Archive for the ‘bonds’ Tag

Back to Basics – Part XX – Form 4952 – Investment Interest Expense

Originally published in the Cedar Street Times

August 7, 2015

Today is my brother, Justin’s, birthday, and I know just what to get him.  We were both avid baseball card collectors from the time we were seven and eight years old on up through our middle school years.  Once, we even put on a “Kids Baseball Card Show” to buy, sell, and trade cards.  We went around advertising the show with flyers on telephone polls all over the local neighborhoods, and secured the neighborhood pool clubhouse facility to host our show.  It was a great success!

At the conclusion of my baseball card collecting career I had amassed over 10,000 cards with albums full of rookie cards and great players at the time.  One of my most prized cards was a 1954 Topps Willie Mays.  I remember wondering, how much money have I invested in all these cards over the years?  Would I be able to retire after selling the cards years later?  The Beckett Baseball Card Monthly price guide certainly made me think so based on the prices they listed and the rapid rates of increase.  Old cards from the 1940s – 1960s were worth hundreds or even thousands of dollars each.

A few years after my interest in card collecting waned, a mass of new brands flooded the markets.  That combined with other problems in baseball at the time sent the card market into an unrecoverable nose dive.  Over 20 years later, most cards are still worth a tiny fraction of their peak.

Although my desire was primarily the personal fun of collecting, there were many adult investors that had serious money in cards.  As with any investment bubble, I am sure there were collectors mortgaging their homes, running up credit card debt and borrowing from family in order to get a piece of the action.

As I reflect on that now, I see there would have been an opportunity for these people to take advantage of today’s topic – Form 4952 – Investment Interest Expense Deduction.   If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Investment interest expense is reported on Schedule A as an itemized deduction and is essentially interest paid on debt used to buy property that produces or hopefully will produce income at some point.  It doesn’t include interest expense incurred in your trade or business, or for passive activities like most rental properties.  These types of interest get reported elsewhere.  So, borrowing money to buy investments such as stocks, bonds, or annuities would qualify.  Many financial companies offer margin loans.  The interest on these loans would certainly qualify as investment interest expense if the proceeds were used to buy more stocks and bonds.  Borrowing money to buy the right to royalty income or to buy property held for investment gain, such as vacant land, art, or even baseball cards would also qualify, among other things.

Due to passive activity rules which limit or even eliminate current deductions on passive rental activities such as a home you rent out, many people would like to be able to deduct the interest as investment interest instead.  However, interest on passive activities is specifically excluded from being classified as investment interest expense.  The interest on vacant land can usually escape this clause, even if small amounts of rent are collected since the rent is incidental to the paramount investment purpose of appreciation.  To be considered incidental, the principal purpose must be to realize gain from appreciation AND the gross rents received for the year must be less than two percent of the lesser of the property’s unadjusted basis or its fair market value.

The rub with investment interest expense is that it is only deductible to the extent that you have investment income!  If you have no investment income, you can’t deduct the expense, and it gets suspended until a year you actually do have investment income.  So what qualifies as investment income?  Well, all of the things we just discussed for which you borrowed  money and can deduct as investment interest expense – so interest, dividends, gains from property held for investment, etc.  Prior to being applied against investment interest expense, the investment income figure is reduced by other investment expenses that you may have reported on Schedule A – such as investment advisory fees, safe deposit boxes, investment subscriptions, etc.

By default, your net capital gains (meaning net long-term capital gains in excess of net short-term capital losses) as well as qualified dividends are not included in investment income.  This is done because both of these already get taxed at favorable lower capital gains rates, so the thinking is, “Why would you want to waste a deduction to offset income that is already getting a lower capital gains rate, when you could instead use it to offset ordinary income taxed at higher rates ?”  The answer is that sometimes you may not be able to ever foresee having much ordinary investment income taxable at higher rates.  And instead of just suspending the deduction and getting n0 current tax benefit, you elect to include your net capital gains and qualified dividends as investment income and use the deduction to help wipe that income out, thus saving you current taxes.

The Form 4952 itself is a rather simple form – only a half page in length.  Part I is a summary of the gross investment interest expense including any current interest and past interest that was carried over.  Part II helps you calculate the net investment income  from interest dividends, gains, capital gains, less investment expenses from Schedule A.  Part III compares parts I and II and calculates the investment interest expense that will be currently deductible, as well as the part that is being suspended to the future if there is not enough investment income to absorb the expenses.

