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May 12 mgmt127a

May 12 mgmt127a - MGMT 127A Investment Deduction(Not...

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May 12, 2008 MGMT 127A Investment Deduction (Not Including Depreciation) First thing to do is distinguish between investment and business. Business—putting up your own labor and capital Investment—simply putting up capital Buying a bond would be investment. Buying stock would be investment. Buying a building that runs itself would be an investment. Example Buy a building with four units, and the tenants sign 25-year leases, then it is investment. However, if you buy a building and you are mowing the lawn and fixing pipes yourself, then it is business. Real estate can be gray area. Three types of investments: Two extremes: 1. Investments that are not now, and are not ever taxed (Tax exempt investments) 2. Investments that are taxed immediately (regular taxable investments) 3. Tax deferred investments. Not taxed now, but in the future. TAX EXEMPT INVESTMENTS
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Tax Exempt Municipal Bond: Buy a $100 Municipal Bond at 7%, so you earn $7 dollars on the purchase of that bond. However, you don’t have the funds to buy it, so you borrowed $100 at 9% interest from the bank. Ignoring taxes, you earn $7 and pay $9 and come out $2 behind. We evaluate investments by determining whether they have positive after-tax cash flow. It would be stupid to look at before tax. When we receive the interest payment on the municipal bond ($7), how much of it will be income? None of it will be income, since interest from municipal bonds is tax- free. Assuming you could write off expense, you would write off $9. The overall impact, incrementally will lower taxable income by $9. As we decrease taxable income by $9, we would save $3 in taxes (assuming 1/3 tax bracket). $3 tax savings is as good as putting money in your pocket. Just as tax cost is a cash outflow, a tax savings is a cash inflow. At the end of the day, wealth has increased by $1. You were behind $2 and then got a refund of $3 What is the rate of return here? What is the rate of return on owner’s equity? The return is infinite ($1/0), because you borrowed the money to make the investment.
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IF this was allowed to be deducted, it may lead people to do irrational things. Anytime I generate tax-exempt revenue (like municipal bonds), my related expenses are not deductible. IF THERE IS NO INCOME BEING REPORTED, THERE IS NO INCOME BEING REPORTED If you don’t report revenue, you should not match an expense to it.
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