Before reviewing taxable income calculation, one should review the basic income tax structure, presented in Figure 11.1. This figure reveals that the first step toward arriving at total tax liability is the calculation of gross income. From this figure, standard or itemized deductions and exemptions are subtracted to arrive at the taxable income. This income is the basis for computing the tentative federal income tax. From this tentative figure, tax credits allowed by law for cer- tain conditions are deducted. Following Figure 11.1, IRS tax form 1040 is repro- duced. One should be comfortable with all lines and items in the 1040 form.
Figure 11.1 Basic Income Tax Structure Source: Author’s own work.
Gross income
Adjustments to gross income
Adjusted gross income Computed tax
Tax credits
Other taxes
Total tax due Deductions
(standard or itemized)
Income remaining after deductions
Exemptions
Taxable income
Input for
Having briefly reviewed the basic income tax structure, we now proceed to a discussion of the procedures for calculating gross income.
Calculation of Gross Income
Calculation of tax liability begins with the computation of total gross income.
Unless specifically excluded by law, gross income comprises all income received in the form of money, property, services, and, in certain circumstances, imputed income. For joint returns, incomes of both spouses must be reported. Based on the source, income also must be divided into several major categories. These are discussed in the following section.
Earned Income. Earned income of employees, which is sometimes called active income, is reported annually on a W-2 form entitled “Wages and Tax Statement,”
or on Form 1099 for self-employed individuals. While salary, commissions, fees, and business profits are the most common forms of earned income, there are additional types of income directly related to gainful employment. An example of this type of income is self-employment income that is reported on Form 1099. Because earned or active income depends on some form of personal activity and remuneration for that activity, losses generally cannot be deducted against this form of income. The only exception is that ordinary and necessary business expenses may be deducted even if that results in a business loss.
Portfolio Income. Portfolio income, which is generated directly from investment activity, consists of interest, dividend income, and capital gains. The current tax law has specific rules governing the reporting of portfolio income and the deduction of losses against this income.
Interest. Interest income includes interest from accounts with banks, credit unions, savings and loan associations, money market funds, and mutual funds.
Interest from the following sources must also be reported as income: (a) Personal notes, (b) loans and mortgages, (c) corporate bonds and debentures, (d) US Treasury bills and bonds, (e) certain taxable municipal bonds, and (f) maturing or annual liquidation of US savings bonds. Generally, the payor sends each income recipient a Form 1099-INT for this income. If the total interest received exceeds
$1,500, the sources of interest must be reported on Schedule B of the tax return.
Dividends. Dividend income results from distribution of earnings and profits that corporations or mutual funds pay to shareholders. The payor generally sends the income recipient a Form 1099-DIV reporting dividend income. As
with interest income, if the total dividend income exceeds $1,500, the sources of income must be detailed on Schedule B of the tax return.
Until 2003, dividends were considered as ordinary income for income tax pur- poses. Under the Jobs and Growth Tax Relief Reconciliation Act of 2003 and the Tax Increase Prevention and Reconciliation Act of 2005, qualifying dividends were taxed at a maximum rate of 15 percent. Beginning in 2013, qualified divi- dends are taxed 20 percent under the American Tax Relief Act of 2012 (Tax Relief Act) only for those taxpayers in the 39.6 percent tax bracket. This legislation extended the 0 and 15 percent capital gains and dividends tax rates for taxpay- ers whose income does not exceed the thresholds set for the highest income tax rate of 39.6 percent. For dividends to be considered “qualifying” (that is, eligible for the lower tax rates), these must be received from domestic or foreign corporations whose stocks are traded on a US securities exchange or another established market. The taxpayer must have held the dividend-paying stock for at least 61 days during the 121-day period beginning 60 days before the ex- dividend date. A longer holding period applies to dividends on certain preferred stocks.
Mutual fund dividends that pass to shareholders are taxable at the special rates to the extent they represent dividends the mutual fund earned on stock, and not other types of fund earnings such as interest.
The dividend received from a mutual insurance company is treated as a nontax- able return of excess premium payment. That is provided it does not exceed accumulated premiums paid. However, if a mutual fund reports capital gains as dividend income, then this income is included on Form 1040 Schedule B. If it is long capital gain, it is reported on Form 1040 Schedule D.
