Apply Income Tax Fundamentals - Series 65

1. What is the formula for capital gain or loss on a sale of a capital asset?

   Gain or loss $=$ proceeds $-$ adjusted cost basis. Capital gain or loss calculation subtracts adjusted basis from sale proceeds to determine the taxable profit or deductible loss realized.

2. What is the maximum annual capital loss deduction against ordinary income for an individual?

   Up to $\$3{,}000$ per year (with carryforward of the excess). The $3,000 limit caps annual ordinary income offsets to prevent excessive deductions, with carryforwards allowing future utilization of excess losses.

3. What is the tax treatment of qualified distributions from a Roth IRA (general rule)?

   Tax-free (no federal income tax on qualified withdrawals). Roth IRA qualified distributions are tax-free due to after-tax contributions, allowing earnings to grow and withdraw without additional federal tax.

4. What is the tax rate characterization of short-term capital gains for individuals?

   Taxed as ordinary income. Short-term gains are treated as ordinary income to align with the tax rates applied to assets held for one year or less.

5. Identify the tax rule for annuity distributions regarding principal versus earnings.

   Earnings are taxed as ordinary income; principal is generally tax-free return. Annuity taxation distinguishes earnings as taxable growth while treating principal repayments as non-taxable recovery of after-tax contributions.

6. Identify the cost basis rule for reinvested dividends in a taxable account.

   Reinvested dividends increase cost basis (they are taxable when paid). Reinvested dividends are considered taxable distributions, with reinvestment treated as a new purchase that adjusts the investment's basis upward.

7. What is the holding-period rule that distinguishes short-term from long-term capital gains?

   Long-term is more than $1$ year; otherwise short-term. The IRS defines long-term gains by a holding period exceeding one year to encourage longer-term investments with preferential treatment.

8. What is the key tax difference between a C corporation and an S corporation?

   C corp has entity-level tax; S corp is pass-through to shareholders. C corporations face double taxation at entity and shareholder levels, while S corporations avoid entity tax by passing income directly to owners.

9. What is the tax rate characterization of long-term capital gains for individuals?

   Taxed at preferential long-term capital gains rates. Long-term gains receive lower rates to promote investment holding periods over one year, reducing effective tax on capital appreciation.

10. What is the tax treatment of nonqualified (ordinary) dividends for individuals?

    Taxed as ordinary income. Nonqualified dividends lack the criteria for preferential treatment, thus integrating into ordinary income for standard taxation.

11. What is the wash sale rule holding period that disallows a loss for tax purposes?

    Purchase of substantially identical security within $30$ days before or after sale. The wash sale rule prevents loss harvesting by disallowing deductions if identical securities are repurchased in the 61-day window around the sale.

12. What is the general rule for whether interest income from corporate bonds is taxable?

    Taxable as ordinary income at federal and usually state levels. Corporate bond interest is fully taxable because it does not qualify for the exemptions granted to government or municipal securities.

13. What is the tax effect of a stock dividend on cost basis and tax at receipt (general rule)?

    Generally not taxable at receipt; basis is allocated over more shares. Stock dividends distribute additional shares without cash, deferring taxation by reallocating existing basis across the increased share count.

14. What is the tax treatment of distributions from a traditional IRA before age $59\frac{1}{2}$ (general rule)?

    Taxable as ordinary income and generally subject to a $10\%$ penalty. Early IRA distributions are penalized to discourage premature withdrawals, ensuring funds remain for retirement with ordinary income taxation applied.

15. When a wash sale occurs, what happens to the disallowed loss for tax purposes?

    It is added to the basis of the replacement shares. In a wash sale, the loss is preserved by increasing the basis of new shares, deferring recognition until a non-wash sale occurs.

16. What is the general netting order for capital gains and losses (short-term vs long-term)?

    Net ST with ST and LT with LT, then net the two results. Netting separates short-term and long-term to apply appropriate rates before combining, ensuring accurate tax treatment of each category.

17. What is the general tax treatment of partnership income to partners?

    Pass-through taxation; partners report their distributive share. Partnerships avoid entity-level tax, requiring partners to report shares of income, deductions, and credits on personal returns for taxation.

18. What is the tax treatment of return of capital distributions from an investment?

    Not taxable when received; reduces cost basis until it reaches $0$. Return of capital represents a non-taxable recovery of investment, systematically reducing basis to track remaining untaxed principal.

19. What is the tax treatment of qualified dividends for individuals?

    Taxed at long-term capital gains rates (preferential rates). Qualified dividends qualify for long-term rates as they originate from domestic or qualified foreign corporations meeting holding requirements.

20. What is the tax status of interest paid by U.S. Treasury securities at the state level?

    Exempt from state and local income taxes. U.S. Treasury interest is exempt from state taxes due to federal supremacy, preventing states from taxing federal obligations.

21. If cost basis is $0$, how is any additional return of capital distribution taxed?

    Taxed as a capital gain. Once basis is exhausted, further distributions exceed recoverable principal, qualifying as realized gains subject to capital gains taxation.

22. Which municipal bond interest is typically exempt from both federal and in-state tax for a resident?

    Interest on bonds issued by the resident's home state (and its municipalities). In-state municipal bonds offer triple tax exemption to incentivize residents to invest in local infrastructure without tax burden.

23. What is the tax effect of a stock split on an investor's total cost basis?

    No change to total basis; basis per share decreases proportionally. Stock splits merely redistribute shares without altering the investment's value, preserving total basis while adjusting per-share amounts.

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