Richard GoldsteinRichard Goldstein

Investors tend to select investments based on their investment philosophy and tolerance for risk, among other criteria. Some investors seek out cash flow while others are willing to forego current cash flow in exchange for significant appreciation. Because taxes are levied on investment income, it’s unwise to consider an investment without understanding the cost involved by making the investment.

Not being an investment advisor, I’m not in a position to make investment recommendations. I am, however, in a position to explain various types of investments and the tax cost associated with each. Accordingly, this month’s column will focus on the tax cost of investments.

Portfolio income

Those who desire current cash flow from their investments may choose investments that generate interest or regular dividends. Investments that provide interest income include certificates of deposit, savings accounts, corporate bonds and government bonds. Investments that generate dividend income include direct equity investments in corporate stocks or investment in mutual funds that invest in corporate stock. Each one of these investments generate current cash flows but can differ significantly in terms of their economic and tax consequences. Additionally, it’s important to understand bond discount and bond premium associated with bond investments and the related tax consequences of each.

Corporations, the U.S. Treasury and states raise money from debt markets by issuing bonds. These bonds are issued at maturity value, at a discount or at a premium. Treasury bonds and Treasury notes pay a stated rate of interest semiannually. However, corporate bonds may pay interest at a stated coupon rate or they may not provide any periodic interest payments. Bonds that don’t pay periodic interest are called zero coupon bonds. Just in case you don’t know the difference between a Treasury bond and a Treasury note, they differ in terms of their maturities. Treasury notes are issued with two-, five- and 10-year maturities. Treasury bonds are issued with maturities with greater than 10 years.

The consequences of owning these types of investments are very similar. The primary differences are that interest from Treasury bonds is exempt from state taxation while interest from corporate bonds is not. Treasury bonds always pay interest periodically while corporate bonds may or may not. The tax rules for determining the timing and amount of interest income from corporate and U.S. Treasury are as follows:

• Interest received is included in gross income.

• If a bond is issued at a discount, special Original Issue Discount rules apply. Taxpayers are required to amortize the discount and include the amount of the current year amortization in gross income in addition to any interest payments received. In the case of corporate zero-coupon bonds, taxpayers are required to pay taxes on income related to the bonds even though they did not receive any payments from the bonds. Bond issuers or brokers are responsible for calculating the yearly amortization of the OID and provide this information to investors using Form 1099-OID.

• If a bond was issued at a premium, taxpayers may elect to amortize the premium. Again, this information will be provided to you. The amount of the current year amortization offsets a portion of the actual interest payments taxpayers are required to include in gross income. The original tax basis of the bond includes the premium and is reduced by amortization of bond premium over the life of the bond.

• If a bond is purchased on a secondary bond market at a premium, the premium is treated exactly like original issue bond premium. Accordingly, an election can be made to amortize the market premium to reduce the annual the annual interest income from the bond. If not, the premium remains as part of the tax cost (basis) of the bond and affects the capital gain or loss taxpayers recognize when the bond sells or is redeemed.

U.S. savings bonds

The bonds are issued at either face value or at a discount. These bonds do not pay interest, rather it accumulates over the term of the bonds and is paid when redeemed at maturity or earlier. An election may be made to include to include the increase in bond redemption value in income each year. While this is generally not advisable, in certain situations the folder may actually not have to pay any tax when redeemed. Interest from Series EE and Series I bonds may be excluded form gross income to the extent the bond proceeds are used to pay for qualifying education expenses. This, however, is subject to a phase-out based on adjusted gross income.

Dividends

Historically, dividends received by investors have been taxed at the same rate as interest. However, in 2003 Congress changed the law for dividends to mitigate the “double tax” on dividend income. Qualified dividends are taxed at a preferential rate: 0, 15, or 20 percent. (Note this may change if and when new tax legislation is passed to exclude 50 percent of the income from tax. Time will tell.) Caution: even though corporations may report to taxpayers the amount of a dividend subject to the reduced rate, taxpayers are responsible to determine if they are in fact entitled to the reduced rate. Qualified dividends are those paid by domestic or certain foreign corporations provided the investor holds the dividend paying stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (the first day on which the purchaser of the stock would not be entitled to receive a dividend declared on the stock).

In the next column, I’ll discuss capital gains and losses, the tax rates pertaining to capital gains, wash sales, passive activity income and losses with emphasis rental real estate. I’ll also discuss the net investment income tax on net passive income. Keep in mind that President Trump has proposed this tax be eliminated along with the estate and gift tax and the alternative minimum tax.

Here are some good moves to consider for your agency before year end: max out on Section 179; consider bonus depreciation; spruce up you company owned business premises (there may be some solid tax benefits in doing so); speed up bonus payments if you are an accrual basis agency. 

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Richard Goldstein is a partner at Buchbinder Tunick & Company LLP, New York, Certified Public Accountants.