000 23 donees) without making a taxable gift.
b. Mr. and Mrs. Zeplin can transfer $552,000 ($24,000 23 donees) without making a taxable
gift.
36. a. Because the $738,000 taxable gift ($750,000 FMV - $12,000 annual exclusion) is less than
Mr. Itos $1 million lifetime exclusion, no amount is subject to gift tax.
b. The $438,000 excess of the $1,438,000 taxable gift ($1,450,000 FMV - $12,000 annual
exclusion) over Mr. Itos $1 million lifetime exclusion is subject to gift tax.
c.

The $207,500 excess of the $620,500 taxable gift ($632,500 FMV - $12,000 annual
exclusion) over Mr. Itos $413,000 remaining lifetime exclusion ($1 million - $587,000
previous taxable gift) is subject to gift tax.

37. Callies investment income

Base amount
Excess investment income
Tax rate (parents marginal rate)
Tax

$5,831
(1,700)
$4,131
.28
$1,157

Callies remaining taxable income

Standard deduction
Taxable income
Tax rate (single)
Tax

$1,700
(850)
$850
.10
$85

Callies total tax ($1,157 + $85)

$1,242

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Chapter16InvestmentandPersonalFinancialPlanning
38. Gross estate
Debts of the decedent
Funeral and administrative expenses
Deductible bequests: First Lutheran Church
Western Wisconsin College
Mrs. JS

$10,000,000
(789,000)
(95,600)
$500,000
1,000,000
2,400,000
(3,900,000)
$5,215,400

Mr. JSs taxable estate

39. a. Mrs. WPs amount realized on sale
Basis
Gain recognized
Mrs. WPs tax rate on capital gain

$200,000
(138,000)
$62,000
.15
$9,300

Sale proceeds
Tax cost
Mrs. WPs after-tax sale proceeds

$200,000
(9,300)
$190,700

b. Grandchildrens amount realized on sale

Basis (carryover from Mrs. WP)
Gain recognized (one-fourth by each seller)
Grandchildrens tax rate on capital gain

$200,000
(138,000)
$62,000
.05
$3,100

Sale proceeds
Tax cost
Grandchildrens after-tax sale proceeds

$200,000
(3,100)
$196,900

Daughters amount realized on sale

Basis (FMV at date of death)
Gain recognized

$200,000
(200,000)
-0-

Sale proceeds
Tax cost
Daughters after-tax sale proceeds

$200,000
-0$200,000

c.

Issue Recognition Problems

1.

Is the election by a cash basis individual to accrue interest income on U.S. savings bonds an
annual election, or is it a permanent election that must apply in all future taxable years?

2.

Is Ms. As receipt of 1,450 additional SBS shares a taxable event? Is a stock dividend taxable to
the recipient? If the stock dividend is taxable, what is the dollar amount of the dividend? What is
Ms. As basis in her new 1,450 shares of SBS stock?

3.

Must Mr. L characterize his entire $24,000 loss realized on the worthless bond as capital loss?
Can Mr. L characterize $6,000 of his worthless security loss as ordinary because it represents
accrued ordinary interest income?

4.

Can Mr. and Mrs. G amortize the $3,000 premium as deductible interest expense over the life of
the bond? If Mr. and Mrs. G hold the bond to maturity, will they recognize a $3,000 capital loss or
ordinary loss when they redeem the bond for $50,000?

5.

Can Mrs. B claim a $12,000 ordinary abandonment loss because she surrendered her shares
back to NN Corporation when the shares still had some minimal value?

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Chapter16InvestmentandPersonalFinancialPlanning
6.

Can Ms. X report a $3,500 nonbusiness bad debt as a capital loss on her tax return? Was the
substance of the original transaction between Ms. X and her daughter a loan or a gift? Did Ms. X
intend that her daughter repay the loan?

7.

Does Mr. O have a $10,000 business bad debt (fully deductible) or a $10,000 nonbusiness bad
debt (capital loss)? Did Mr. O make the loan to MNOP as part of his business or as an
investment?

8.

What happens to an individuals loss carryforwards when that individual dies? Are any of Ms. Ts
loss carryforwards deductible on her final Form 1040? Can another taxpayer inherit Ms. Ts loss
carryforwards, or do the carryforwards die with her?

9.

When an individual sells an interest in a passive activity to a related party, can the individual
deduct any suspended losses from the activity?

10. Does the abandonment of an interest in a passive activity qualify as a disposition that triggers a
deduction for any suspended losses from the activity?
11. Does the transfer of Mr. OGs property into trust qualify for a marital deduction for federal estate
tax purposes? Does Mrs. OGs income interest in the trust qualify for a marital deduction?
12. Is the $140,000 value of the IRA included in Mr. Ds taxable estate? When Mr. Ds son withdraws
funds from the IRA inherited from his father, must the son recognize the withdrawals as taxable
income? Is the sons tax basis in the inherited IRA stepped up to $140,000 (FMV at date of
death) so that a withdrawal of the $140,000 fund balance is a tax-free return of basis to the son?
13. What is Mr. ASs tax basis in the real property after to his wifes death? Is the basis in one-half of
the property or the basis in the entire property stepped up to FMV on the death of a co-owner?
Research Problems
1.

This problem is based on the facts in Dorothy Dye v. United States, 121 F. 3d 1399 (CA-10,
1997). The IRS argued that Ms. Dye must claim the legal fees incurred in her suit against her
stockbroker as miscellaneous itemized deductions (subject to the 2 percent AGI floor). The Tenth
Circuit Court of Appeals applied the origin of claim doctrine to conclude that the portion of the
legal fees relating to Mrs. Dyes procurement of capital gain income should be treated as a
capital loss rather than an ordinary deduction. Based on this decision, Mrs. Baker can net her
legal fees against the capital gain from her settlement.

2.

The sequence of events suggests that Todd Zimler believed that he could convert $100,000 of
the $125,000 unrealized capital loss on the investment land to ordinary loss. However, Section
1244(d)(1) prevents such a conversion. This paragraph applies if an individual made a tax-free
exchange of property for Section 1244 stock, and the basis of the property exceeded its FMV.
When the individual sells the stock, any Section 1244 ordinary loss must be reduced by such
excess. Without this anti-conversion rule, Todds sale of his Section 1244 stock would result in
a $100,000 Section 1244 loss and a $23,000 capital loss. However, because the basis of the
investment land that Todd exchanged for the stock was $125,000 more than the lands FMV,
Todds Section 1244 loss is reduced to zero, and he recognizes a $123,000 capital loss.

16-11

Chapter16InvestmentandPersonalFinancialPlanning
3.

According to Section 469(h)(2), Rachels limited interest in HN Partnership is a passive activity

(i.e. a business activity in which Rachel does not materially participate). Consequently, her
$3,810 loss is deductible in 2007 only to the extent that she has passive activity income for the
year. The classification of Rachels interest in Jams-n-Jellies LLC as either active or passive
depends on whether her 592 hours of work represents material participation in the LLCs
business. According to Reg. Sec. 1.469-5T(a)(1), an individual materially participates in an
activity if the individual participates for more than 500 hours during the year. Based on this 500hour rule, Rachel materially participated in the LLCs business for 2007, and her share of
ordinary business income is active rather than passive. Her consulting income from the LLC and
her salary as a librarian are not passive activity income according to Section 469(e)(3).
Therefore, Rachel has no passive activity income for 2007 and cannot deduct any of her
partnership loss.

Tax Planning Cases

1.

Ms. K should sell the 800 shares acquired on December 3, 2001, and 200 of the shares
acquired on July 12, 1997. She held both blocks for more than 12 months; consequently, her
recognized gain will be long-term capital gain taxed at 15 percent. The shares purchased in
2001 have a higher per share basis than those purchased in 1997, and their sale will generate
less gain. Ms. K should not sell any qualified small business stock (the shares acquired on
September 30, 2004) until after September 30, 2009. If she sells the stock before this date, she
is not eligible for the 50 percent exclusion. If Ms. K sells the stock acquired on October 2, 2007,
she would recognize short-term capital gain taxed at 35 percent.

2.

