Interactive Review
Course #10071
Investment Income & Expenses
8A. True – Incorrect Return
The amount of losses and tax credits you can claim from passive activities is limited. You are generally allowed to deduct passive activity losses only up to the amount of your passive activity income. Also, you can use credits from passive activities only against tax on the income from passive activities. There are exceptions for certain activities, such as rental real estate activities.
8B. False – Correct Return
You may not generally deduct passive activity losses in excess of the amount of your passive activity income. A passive activity generally is any activity involving the conduct of any trade or business in which you do not materially participate and any rental activity. However, if you are involved in renting real estate, the activity is not a passive activity if both of the following are true.
1. More than one-half of the personal services you perform during the year in all trades or
businesses are performed in real property trades or businesses in which you
materially participate.
2. You perform more than 750 hours of services during the year in real property trade
or businesses in which you materially participate.
The term “trade or business” generally means any activity that involves the conduct of a trade or business, is conducted in anticipation of starting a trade or business, or involves certain research or experimental expenditures. However, does not include rental activities or certain activities treated as incidental to holding property for investment. You are considered to materially participate in an activity if you are involved on a regular, continuous, and substantial basis in the operations of the activity.
9A. True – Correct Return
If you borrow money to buy property you hold for investment, the interest you pay is investment interest. You can deduct investment interest subject to the limits. Generally, your deduction for investment interest expense is limited to the amount of your net investment income. You can carry over the amount of investment interest that you could not deduct because of this limit to the next tax year. The interest carried over is treated as investment interest paid or accrued in that next year. You can carry over disallowed investment interest to the next tax year even if it is more than your taxable income in the year the interest was paid or accrued. However, you cannot deduct interest you incurred to produce tax-exempt income. Nor can you deduct interest expenses on straddles. Investment interest does not include any qualified home mortgage interest or any interest taken into account in computing income or loss from a passive activity.
9B. False – Incorrect Return
If you borrow money to buy property you hold for investment, the interest you pay is investment interest. You can deduct investment interest subject to the limits. However, you cannot deduct interest you incurred to produce tax-exempt income. Investment interest does not include any qualified home mortgage interest or any interest taken into account in computing income or loss from a passive activity. Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. It also includes property that produces gain or loss (not derived in the ordinary course of a trade or business) from the sale or trade of property producing these types of income or held for investment (other than an interest in a passive activity). Investment property also includes an interest in a trade or business activity in which you did not materially participate (other than a passive activity).
10A. True – Incorrect Return
Some expenses that you incur as an investor are not deductible. You may have expenses that are for both tax-exempt and taxable income. If you can not specifically identify what part of the expenses is for each type of income, you can divide the expenses, using reasonable proportions based on facts and circumstances. You must attach a statement to your return showing how you divided the expenses and stating that each deduction claimed is not based on tax-exempt income.
10B. False – Correct Return
You may have expenses that are for both tax-exempt and taxable income. If you can not specifically identify what part of the expenses is for each type of income, you can divide the expenses, using reasonable proportions based on facts and circumstances. You must attach a statement to your return showing how you divided the expenses and stating that each deduction claimed is not based on tax-exempt income. One accepted method for dividing expenses is to do it in the same proportion that each type of income is to the total income. If the expenses relate in part to capital gains and losses, include the gains, but not the losses, in figuring this proportion. To find the part of the expenses that is for the tax-exempt income, divide your tax-exempt income by the total income and multiply your expenses by the result.
Example. You received $6,000 interest; $4,800 was tax-exempt and $1,200 was taxable. In earning this income, you had $500 of expenses. You cannot specifically identify the Amount of each expense item that is for each income item, so you must divide your expenses. 80% ($4,800 tax-exempt interest divided by $6,000 total interest) of your expenses is for the tax-exempt income. You cannot deduct $400 (80% of $500) of the expenses. You can deduct $100 (the rest of the expenses) because they are for the taxable interest.
11A. True – Incorrect Return
Ordinarily, a transaction is not a trade when you voluntarily sell property for cash and immediately buy similar property to replace it. The sale and purchase are two separate transactions. If you trade business or investment property for other business or investment property of a like kind, you do not pay tax on any gain or deduct any loss until you sell or dispose of the property you receive. To be nontaxable, a trade must meet six conditions. Under a different rule, you can exchange common stock for common stock or preferred stock for preferred stock in the same corporation without having a recognized gain or loss. This is true for a trade between two stockholders as well as a trade between a stockholder and the corporation.