Capital Gains and Losses: An Overview. A capital gain is the profit realized from the sale of a capital asset, which refers to the property owned by an individual for investment purposes or for personal use. For example, stocks and bonds, real estate, furniture, automobiles, and household furnishings are all capital assets.
Gains on property held for personal use must be reported as capital gains, but losses on these assets are not deductible. Gains on investment property, such as stocks and bonds, real estate, and so on, must also be reported as capital gains.
However, capital losses on investments can be fully offset only against capital gains. During any tax year, capital losses in excess of gains can be used to offset up to $3,000 of ordinary income on a dollar-for-dollar basis. Any excess losses realized during the tax year can be carried forward, offsetting capital gains and income in subsequent tax years. The major provisions of the current law affect- ing the treatment of capital gains are presented next.
Capital-Gains-Tax Rates. The maximum tax rate for long-term capital gains (and dividends) is 20 percent for individual taxpayers in the highest income tax rate of 39.6 percent. Capital gains and dividends are at a 0 percent rate for individual taxpayers if their ordinary income is taxed 15 percent or less. Individual taxpay- ers subject to an ordinary income rate greater than 15 percent, but below the top ordinary income tax rate of 39.6 percent, will continue at the 15 percent rate on capital gains and dividends.
High Income Taxpayers. Higher income taxpayers must also pay 3.8 percent addi- tional tax on net investment income to the extent the threshold income is exceeded. Thus, the capital gains and dividend tax rate will be 18.8 percent or 23.8 percent to the extent the 3.8 percent surtax on the net investment income applies to capital gain and dividend income. This tax provision came from health care reform in 2010. Net investment income generally includes amounts from interest, dividends, long and short-term capital gains, royalties, rents, and pas- sive activity income. The tax is levied at the 3.8 percent rate on the lesser of the individuals net investment income or the excess of modified AGI over $250,000 (married and surviving spouses, $125,000 married filing separate, and $200,000 for all other individual taxpayers).
Long Term Versus Short Term. Assets held for one year or less are in the short- term category, while those held for more than one year are in the long-term category. Short-term capital gains are treated as ordinary income. The taxpayer should use Schedule D in Form 1040 to report the sales of assets and obtain the benefits of lower rates on qualifying long-term gains. The following table dis- plays the differences in taxes owed on a $20,000 short-term and long-term gain.
Schedule D in Form 1040 to report the sales of assets and obtain the benefits of lower rates on qualifying long-term gains. The following table displays the dif- ferences in taxes owed on a $20,000 short- and long-term gain.
2015 Tax on a $20,000 Profit from the Sale of an Investment
Tax Bracket Short Term Long Term
10 percent $2,000 $0
15 percent $3,000 $0
25 percent $5,000 $3,000
28 percent $5,600 $3,000
33 percent $6,600 $3,000
35 percent $7,000 $3,000
39.6 percent $7,920 $3,000
Selling and Buying. The lower tax on long-term gains makes the timing of sales important. Investors are required to offset capital gains with capital losses before calculating their tax. If, for example, an investor has already taken long-term gains during the year, it may be advantageous to delay the sale of additional shares that are in a loss position until next year. Since long-term gains are taxed at a lower rate, it is better to use losses to offset more highly taxed regular income.
The maxim against letting taxes dictate investment decisions remains valid.
However, securities whose main appeal is the fully taxed interest income they generate—such as corporate bonds—are at a disadvantage compared with growth stocks and high dividend-paying stocks, whose earnings are subject to lower capital gains rates. Note that gains on the sale of collectibles—such as art, antiques, stamps, gems, and coins—do not benefit from the same low tax rates afforded stocks. The capital gains rate on the profit of collectibles is 28 percent.
Computation of Capital Gains and Losses. Tax rules on capital gains and losses can be explained by examining the following steps required for reporting gains and losses:
Step 1. Calculate the cost or tax basis of the capital asset. The basis is the pur- chase price of the asset, plus expenses incurred in improving the asset, minus depreciation (if applicable).