As for the card collecting Justin and I did, I sure am glad we didn’t go into debt buying baseball cards and having to file 4952s! Now about that gift – how about a box of wax packs or a factory sealed set – I know just where to get them…

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back to Basics – Part VIII – Schedule D

Originally published in the Cedar Street Times

January 23, 2015

Imagine yourself on Antiques Roadshow and they tell you that an old porcelain mug you found in your attic last summer is worth $8,000-$10,000 dollars!  You are of course elated, and decide to sell the mug.  Fast forward to February, and your accountant starts asking you questions about this sale, such as your adjusted cost basis and your holding period.  You really have no idea how you even got it.  You know it was in the family for a long time, and you think that maybe it was in a box of things your mom left for you when she moved to Palm Springs where she now resides.  What do you do?  I don’t know exactly, but I know this much – it will go on your Schedule D in some form.

In this issue, we are discussing Schedule D – Capital Gains and Losses.  Prior articles are republished on my website at www.tlongcpa.com/blog if you would like to catch up on our Back to Basics series on personal tax returns.

Schedule D is used to report gains or losses from the sale or exchange of capital assets.  Capital assets consist of a variety of things.  The personal use items you own – such as your home, your vehicles, household items etc. are capital assets.  Gains from the sale of personal items are taxed.  Losses, however, are generally disallowed. Your personal investments such as stocks, bonds, or real property held as an investment are also capital assets.  Gains and losses are allowed on personal investments.

The same types of items used in your trade or business, however, would be reported on a Form 4797 and would be taxed differently as well.

Assets that have a mix of personal use and business use can have elements reported on both forms.

To determine your gain or loss on a capital asset, you must know your cost basis in it.  If it is something you bought, your cost basis is generally the amount you paid for it; if it is something you inherited, your cost basis is often the fair market value at the date of death; or if it was something given to you, your cost basis is generally the same as that of the prior owner.

There can also be adjustments to this basis, such as when you make improvements to your home – the money you spend would be an adjustment upwards.  Once you know your adjusted cost basis, you simply subtract it from the sales price to determine your gain or loss.  If you scrapped it, your sales price is zero.  Sometimes it can be quite challenging to determine the cost basis, especially if records no longer exist.  Technically, if you cannot prove your basis, the IRS can take the position that your basis is zero.  This could be very unfavorable, especially if you just sold a $10,000 mug with unknown origins!

It is also important to know the length of your “holding period.”  The date you purchase the property is generally the beginning of your holding period and the date you dispose of the property is the end of your holding period.  For property received as a gift, you include the holding period of the person who gave it to you.

If your holding period is over a year, it is subject to favorable long-term capital gains rates – basically a 15 percent federal rate for most people.  (Although it could be as low as zero percent or as high as 20 percent depending on your tax bracket and the amount of capital gains you have.  Also, collectible items you sell such as old coins or antique vehicles are taxed at a 28 percent rate.)  If your holding period for the asset is a year or less, it is considered a short-term holding and is taxed like ordinary income (a higher rate for most people).  Inherited property is always considered to have a long-term holding period.  California does not have a special rate for long-term holdings and treats all capital gains as ordinary income on its tax return.

As mentioned before, there is no deduction for losses on your personal use items.  You can, however, take a loss on your personal investments.  They would reduce any other capital gains, first, and then if there are still losses remaining, you can use $3,000 to offset any other type of income you have on your tax returns.  The rest would get carried over to future years.

The Schedule D itself is essentially a summary of capital gain and loss activity that are mostly determined by other forms that feed into the Schedule D.  Part I summarizes short-term gains and losses, and Part II summarizes long-term gains and losses.  Form 8949 is the main supporting form used in both of these sections.  It was added a few years ago after changes to broker cost basis reporting requirements occurred.  The Form 8949 sorts out long-term and short-term transactions for which cost basis is reported to the IRS and not reported to the IRS, and handles the actual transactional reporting.

Parts I and II also have areas were short-term and long-term gains can be reported from other forms such as installment agreements, business casualty and theft losses, like-kind exchanges, as well as pass through entities such as partnerships, S-corporations, estates, and trusts.  Long-term capital gains distributions from mutual funds on a 1099-DIV are reported in Part II.  (Short-term capital gains distributions from mutual funds are actually included as ordinary dividends on the 1099-DIV, and are reported on Schedule B instead.)  In addition, short-term and long-term loss carryovers from prior years are added into their respective parts on Schedule D.

Part III nets the short-term gains or losses against the long-term gains or losses.  It then helps you determine the gain or loss to enter on the 1040.  It also walks you through several worksheets to determine the amount of tax and tax rates you will pay on any gains.

So what would you do about the mug?  Hopefully mom would have some recollection of the history.  Maybe there was a somewhat recent time when it was passed by inheritance and would have received a step-up in basis.  Of course, you should have figured that out before you sold it, and then had an appraisal done to support it!  Otherwise, if it had just been gifted from one person to the next, the mug probably had very little if any cost basis, and you might be stuck with a big taxable gain.

In two weeks we will discuss Schedule E – Supplemental Income and Loss.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.