11B. False – Correct Return
The sale and purchase are two separate transactions. When you voluntarily sell property for cash and immediately buy similar property to replace it, the transaction is ordinarily not a trade. A sale is generally a transfer of property for money or a mortgage, note, or other promise to pay money. A trade is a transfer of property for other property or services, and may be taxed in the same way as a sale.
12A. True – Correct Return
If you received investment property in trade for other property, the basis of the new property is its fair market value at the time of the trade unless you received the property in a nontaxable trade. The basis of property you buy is usually its cost. The cost is the amount you pay in cash, debt obligations, or other property or services. Basis is a way of measuring your investment in property for tax purposes. You must know the basis of your property to determine whether you have a gain or loss on its sale or other disposition. Investment property you buy normally has an original basis equal to its cost. If you get property in some way other than buying it, such as by gift or inheritance, its fair market value may be important in figuring the basis.
12B. False – Incorrect Return
The basis of investment property received for other property in a taxable trade, is its fair market value at the time of trade.
Example. You trade A Company stock for B Company stock having a fair market value of $1,200. If the adjusted basis of the A Company stock is less than $1,200, you have a taxable gain on the trade. If the adjusted basis of the A Company stock is more than $1,200, you have a deductible loss on the trade. The basis of your B Company stock is $1,200. If you later sell the B Company stock for $1,300, you will have a gain of $100.
If you have a nontaxable trade, you do not recognize gain or loss until you dispose of the property you received in the trade. The basis of property you received in a nontaxable or partly nontaxable trade is generally the same as the adjusted basis of the property you gave up. Increase this amount by any cash you paid, additional costs you had, and any gain recognized. Reduce this amount by any cash or unlike property you received, any loss recognized, and any liability of yours that was assumed or treated as assumed.
13A. True – Correct Return
A debt against the property, against you, that is paid off as a part of the transaction or that is assumed by the buyer must be included in the amount realized. This is true even if neither you nor the buyer is personally liable for the debt. For example, if you sell or trade property that is subject to a non-recourse loan, the amount you realize generally includes the full amount of the note assumed by the buyer even if the amount of the note is more than the fair market value of the property.
Example. You sell stock that you had pledged as security for a bank loan of $8,000. Your basis in the stock is $6,000. The buyer pays off your bank loan and pays you $20,000 in cash. The amount realized is $28,000 ($20,000 plus $8,000). Your gain is $22,000 ($28,000 minus $6,000).
13B. False – Incorrect Return
If you sell or trade property that is subject to a non-recourse loan, the amount you realize generally includes the full amount of the note assumed by the buyer even if the amount of the note is more than the fair market value of the property. You figure gain or loss on a sale or trade of property by comparing the amount you realize with the adjusted basis of the property. If the amount you realize from a sale or trade is more than the adjusted basis of the property you transfer, the difference is a gain. If the adjusted basis of the property you transfer is more than the amount you realize, the difference is a loss. The amount you realize from a sale or trade of property is everything you receive for the property. This includes the money you receive plus the fair market value of any property or services you receive. A debt against the property, or against you, that is paid off as a part of the transaction or that is assumed by the buyer must be included in the amount realized.
14A. True – Incorrect Return
If you trade business or investment property for other business or investment property of a like kind, you do not pay tax on any gain or deduct any loss until you sell or dispose of the property you receive. If you give up unlike property in addition to the like property, you must recognize gain or loss on the unlike property you give up. The gain or loss is the difference between the adjusted basis of the unlike property and its fair market value. You must report the trade of like property on Form 8824. If you figure a recognized gain or loss on Form 8824, report it on Schedule D (Form 1040) or on Form 4797, Sales of Business Property, whichever applies.
14B. False – Correct Return
You do not pay tax on any gain or deduct any loss until you sell or dispose of the property you receive, if you trade business or investment property for other business or investment property of a like kind. To be nontaxable, a trade must meet all six of the following conditions.
1. The property must be business or investment property. You must hold both theproperty you trade and the property you
receive for productive use in your trade or business or for investment. Neither property may be property used for
personal purposes, such as your home or family car.
2. The property must not be held primarily for sale. The property you trade and the property you receive must not be
property you sell to customers, such as merchandise.
3. The property must not be stocks, bonds, notes, choses in action, certificates of trust or beneficial interest, or other
securities or evidences of indebtedness or interest, including partnership interests. However, you can have a nontaxable
trade of corporate stocks under a different rule.
4. There must be a trade of like property. The trade of real estate for real estate, or personal property for similar personal
property, is a trade of like property. The trade of an apartment house for a store building, or a panel truck for a pickup
truck, is a trade of like property. The trade of a piece of machinery for a store building is not a trade of like property. Real
property located in the United States and real property located outside the United States are not like property. Also,
personal property used predominantly within the United States and personal property used predominantly
outside the United States are not like property.
5. The property to be received must be identified in writing within 45 days after the date you transfer the property given up in
the trade. If you received the replacement property before the end of the 45-day period, you automatically are treated as
having met the 45-day written notice requirement.
6. The property to be received must be received by the earlier of:
a. The 180th day after the date on which you transfer the property given up in the trade, or
b. The due date, including extensions, for your tax return for the year in which the transfer of the property given up occurs.
If you trade property with a related party in a like-kind exchange, a special rule may apply.
15A. True – Correct Return
If you sell or trade at a loss property that you acquired from a related party, you cannot recognize the loss that was not allowed to the related party.
Example Your brother sells you stock for $7,600. His cost basis is $10,000. Your brother cannot deduct the loss of $2,400. Later, you sell the same stock to an unrelated party for $10,500, realizing a gain of $2,900. Your reportable gain is $500 — the $2,900 gain minus the $2,400 loss not allowed to your brother.
15B. False – Incorrect Return
You cannot recognize the loss that was not allowed to the related party, if you sell or trade at a loss property that you acquired from a related party. If you sell or trade at a gain property that you acquired from a related party, you recognize the gain only to the extent that it is more than the loss previously disallowed to the related party. This rule applies only if you are the original transferee and you acquired the property by purchase or exchange. This rule does not apply if the related party’s loss was disallowed because of the wash sale rules.
Example Your brother sells you stock for $7,600. His cost basis is $10,000. Your brother cannot deduct the loss of $2,400. Later, you sell the same stock to an unrelated party for $6,900, realizing a loss of $700— your $7,600 basis minus $6,900. You cannot deduct the loss that was not allowed to your brother.
16A. True – Incorrect Return
Any property you own is a capital asset, except the following non-capital assets.
1. Property held mainly for sale to customers or property that will physically become a part of the merchandise that is for sale to customers.
2. Depreciable property used in your trade or business, even if fully depreciated.
3. Real property used in your trade or business.
4. A copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property —
a. Created by your personal efforts,
b. Prepared or produced for you (in the case of a letter, memorandum, or similar property), or
c. Acquired under circumstances (for example, by gift) entitling you to the basis of the person who created the property or for whom it was prepared or produced.
5. Accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of property described in (1).
6. U.S. Government publications that you received from the government for free or for less than the normal sales price, or that you acquired under circumstances entitling you to the basis of someone who received the publications for free or for less than the normal sales price.
7. Certain commodities derivative financial instruments held by commodities derivatives dealers. For more information, see
section 1221 of the Internal Revenue Code.
8. Hedging transactions, but only if the transaction is clearly identified as a hedging transaction before the close of the day on
which it was acquired, originated, or entered into.
9. Supplies of a type you regularly use or consume in the ordinary course of your trade or business.
16B. False – Correct Return
Property held mainly for sale to customers or property that will physically become a part of the merchandise that is for sale to customers are non-capital assets. You need to classify your gains and losses as either ordinary or capital gains or losses. You then need to classify your capital gains and losses as either short term or long term. If you have long-term gains and losses, you must identify your 28% rate gains and losses. If you have a net capital gain, you must also identify any unrecaptured section 1250 gain.
17A. True – Correct Return
For securities traded on an established securities market, your holding period begins the day after the trade date you bought the securities, and ends on the trade date you sold them. Do not confuse the trade date with the settlement date, which is the date by which the stock must be delivered and payment must be made.
Example. You are a cash method, calendar year taxpayer. You sold stock at a gain on December 29, 2009. According to the rules of the stock exchange, the sale was closed by delivery of the stock 3 trading days after the sale, on January 3, 2010. You received payment of the sale price on that same day. Report your gain on your 2009 return, even though you received the payment in 2010. The gain is long term or short term depending on whether you held the stock more than 1 year. Your holding period ended on December 29. If you had sold the stock at a loss, you would also report it on your 2009 return.
17B. False – Incorrect Return
Your holding period begins the day after the trade date you bought the securities, and ends on the trade date you sold them, for securities traded on an established securities market. If you sold or traded investment property, you must determine your holding period for the property. Your holding period determines whether any capital gain or loss was a short-term or a long-term capital gain or loss. If you hold investment property more than 1 year, any capital gain or loss is a long-term capital gain or loss. If you hold the property 1 year or less, any capital gain or loss is a short-term capital gain or loss.
To determine how long you held the investment property, begin counting on the date after the day you acquired the property. The day you disposed of the property is part of your holding period.
Example. If you bought investment property on February 5, 2009, and sold it on February 5, 2010, your holding period is not more than 1 year and you have a short-term capital gain or loss. If you sold it on February 6, 2010, your holding period is more than 1 year and you have a long-term capital gain or loss.
18A. True – Correct Return
Generally, you determine whether you have short-term or long-term capital gain or loss on a short sale by the amount of time you actually hold the property eventually delivered to the lender to close the short sale.
Example. Even though you do not own any stock of the Ace Corporation, you contract to sell 100 shares of it, which you borrow from your broker. After 13 months, when the price of the stock has risen, you buy 100 shares of Ace Corporation stock and immediately deliver them to your broker to close out the short sale. Your loss is a short-term capital loss because your holding period for the delivered property is less than one day.
18B. False – Incorrect Return
The amount of time you actually hold the property eventually delivered to the lender to close the short sale, generally determines whether you have short-term or long-term capital gain or loss on a short sale. A short sale occurs when you agree to sell property you do not own (or own but do not wish to sell). You make this type of sale in two steps.
1. You sell short. You borrow property and deliver it to a buyer.
2. You close the sale. At a later date, you either buy substantially identical property and
deliver it to the lender or make delivery out of property that you held at the time of thesale.
Delivery of property borrowed from another lender does not satisfy this requirement. You do not realize gain or loss until delivery of property to close the short sale. You will have a capital gain or loss if the property used to close the short sale is a capital asset.
19A. True – Incorrect Return
Loss from a wash sale of one block of stock or securities cannot be used to reduce any gains on identical blocks sold the same day.
Example. During 2002, you bought 100 shares of X stock on each of three occasions. You paid $158 a share for the first block of 100 shares, $100 a share for the second block, and $95 a share for the third block. On December 23, 2009, you sold 300 shares of X stock for $125 a share. On January 6, 2010, you bought 250 shares of identical X stock. You cannot deduct the loss of $33 a share on the first block because within 30 days after the date of sale you bought 250 identical shares of X stock. In addition, you cannot reduce the gain realized on the sale of the second and third blocks of stock by this loss.
19B. False – Correct Return
Gains on identical blocks sold the same day, cannot be reduced by any loss from a wash sale of one block of stock or securities. You cannot deduct losses from sales or trades of stock or securities in a wash sale. A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:
1. Buy substantially identical stock or securities,
2. Acquire substantially identical stock or securities in a fully taxable trade, or
3. Acquire a contract or option to buy substantially identical stock or securities.
If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale. If your loss was disallowed because of the wash sale rules, add the disallowed loss to the cost of the new stock or securities. The result is your basis in the new stock or securities. This adjustment postpones the loss deduction until the disposition of the new stock or securities. Your holding period for the new stock or securities begins on the same day as the holding period of the stock or securities sold.
Example 1. You buy 100 shares of X stock for $1,000. You sell these shares for $750 and within 30 days from the sale you buy 100 shares of the same stock for $800. Because you bought substantially identical stock, you cannot deduct your loss of $250 on the sale. However, you add the disallowed loss of $250 to the cost of the new stock, $800, to obtain your basis in the new stock, which is $1,050.
20A. True – Correct Return
If you buy a call or a put, you may not deduct its cost. It is a capital expenditure. If you sell the call or the put before you exercise it, the difference between its cost and the amount you receive for it is either a long-term or short-term capital gain or loss, depending on how long you held it. If the option expires, its cost is either a long-term or short-term capital loss, depending on your holding period, which ends on the expiration date. If you exercise a call, add its cost to the basis of the stock you bought. If you exercise a put, reduce your amount realized on the sale of the underlying stock by the cost of the put when figuring your gain or loss. Any gain or loss on the sale of the underlying stock is long term or short term depending on your holding period for the underlying stock.
20B. False – Incorrect Return
If you buy a call or a put, it is a capital expenditure and you may not deduct its cost. Gain or loss from the sale or trade of an option to buy or sell property that is a capital asset in your hands, or would be if you acquired is capital gain or loss.
Example 1. You purchased an option to buy 100 shares of XYZ Company stock. The stock increases in value and you sell the option for more than you paid for it. Your gain is capital gain because the stock underlying the option would have been a capital asset in your hands.
Example 2. The facts are the same as in Example 1, except that the stock decreases in value and you sell the option for less than you paid for it. Your loss is a capital loss.
If you have a loss because you did not exercise an option to buy or sell, you are considered to have sold or traded the option on the date that it expired.
21A. True – Correct Return
You may qualify for a tax-free rollover of certain gains from the sale of publicly traded securities. This means that if you buy certain replacement property and make the choice described in this section, you postpone part or all of your gain. You postpone the gain by adjusting the basis of the replacement property. This postpones your gain until the year you dispose of the replacement property. You qualify to make this choice if you meet all the following tests.
1. You sell publicly traded securities at a gain. Publicly traded securities are securities traded on an established securities market.
2. Your gain from the sale is a capital gain.
3. During the 60-day period beginning on the date of the sale, you buy replacement property. This replacement property must be either common stock or a partnership interest in a specialized small business investment company (SSBIC). This is any
partnership or corporation licensed by the Small Business Administration under section 301(d) of the Small Business Investment Act of 1958, as in effect on May 13, 1993.
21B. False – Incorrect Return
You may qualify for a tax-free rollover of certain gains from the sale of publicly traded securities when you purchase as replacement property, either common stock or a partnership interest in a specialized small business investment company (SSBIC). You postpone the gain by adjusting the basis of the replacement property. The amount of gain you can postpone each year is limited to the smaller of:
1. $50,000 ($25,000 if you are married and file a separate return), or
2. $500,000 ($250,000 if you are married and file a separate return), minus the amount
of gain you postponed for all earlier years.
Report the entire gain realized from the sale on line 1 or line 8 of Schedule D (Form 1040), whichever is appropriate. To make the choice to postpone gain, enter “SSBIC Rollover” in column (a) of the line directly below the line on which you reported the gain. Enter the amount of gain postponed in column (f). Enter it as a loss (in parentheses). Also, attach a schedule showing how you figured the postponed gain, the name of the SSBIC in which you purchased common stock or a partnership interest, the date of that purchase, and your new basis in that SBIC stock or partnership interest. You must make the choice to postpone gain no later than the due date (including extensions) for filing your tax return for the year in which you sold the securities. If your original return was filed on time, you may make the choice on an amended return filed no later than 6 months after the due date of your return (excluding extensions). Enter “Filed pursuant to section 301.9100-2” at the top of the amended return, and file it at the same address you used for your original return. Your choice is revocable with the consent of the IRS.
22A. True – Correct Return
Gains and losses from selling securities as part of a trading business are not subject to self-employment tax. This is true whether the election is made or not. Special rules apply if you are a trader in securities in the business of buying and selling securities for your own account. To be engaged in business as a trader in securities, you must meet all the following conditions.
• You must seek to profit from daily market movements in the prices of securities and
not from dividends, interest, or capital appreciation.
• Your activity must be substantial.
• You must carry on the activity with continuity and regularity.
22B. False – Incorrect Return
Transactions from trading activities result in capital gains and losses and must be reported on Schedule D (Form 1040). Losses from these transactions are subject to the limit on capital losses. These gains and losses as part of a trading business are not subject to self-employment tax. The following facts and circumstances should be considered in determining if your activity is a securities trading business.
• Typical holding periods for securities bought and sold.
• The frequency and dollar amount of your trades during the year.
• The extent to which you pursue the activity to produce income for a livelihood.
• The amount of time you devote to the activity.
If your trading activities are not a business, you are considered an investor, and not a trader. It does not matter whether you call yourself trader or a “day trader.” You may be a trader in some securities and have other securities you hold for investment.
Copyright © 2010 By
CPE Accounting and Tax Institute
All Rights Reserved