Step 2. Determine whether each transaction qualifies as a short- or long-term capital gain or loss by documenting the holding period. Then determine the net long-term or short-term capital gain or loss. The formula is:
Net Gain/Loss = Amount Realized – Adjusted Basis
Step 3. Calculate the net short-term capital gain or loss by subtracting short- term losses from short-term gains.
Step 4. Calculate the net long-term capital gain or loss by subtracting long-term losses from long-term gains.
Step 5. Determine the net capital gains amount by combining Steps 3 and 4.
The results of these computations are used to calculate the taxable income. The capital gain or loss reporting rules are summarized in Figure 11.2.
Wash Sales. The wash sale provision, applicable to the sale of stocks and securi- ties, denies the deduction of a loss on the sale or exchange of securities if sub- stantially identical securities are acquired within 30 days prior to, or subsequent to, the sale or exchange. The wash sale rules apply, regardless of whether the
individual voluntarily sells the stock to realize a loss for income tax purposes, is forced to sell, or sells to prevent a bigger loss. A repurchase of substantially iden- tical securities within 30 days before or after the sale at a loss prohibits the deduction. The provisions also apply when the individual enters into an option to acquire substantially similar stocks or securities. The wash sale rules apply only to loss transactions. They do not include transactions involving gains. The nondeductible loss is deferred and added to the purchase price of the reac- quired shares to calculate the tax basis for that asset.
Capital Gains and Sale of Residence. If a homeowner is considering the sale of the principal residence, and the home appreciated in value since it was purchased, or the homeowner has accumulated a lot of deferred profit from previous sales, the current tax law could be of significant value. But the law is still no more sym- pathetic than in previous years to homeowners who wind up selling at a loss.
Here are the salient features of the relevant provisions of the current law.
Figure 11.2 Capital Gain Tax Calculation Source: Author’s own work.
Loss
Loss or
Net long-term or short-term capital
Balance carried forward to offset capital gains
and income in subsequent years Up to $3000 used
to reduce taxable income Gain
Net Long-term capital
Gain Loss
Short-term capital
Gain Loss
Net
Loss Gain
Gain
Taxed as ordinary income or as long-term
capital gain rate
House for Sale. Under the current law, up to $500,000 of current profit is tax free for joint filers ($250,000 for single filers). More important, a homeowner can claim a new $500,000 exemption every two years.
One requirement for tax-free profits generated by a home sale is that the home be the principal residence—but that could include a vacation home of the owner. Of course, some sellers with large accumulated gains may find that
$500,000 does not shelter all their profit. While they may not be able to avoid paying taxes altogether by buying a new home as under prior law, at least on the excess they can pay tax at the lower capital gains rate.
Selling at a Loss. Many people find it unfair that while they may have to pay tax when they sell a home at a profit, they are prohibited from deducting a loss generated by a home sale. Congress did consider allowing a limited ability to deduct such losses. But, since so much home profit escapes taxes, the rationale for deductible losses on home sales was considerably weakened, and Congress dropped the idea.
Passive Income. The tax law provides that losses from passive activities, such as tax shelters, in which an individual does not materially participate, may be used only to offset income from such activities. That is, the passive activity losses may not be used to offset the income from compensation, interest, dividends, nonbusiness capital gains, or active business income. However, passive activity losses can be carried forward and applied against income from passive activities in future years. These losses may also be deducted in the year in which the passive activity is liquidated.
An exception to the passive loss rules applies to certain real estate activities with active participation. Individuals who own at least 10 percent of the rental property and make management decisions, and whose AGI is less than $100,000, can offset regular income with up to $25,000 of rental-related losses. That is pro- vided they actively participated in the rental real estate activity. The maximum special allowance of $25,000 ($12,500 for married individuals filing separate returns and living apart at all times during the year) is reduced by 50 percent of the amount of the individual’s modified AGI that is more than $100,000 ($50,000 if the individual is married filing separately). If the modified AGI is $150,000 or more ($75,000 or more if the individual is married filing separately), the special allowance is phased out. Application of this exception to the passive income rule is demonstrated in Table 11.1.