If Ms. EH cashes in the policy, her after-tax cash flow would be $82,750.
Cash surrender value
Investment in policy
Ordinary gain recognized on surrender
Tax rate
Tax

$95,000
(46,000)
$49,000
.25
$12,250

Cash proceeds on surrender

Tax cost
After-tax cash flow

$95,000
(12,250)
$82,750

If she borrows against the policy and repays the debt from the death benefit, the NPV of her
after-tax cash flows would be $93,553.
Loan proceeds in year 0
Present value of interest payments in years 1 through 9
($3,500 6.802 discount factor at 6%)
Present value of year 9 death benefit less repayment
($80,000 .592 discount factor at 6%)
NPV

$70,000
(23,807)
47,360
$93,553

Thus, Ms. EH should borrow against the policy to maximize NPV of cash flows.

16-12

Chapter16InvestmentandPersonalFinancialPlanning
3.

a. If Mr. and Mrs. KQ can deduct the annual interest and tax payments required to carry the
land for five years, the NPV of the cash flows is positive and they should make the
investment.
Year
0
1
2
3
4
5

Investment
in Land

Interest and
Taxes

Tax Savings
from Deduction

Net Cash
Flow

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

$2,100
2,100
2,100
2,100
2,100

$(40,000)
(3,900)
(3,900)
(3,900)
(3,900)
(3,900)

$(40,000)

Sales proceeds net of debt repayment $100,000

Tax cost of sale:
Amount realized
$160,000
Basis in land
(100,000)
Gain recognized
$60,000
Tax rate
.15
Tax
(9,000)
After-tax cash from sale
$91,000
Present value ($91,000 .650 discount factor)
NPV

Present Value
$(40,000)
(3,576)
(3,284)
(3,011)
(2,761)
(2,535)
$(55,167)

59,150
$3,983

b. If Mr. and Mrs. B cannot deduct the interest and tax payments and elect to capitalize them,
the NPV of cash flows is negative and they should not make the investment.
Year
0
1
2
3
4
5

Investment
in Land

Interest and
Taxes

Tax Savings
from Deduction

$(40,000)
(6,000)
(6,000)
(6,000)
(6,000)
(6,000)

-0-0-0-0-0-

Sales proceeds net of debt repayment $100,000

Tax cost of sale:
Amount realized
$160,000
Basis in land
(130,000)
Gain recognized
$30,000
Tax rate
.15
Tax
(4,500)
After-tax cash from sale
$95,500
Present value ($95,500 .650 discount factor)
NPV

16-13

Net Cash
Flow
$(40,000)
(6,000)
(6,000)
(6,000)
(6,000)
(6,000)

Present Value
$(40,000)
(5,502)
(5,052)
(4,632)
(4,248)
(3,900)
$(63,334)

62,075
$(1,259)

Chapter16InvestmentandPersonalFinancialPlanning
4.

Mr. and Mrs. U will pay AMT in the years in which Mr. U exercises his incentive stock options,
and their total tax (regular tax and AMT) will be $85,736.
Taxable income
AMT adjustments and preferences
AMTI
Exemption ($62,550 $46,250)
Taxable AMTI
Tentative minimum tax:
$175,000 26%
$143,700 28%

$260,000
75,000
$335,000
(16,300)
$318,700
$45,500
40,236
$85,736
(65,000)
$20,736

Regular tax on $260,000 (MFJ)

AMT

If they purchase the corporate bond and earn an additional $5,000 taxable income, their total tax
will be $87,486.
Taxable income
AMT adjustments and preferences
AMTI
Exemption ($62,550 $47,500)
Taxable AMTI
Tentative minimum tax:
$175,000 26%
$149,950 28%

$265,000
75,000
$340,000
(15,050)
$324,950
$45,500
41,986
$87,486
(66,650)
$20,836

Regular tax on $265,000 (MFJ)

AMT

Therefore, the incremental tax cost of the additional income is $1,750 ($87,486 $85,736), and
the annual after-tax cash flow from the investment is $3,250 ($5,000 $1,750).
If they purchase the private activity bond, the additional $3,750 income is not subject to regular
tax but is a preference item that increases AMTI to $338,750. Their total tax will be $87,049.
Taxable income
AMT adjustments and preferences
AMTI
Exemption ($62,550 $47,188)
Taxable AMTI
Tentative minimum tax:
$175,000 26%
$152,938 28%

$260,000
78,750
$338,750
(15,362)
$323,388
$45,500
41,549
$87,049
(65,000)
$22,049

Regular tax on $260,000 (MFJ)

AMT

The incremental tax cost of the additional income is $1,313 ($87,049 $85,736), and the annual
after-tax cash flow from the investment is $2,437 ($3,750 $1,313). Therefore, the corporate
bond is the superior investment for Mr. and Mrs. U.

