Chapter 16 - Investment and Personal Financial Planning
Chapter 16
Questions and Problems for Discussion
1.

a. Interest on U. S. Treasury bonds is taxable income for federal purposes but tax­exempt for state purposes.
b. Interest on a State bond is tax­exempt for federal purposes but may be taxable income or tax­exempt for state purposes, depending on the taxpayer’s 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 tax­deferred annuity. The value of the tax deferral offered by the annuity is a function of the investor’s 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 TK’s 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 before­tax rate of return)
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Chapter 16 - Investment and Personal Financial Planning 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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Chapter 16 - Investment and Personal Financial Planning
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