Active or Passive Income. Not all incomes can be categorized as either active or passive income. Examples of incomes which could be either active or passive
Table 11.1 Allowable Deduction of Real Estate Losses
Assume Carl has annual wages of $70,000 and income from an equipment leasing limited partnership of $3,000
Carl owns and operates a real estate investment property which generates the following tax loss.
Income $35,000
Out-of-pocket operating expense –$30,000
Net operating income $5,000
Less depreciation expense –$10,000
Net tax loss –$5,000
Carl can use the $5,000 loss to offset his $3,000 income from a passive activity, and the remaining $2,000 to offset his ordinary income.
Source: Author’s own work.
include: (a) gains received on dealings in real estate and other property. (b) interest received on securities and loans, and (c) royalties. Expenses related to the generation of income under (a) and (c) may be deducted directly from income, rather than as itemized deductions subject to the 2 percent AGI floor.
Miscellaneous Income. Individuals are taxed on certain types of incomes which do not fall into any of the categories just listed. These include: (a) annuities in excess of the original investment; (b) income from an interest in an estate or trust, excluding the principal of any gift or bequest received; (c) prizes and awards; (d) certain fringe benefits; and (e) up to 85 percent of Social Security benefits received.
Tax-Exempt Income: Municipal Bonds. Municipal bonds are qualifying tax-free bonds issued by municipalities (such as states, cities, and school districts) to raise funds for financing local projects. Interest income from municipal bonds is exempt from federal income tax. The reason is to help municipalities sell bonds and obtain financing for community improvement by making the municipal bond interest rate more attractive than the interest rates on comparable corpo- rate bonds, net of federal and state taxes. However, municipal bond interest could be subject to the alternative minimum tax (AMT; discussed later).
Tax-exempt municipal bonds provide investors with an alternative to investing in taxable corporate bonds and US Treasury instruments. The key question, therefore, becomes: Which of the three types of bonds offers a higher after-tax rate of return? The answer depends on the marginal tax bracket of the investor.
Consider an investor in the 8 percent income tax bracket who wishes to
purchase either a municipal bond paying 8 percent or a corporate bond of equal riskiness, currently yielding 10 percent. The municipal bond pays 8 percent after-tax, whereas the corporate bond pays only 7.2 percent on an after-tax basis, as shown here:
Before tax interest rate
Investor,s income ta ,
% . 10 = 10
× xx
rate,
After-tax interest rate,
30 30 7 0 070
% . . % .
=
=
=
In this case, the investor in the 28 percent tax bracket will find the municipal bond to be more attractive than the corporate bond. A comparison of tax- exempt with taxable yields for several interest levels is presented in Table 11.2.
It can be seen from this table that a taxpayer in the 35 percent tax bracket would prefer a fully taxable corporate bond over a municipal bond yielding 8 percent only if the taxable bond yielded over 12.31 percent.
Social Security Income. Many Social Security recipients pay higher rates than they expect because, once their incomes pass a certain level, as much as 85 per- cent of their Social Security benefits are taxed.
Under the current law, for single individuals with annual incomes of less than
$25,000 and married couples filing a joint return with annual incomes of less than $32,000, no amount of Social Security income is taxable. For single individ- uals, modified income between $25,000 and $34,000 and married couples filing jointly with modified income between $32,000 and $44,000, no more than 50 per- cent of Social Security income is included in gross income. For single individuals with modified income in excess of $34,000 and married couples filing jointly with modified income in excess of $44,000, no more than 85 percent of Social Security is includable in gross income. For income above these limits, as much as 85 per- cent of Social Security income could be included in gross income. Thus, above the range, increases in the non-Social Security income have marginal effect on how much the benefit is taxed. Below the range, none of the benefit is taxed.
Nontaxable Income. Several sources of income are treated as nontaxable income.
These sources include: (a) gifts and inheritances (b) interest on certain state and municipal bonds, and interest received from certain mutual funds that hold such bonds, (c) returns of capital, (d) reimbursements received from an employer for business expenses, if properly reported; (e) up to $500,000 of current profit from the sale of principal residence for joint filers every two years, (f) 15 percent of Social Security benefits up to the exempt amount, (g) compensation for injury