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Individuals

Tax Treatment of Various Investment Options

By April 24, 2015No Comments

Earnings

  1.  Stocks: When you purchase stock, you are purchasing an ownership interest in a corporation. Since corporations are taxed as stand-alone entities, you do not pay any tax on the earnings of a corporation and do not receive any benefit from the corporation’s losses. You will have no tax impact from your investment in a corporation until the corporation distributes a portion of its earnings and profits in the form of a dividend. Dividends are generally taxable to the owner at ordinary income tax rates. If you meet the holding period requirements in a domestic corporation, then the dividends are considered to be “qualified” and are taxed at the beneficial capital gains rates.
  2. Bonds: When you purchase a bond, you are lending money to a corporation at a specified rate of interest for a specified duration. Purchasing a bond gives you no ownership interest in the corporation, as such you will never have any tax impact resulting from the corporation’s earnings and profits. You will, however, receive periodic payments of interest which are taxed at ordinary income rates.
  3. State Municipal Bonds: State muni bonds are the same as ordinary bonds, only they are issued by state governments. For federal tax purposes, there is no tax impact from the receipt of state muni interest. On the other hand, most states only exempt their own muni bonds from taxation. If you are a California resident, interest from a California muni bond is tax exempt while interest from a New Jersey muni bond is taxable for state purposes. Another important consideration is private activity bonds (PABs).  States will issue PABs to finance the project of a private user. While PABs are tax-exempt for ordinary tax purposes, they are taxable for alternative minimum tax (AMT) purposes.
  4.  PTPs: When you purchase a PTP, you are purchasing an ownership interest in a partnership. Since partnerships are flow-through entities, any income earned by the partnership flows through the entity and is taxed at the partner level. All of the income that flows through retains the same character in the hands of the owner as it had in the partnership. The owner is able to take partnership losses (subject to the limitations discussed later) and deduct them against ordinary income from other sources. Since partnership income is being taxed as it is earned, any distributions made by the partnership to the owner are not treated as a taxable event.

Loss Limitations:

  1. Stocks: Losses do not flow through to the owner; No losses to limit.
  2. Bonds: Not an equity interest; No losses to limit.
  3. State Muni Bonds: Not an equity interest; No loses to limit.
  4. PTPs: Since losses are passed through from the partnership to the individual partners, there is an opportunity to manufacture losses to avoid taxes. Congress passed the passive activity rules and the at-risk rules to prevent these techniques. Under the passive activity rules, an investment in a PTP is considered “passive.” This is significant because losses from a PTP are treated as passive and may only offset passive income. Congress further limited the ability to deduct PTP losses by making it so that passive losses from a PTP may only be deducted against future passive income from the same PTP. Any disallowed passive losses are carried forward until either the PTP has passive income or the ownership interest is disposed of. A partner’s ability to deduct losses is also limited by the at-risk rules. A partner’s basis is increased by his/her initial contribution, any subsequent contributions and any income recognized. The basis is decreased by any distributions received and any losses recognized. A partner cannot deduct any losses in excess of his/her basis, plus any qualified debt being allocated to them from the partnership. Any disallowed losses are carried forward until the partner has an amount at risk.

Sale Impact

  1. Stocks:Stock sales receive capital gain treatment. You can deduct capital losses against capital gains and may deduct up to $3,000 of excess capital losses over capital gains against ordinary income per year. Any unused capital losses are carried forward. Long term capital gains are taxed at beneficial rates while short term capital gains are taxed at ordinary rates:

Marginal Tax Rate     Capital Gain Rate  

39.6%                                      20%

25-35%                                    15%

10-15%                                    0%

  1. Bonds: If you hold a bond through its entire life, any premium or discount should have been amortized and there will be no gain or loss on redemption. If you sell a bond prior to its maturity, any gain or loss is treated the same as a stock sale.
  2. State Muni Bonds: While interest received from a muni bond is tax exempt, there is no beneficial treatment for gains or losses when sold. The sale of muni bonds is treated the same as the sale of ordinary bonds.
  3. PTPs: Any gain or loss on the disposal of a PTP receives the same tax treatment as the sale of stock. However, a portion of the gain is often re-classed as ordinary income under the depreciation recapture rules.

Loss Harvesting

  1. Stocks: When you have a significant capital gain, it may make sense to sell other securities with a loss position. This practice allows you to reduce your current year income by the capital loss. If you want to maintain your position in the loss security, you have the option to repurchase the security. However, the “wash-sale” rules exist to deter this approach. If you repurchase the securities within thirty days of the sale, the loss is disallowed and added to the basis of the repurchased securities. If you want to maintain your position in a particular industry, you can reinvest the proceeds in a similar stock to avoid wash-sale treatment.
  2. Bonds: Same rules apply as the rules for stocks.
  3. State Muni Bonds: Same rules apply as the rules for stocks.
  4. PTPs: If you have gains on the sale of a PTP interest, you have the ability to harvest a loss from another investment type. Because of the added complexities of an ownership interest in a PTP, it does not make sense to harvest a loss from a PTP interest if you intend to maintain an ownership interest going forward.

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