16-14

Chapter16InvestmentandPersonalFinancialPlanning
5.

a. The NPV of cash flows from Investment A is $15,028.

Annual before-tax cash flow
Tax cost ($7,200 taxable income 25%)

$7,200
(1,800)
$5,400

After-tax cash flow in years 0-2:

$5,400 2.783 discount factor

$15,028

Because Ms. ZH has no passive activity income, she cannot deduct the $50,000 of year 0
and 1 losses from Investment P until year 2, when the investment generates $73,000
passive activity income. Consequently, the NPV of cash flows from Investment P is only
$14,783.
Year
0
1
2

Cash flow
-0-0$23,000

Taxable Income/
(Deductible Loss)

(Tax Cost)/
Tax Savings

Net Cash
Flow

Present
Value

-0-0$23,000

-0-0(5,750)

-0-0$17,250

-0-0$14,783

Therefore, Investment A is the superior investment.

b. The NPV of cash flows from Investment A is $13,024.
Annual before-tax cash flow
Tax cost ($7,000 taxable income 35%)
After-tax cash flow in years 0-2:
$4,680 2.783 discount factor

$7,200
(2,520)
$4,680
$13,024

Because Ms. ZH has $40,000 passive activity income in years 0 and 1, she can deduct the
losses generated by Investment P. Consequently, NPV of cash flows from Investment P is
$14,668.
Year
0
1
2
NPV

Cash flow
-0-0$23,000

Taxable Income/
(Deductible Loss)

(Tax Cost)/
Tax Savings

$(25,000)
(25,000)
73,000

$8,750
8,750
(25,550)

Therefore, Investment P is the superior investment.

16-15

Net Cash
Flow
$8,750
8,750
(2,550)

Present
Value
$8,750
8,103
(2,185)
$14,668

Chapter16InvestmentandPersonalFinancialPlanning
6.

a. If Ms. BB invests in the TNB Limited Partnership, her $8,000 partnership income would be
passive activity income. Therefore, she could deduct her $5,700 suspended passive activity
loss in 2008. Her net taxable income would be $2,300, her tax cost at 25% would be $575,
and her after-tax income would be $7,425 ($8,000 partnership income $575 tax cost),
which represents a 7.425% return on her $100,000 investment.
If Ms. BB invests in the bond fund, her $10,000 interest income would be portfolio
income. Because she has no passive activity income, she could not deduct her suspended
passive activity loss in 2008. Her net taxable income would be $10,000, her tax cost at 25%
preferential rate would be $2,500, and her after-tax income would be $7,500 ($10,000
interest $2,500 tax cost), which represents a 7.5% return on her annual investment. Thus,
the mutual fund is the better investment.
b. If Ms. BB invests in the TNB Limited Partnership, her $8,000 partnership income would be
passive activity income. Therefore, she could deduct her $5,700 suspended passive activity
loss in 2008. Her net taxable income would be $2,300, her tax cost at 35% would be $805,
and her after-tax income would be $7,195 ($8,000 partnership income $805 tax cost),
which represents a 7.195% return on her $100,000 investment.
If Ms. BB invests in the bond fund, her $10,000 interest income would be portfolio
income. Because she has no passive activity income, she could not deduct her suspended
passive activity loss in 2008. Her net taxable income would be $10,000, her tax cost at 35%
preferential rate would be $3,500, and her after-tax income would be $6,500 ($10,000
interest $3,500 tax cost), which represents a 6.5% return on her annual investment. Thus,
the partnership interest is the better investment.

16-16