Chapter12 - Chapter 12 Deductions for Certain Investment...

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1 Chapter 12 Deductions for Certain Investment Expenses & Losses
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2 The Problem of Tax Shelters What is a “tax shelter” An investment that produces certain tax benefits
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3 Common Elements of a Tax Shelter Vehicle: Partnership or S corp Losses/Credits
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4 Common Elements of a Tax Shelter Deferral Mismatching of revenue and expense Front-end loading of deductions: deductions now, income later Present value. Defer payment of $10,000 of taxes for a 5-year period. After tax rate of return of 10% Present value of tax payment is only $6,210 [$10,000 x (1/(1.10)5]. Postponing payment of tax saves $3,790, a decrease of almost 38 percent! 30,000 (10,000) 40,000 5 Total 4 3 2 1 0 20,000 10,000 (10,000) (50,000) Net income Net (loss) (200,000) (20,000) (30,000) (50,000) (90,000) Deductions 200,000 40,000 40,000 40,000 40,000 Revenue
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5 Buy office building Cost $100,000 Depreciation (40,000 ) Adjusted basis $60,000 Sell office building Amount realized $100,000 Adjusted basis (60,000) Gain realized $40,000 Tax savings from depreciation 40% tax rate x $40,000 = tax savings of $16,000 15% CG tax rate x $40,000 = tax cost of $6,000 Common Elements of a Tax Shelter Conversion: Deduct expenses at ordinary rates Recover deductions at capital gains rates
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6 Common Elements of a Tax Shelter Leverage Investment $100,000 $1,000 interest Return 1% $10,000 $90,000 borrowed Return on equity 10% $1,000 interest
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7 Passive Losses: Example Construction Corp forms limited partnership to build apartments. Corp contributes $10,000 for 10% GP interest and will be paid to do the construction. Nine doctors, who pay taxes at a rate of 90% (1960s), invest 10,000 each, a total of $90,000, to obtain a LP interest. Partnership borrows $900,000 and uses it along with the $100,000 to construct a $1,000,000 building. Construction was finished this year and the building was rented. Corp 9 LPs 1 GP 10,000 90,000 900,000 loan
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8 Passive Losses: Example (cont.) Rental income 100,000 Deductible BUSINESS expenses: Repairs 20,000 Maintenance 20,000 Taxes 20,000 Insurance 20,000 Management 20,000 Total deductions (100,000 ) Net cash flow (Break even) 0 Depreciation (200,000 ) Loss (200,000) Limited partner’s share (10% x $200,000) (20,000) Partner’s marginal tax rate x 90 % Tax savings IF loss can be used 18,000 Investment (10,000 ) Cash flow from investment $ 8,000
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9 Government Response to Tax Shelters Tax shelters led to decreased compliance Government’s response 1) Limitations on deduction of investment interest 2) “At risk” limitations (loophole for real estate), 3) Sec. 469 “Passive activity” rules in TRA ’86 Packwood’s two pitchers of beer lunch meeting
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10 General Features of Section 469 Generally prohibits taxpayers from deducting losses arising from passive activities against the income of other activities Classification system Tax Shelter
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11 General Rules of § 469 Losses from passive activities deducted only
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This note was uploaded on 03/23/2010 for the course ACCT 402 taught by Professor Toleno during the Spring '10 term at Providence College.

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Chapter12 - Chapter 12 Deductions for Certain Investment...

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