Chapter 7: Interest, Dividends, Capital Gains, etc.

1. It would be unwise to make an investment without considering the tax cost, as two
investments with identical before-tax rates of return may generate different after-tax rates of
return if investment income is taxed differently.
2. Investment income may be taxed at ordinary rates (interest, ordinary dividends, short-term
capital gains), preferred rates (qualified dividends, long-term capital gains), or may be tax-
exempt (muni interest).

Interest Income:

Dividend Income:

 Qualified Dividends:

Capital Gains and Losses:

If a taxpayer disposes of a capital asset, the resulting gain or loss realized is a capital gain or
capital loss.
What is a capital asset?
Unrealized gains and losses are not included in taxable income. You only report gains or losses
when an asset is sold. To calculate realized gain or loss:

Amount Realized (Sales Proceeds)

(Adjusted basis in Investment)
Realized gain/loss

 Adjusted basis includes any fees associated with the purchase of the asset.
 Amount realized is reduced by any selling fees associated with the sale of the asset.
 If you deal through a broker, you will receive a 1099-B for all stock sales, reporting the
amount realized and adjusted basis in each security sold during the year.

Rules for capital gains and losses:

 A net capital gain is included in taxable income
 Holding period matters:
o Short-term capital gains are taxed at the taxpayer’s marginal rate (ordinary income)
 Short-term capital gains result from sales of capital assets held for one year or
less
o Long-term capital gains are taxed at the taxpayer’s preferred rate
 Long-term capital gains result from sales of capital assets held for more than
one year
 What about a net capital loss?

Note: Personal use assets are capital assets. If a taxpayer sells a personal use asset for a gain, that
gain is taxable income (for example, a taxpayer sells jewelry for more than the purchase price). If
a taxpayer sells a personal use asset for a loss, however, that loss is non-deductible (for example,
if you sell your car for less than your purchase price). So gains are taxable, losses are non-
deductible when personal use assets are sold.
Netting process for capital gains and losses:
1. Short-term gains and losses are netted together, including any short-term capital loss
carried forward from a prior year
2. Long-term gains and losses are netted together, including any long-term capital loss
carried forward from a prior year
3. If the net short-term gain/loss and the net long-term gain/loss have opposite signs (one is
a gain, one is a loss), net them together. If they have the same sign, do not net them
together.

Example:
STCG 15,000
STCL (5,000)
LTCG 15,000
LTCL (10,000)

Net the short term items together = 10,000 gain

Net the long term items together = 5,000 gain
They have the same sign – do not net together. ST is taxed at ordinary rates; LT is taxed
at preferred rates.

Example:
STCG 15,000
STCL (5,000)
LTCG 5,000
LTCL (10,000)

Net the short term items together = 10,000 gain

Net the long term items together = (5,000) loss
They have different signs – net together for a $5,000 short-term gain, taxed at ordinary
rates.

Example:
STCG 15,000
STCL (5,000)
LTCG 5,000
LTCL (20,000)

Net the short term items together = 10,000 gain

Net the long term items together = (15,000) loss
They have different signs, so net together = (5,000) net long-term loss

The taxpayer can deduct 3,000 against ordinary income, the remaining 2,000 loss
becomes a carry forward to the next tax year

Assume that next year, the taxpayer has no capital transactions. The taxpayer can deduct
$2,000 against ordinary income (up to $3,000 per year)
Examples:

John bought 1,000 shares of Intel stock on October 18, 2011 for $30 per share plus a $750
commission he paid to his broker. On December 12, 2018, he sells the shares for $42.50 per
share. He also incurs a $1,000 fee for this transaction.

a. What is John’s adjusted basis in the 1,000 shares of Intel stock?

b. What amount does John realize when he sells the 1,000 shares?

c. What is the gain/loss for John on the sale of his Intel stock? What is the character
of the gain/loss?

Jeb Landers has recently retired and now wants to pursue his life-long dream of owning a
sailboat. To come up with the necessary cash, he sells the following investments:

Stock Market Value Basis Scenario 1 Type Scenario 2 Type

A $40,000 $ 5,000 Long Short
B  20,000  30,000 Long Short
C  20,000  12,000 Short Long
D  17,000  28,000 Short Long

What is the amount and nature of Jeb's capital gains and losses (Scenario 1)?

Consider the original facts, except that Scenario 2 dictates the long- and short-term capital gains.
What is the amount and character of Jeb's net gain (or loss) on the sale of the shares in this
situation?
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 $64,000. Meg works part-time at the same
university. She earns $41,000 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.

a. What is the Comers’ tax liability for 2019 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 2019 if Matt earns a salary of $40,000 and they
report the following capital gains and losses for the year?

Short-term capital gains $1,500

Short-term capital losses $0
Long-term capital gains $13,000
Long-term capital losses ($10,000)
Shaun bought 300 shares of Dental Equipment, Inc. several years ago for $10,000. Currently the
stock is worth $8,000. Shaun’s 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)?

Special Rules for Certain Types of Capital Gains

1. Unrecaptured Section 1250 Gain is subject to a maximum tax rate of 25%

a. When individuals sell depreciable real property at a gain, some or all of the gain is
subject to a maximum tax rate of 25%.

2. Gains from the sale of collectibles are taxed at a 28% tax rate.
a. Works of art, any rug or antique, any metal or gem, any stamp or coin, any
alcoholic beverage, or other similar items held for more than one year.

Reporting Capital Gains and Losses

The details of each sale are reported on Form 8949: Description, purchase date, sale date,
proceeds, basis, gain or loss

Taxpayers then use Schedule D to summarize the sales and apply the netting process.
Other Considerations:

 Related party sales

 When taxpayers sell capital assets at a loss to a related party, they are not able to
deduct the loss

 Wash Sale Rules

 These rules apply to taxpayers who sell stock at a loss, to generate a capital loss,
and then immediately buy back the stock because they would like to keep the
investment as part of their portfolio
 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 the sale buys substantially
identical stocks or securities
 Losses generated from wash sales are nondeductible (realized losses are not
recognized)
 But the benefit of the loss is not lost forever. The disallowed loss is added to the
basis of the newly acquired shares of stock

Example: Nick and Rachel Sutton own 100 shares of Cisco stock that they purchased in June
2012 for $50 a share. On December 21, 2019, Nick and Rachel sell the shares for $40 a share to
generate cash for the holidays.

Later, however, Nick and Rachel decide that Cisco might be a good long-term investment. On
January 3, 2020 (13 days later), the Suttons purchase 100 shares of Cisco stock for $41 a share
($4,100).

What is the tax impact of the December 21 sale?

What if the Suttons had only purchased 40 shares of Cisco stock instead of 100 shares on
January 3, 2020?
Rental Income:

Royalty Income:

Medicare Tax on Net Investment Income: