Tax Midterm Exam
portfolio income - interest and dividends - ANS types of investment if a taxpayer wants a steady
stream of cash flows from the investment:
-debt instruments which generate interest income. ex CDs, savings accounts, corporate bonds,
government bonds
-direct equity investments which generate regular dividend payments. ex investments in dividend
paying corporate stocks or mutual funds
portfolio income - interest - ANS taxpayers interest income form interest paying investment when
taxpayers receive the interest payments
interest paying investment's after tax rate of return = PTR x (1-MTR)
interest paying investment's after tax future value = I x (1+r)^n
for bonds, the formulas assume that the bonds are purchased at face value. special rules apply for
determining the timing and amount of interest from bonds when there is a bond discount or a bond
premium
Arlo recently deposited 30000 in a savings account paying a guaranteed interest rate of 6 percent for
the next 10 years
if arlo 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
(b) Assuming he leaves his after-tax earnings in his savings account, how much interest will Arlo earn
after-tax for the second year of his investment? - ANS after tax rate of return = PTR x (1-MTR) = 6% -
(1-20%) = 4.8%
first year after tax earnings = 30000 x 4.8% = 1440
second year after tax earnings = (30000 + 1440) x 4.8% = 1509
Arlo recently deposited $30,000 in a savings account paying a guaranteed interest rate of 6 percent
for the next 10 years. Expects marginal tax rate to be 20 percent for the next 10 years. (c) 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? - ANS after tax future value = I x (1+r)^n = 30000 x (1+.048)4 = 36188
treasury bonds - ANS always pay interest
,pay stated rate of interest semi-annually
interest is exempt from state tax
less risk
corporate bonds - ANS may or may not pay interest
corporate bonds that pay interest do so at the stated coupon rate and make payments periodically
corporate bonds that do not pay interest = zero coupon bonds
interest subject to state tax
generally riskier
US treasury bonds v corporate bonds purchased from issuer - ANS interest income from corporate
and US treasury bonds included in income:
-when the bond is issued at face value (price=par), interest payments are included in income as they
are received
-when the bond is issued at a discount (price<par), TP will include in income interest payments
actually received during the year and the current year amortization of the original issue discount
(provided by bond issuer)
-when the bond was issued at premium (price>par), include interest payments actually received
during the year and current year amortization of the premium (if TP elects to amortize the premium)
tp must do the amortizations, subtracted from interest payment
corporate and US treasury bonds purchased on secondary market - ANS purchased at a discount
-interest payments included as received
-when bond matures, the entire market discount is included as interest income or
-if the bond is sold prior to maturity, a ratable amount of the market discount is treated as interest
income on the data of sale
--accrued market discount: (# days bond held/#days until maturity when bond is purchased)*market
discount
purchased at premium
-same as bond originally issued at premium
US savings bond - ANS do not pay periodic interest
,-accumulated interest is paid at maturity or redemption
tp recognizes interest when they redeem the bond
interest income = excess of the bond's proceeds over the price of the bond
At the beginning of his current tax year Rachel invests $12,000 in original issue U.S. Treasury bonds
with a $10,000 face value that mature in exactly 10 years. Rachel receives $700 in interest (i.e.,
stated annual interest rate of 7%; $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 Rachel report this year if she elects to amortize the bond
premium?
b)How much interest will she report this year if she does not elect to amortize the bond premium? -
ANS Period 1:
adj basis 12000
cash 350
income 300
amort 50
Period 2:
adj basis 11950
cash 350
income 299
amort 51
cash calculated as 1/2 x .07 x face value = 350
income calculated as 1/2 x .05 x adj basis = 300 and 299
a) interest income = 700-101=599
b) interest income = 700
dividends - ANS taxed annually when the dividend is recieved
qualifed dividends are taxed at 0, 15, or 20% preferential rate depending on taxpayer's filing status
what requirements must be met for a dividend to be a qualified dividend - ANS domestic of certain
qualified foreign income
, must hold the stock for more than 60 days during the 121 day period that begins 60 days before the
ex-dividend date (the first day on which the purchaser of the stock would not be entitled to receive a
declared dividend on the stock)
Raylan, a single taxpayer, invests $10,000 in preferred shares with a dividend rate of 6%. The
dividends are qualified dividends and his MTR is 35%. [Assume dividend rate and tax rate are
constant over time]. Assume his taxable income is $250,000.
(a)Assuming Raylan reinvests the after-tax dividend income in additional preferred shares, what is
his accumulated balance in preferred shares after 3 years?
(b)What is Raylan's after tax return in each year?
(c) Assuming Raylan withdraws the after-tax dividend income each year, how much dividend income
will he have earned after 3 years? - ANS a)
Step 1: .06 (1-.15) = 5.1%
Step 2: 10000(1.051)^3 = 11609
b)
5.1% dividends are taxed annually
c)
year 1: 10000 x 5.1% = 510
year 2: 10000 x 5.1% = 510
year 3: 10000 x 5.1% = 510
sum = 1530
portfolio income: capital gains and losses - ANS capital assets are typically investment type assets
and personal use assets
realized gain (or loss) = amount realized - adjusted basis
why are the advantages of investing in capital assets from a tax perspective - ANS gains are deferred
for tax purposes until the TP disposes of the assets
gains are generally taxed at preferential rates
types of capital gains and losses - ANS short term capital gains:
-holding period <1 year
-taxed at ordinary rates
portfolio income - interest and dividends - ANS types of investment if a taxpayer wants a steady
stream of cash flows from the investment:
-debt instruments which generate interest income. ex CDs, savings accounts, corporate bonds,
government bonds
-direct equity investments which generate regular dividend payments. ex investments in dividend
paying corporate stocks or mutual funds
portfolio income - interest - ANS taxpayers interest income form interest paying investment when
taxpayers receive the interest payments
interest paying investment's after tax rate of return = PTR x (1-MTR)
interest paying investment's after tax future value = I x (1+r)^n
for bonds, the formulas assume that the bonds are purchased at face value. special rules apply for
determining the timing and amount of interest from bonds when there is a bond discount or a bond
premium
Arlo recently deposited 30000 in a savings account paying a guaranteed interest rate of 6 percent for
the next 10 years
if arlo 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
(b) Assuming he leaves his after-tax earnings in his savings account, how much interest will Arlo earn
after-tax for the second year of his investment? - ANS after tax rate of return = PTR x (1-MTR) = 6% -
(1-20%) = 4.8%
first year after tax earnings = 30000 x 4.8% = 1440
second year after tax earnings = (30000 + 1440) x 4.8% = 1509
Arlo recently deposited $30,000 in a savings account paying a guaranteed interest rate of 6 percent
for the next 10 years. Expects marginal tax rate to be 20 percent for the next 10 years. (c) 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? - ANS after tax future value = I x (1+r)^n = 30000 x (1+.048)4 = 36188
treasury bonds - ANS always pay interest
,pay stated rate of interest semi-annually
interest is exempt from state tax
less risk
corporate bonds - ANS may or may not pay interest
corporate bonds that pay interest do so at the stated coupon rate and make payments periodically
corporate bonds that do not pay interest = zero coupon bonds
interest subject to state tax
generally riskier
US treasury bonds v corporate bonds purchased from issuer - ANS interest income from corporate
and US treasury bonds included in income:
-when the bond is issued at face value (price=par), interest payments are included in income as they
are received
-when the bond is issued at a discount (price<par), TP will include in income interest payments
actually received during the year and the current year amortization of the original issue discount
(provided by bond issuer)
-when the bond was issued at premium (price>par), include interest payments actually received
during the year and current year amortization of the premium (if TP elects to amortize the premium)
tp must do the amortizations, subtracted from interest payment
corporate and US treasury bonds purchased on secondary market - ANS purchased at a discount
-interest payments included as received
-when bond matures, the entire market discount is included as interest income or
-if the bond is sold prior to maturity, a ratable amount of the market discount is treated as interest
income on the data of sale
--accrued market discount: (# days bond held/#days until maturity when bond is purchased)*market
discount
purchased at premium
-same as bond originally issued at premium
US savings bond - ANS do not pay periodic interest
,-accumulated interest is paid at maturity or redemption
tp recognizes interest when they redeem the bond
interest income = excess of the bond's proceeds over the price of the bond
At the beginning of his current tax year Rachel invests $12,000 in original issue U.S. Treasury bonds
with a $10,000 face value that mature in exactly 10 years. Rachel receives $700 in interest (i.e.,
stated annual interest rate of 7%; $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 Rachel report this year if she elects to amortize the bond
premium?
b)How much interest will she report this year if she does not elect to amortize the bond premium? -
ANS Period 1:
adj basis 12000
cash 350
income 300
amort 50
Period 2:
adj basis 11950
cash 350
income 299
amort 51
cash calculated as 1/2 x .07 x face value = 350
income calculated as 1/2 x .05 x adj basis = 300 and 299
a) interest income = 700-101=599
b) interest income = 700
dividends - ANS taxed annually when the dividend is recieved
qualifed dividends are taxed at 0, 15, or 20% preferential rate depending on taxpayer's filing status
what requirements must be met for a dividend to be a qualified dividend - ANS domestic of certain
qualified foreign income
, must hold the stock for more than 60 days during the 121 day period that begins 60 days before the
ex-dividend date (the first day on which the purchaser of the stock would not be entitled to receive a
declared dividend on the stock)
Raylan, a single taxpayer, invests $10,000 in preferred shares with a dividend rate of 6%. The
dividends are qualified dividends and his MTR is 35%. [Assume dividend rate and tax rate are
constant over time]. Assume his taxable income is $250,000.
(a)Assuming Raylan reinvests the after-tax dividend income in additional preferred shares, what is
his accumulated balance in preferred shares after 3 years?
(b)What is Raylan's after tax return in each year?
(c) Assuming Raylan withdraws the after-tax dividend income each year, how much dividend income
will he have earned after 3 years? - ANS a)
Step 1: .06 (1-.15) = 5.1%
Step 2: 10000(1.051)^3 = 11609
b)
5.1% dividends are taxed annually
c)
year 1: 10000 x 5.1% = 510
year 2: 10000 x 5.1% = 510
year 3: 10000 x 5.1% = 510
sum = 1530
portfolio income: capital gains and losses - ANS capital assets are typically investment type assets
and personal use assets
realized gain (or loss) = amount realized - adjusted basis
why are the advantages of investing in capital assets from a tax perspective - ANS gains are deferred
for tax purposes until the TP disposes of the assets
gains are generally taxed at preferential rates
types of capital gains and losses - ANS short term capital gains:
-holding period <1 year
-taxed at ordinary rates
