Example of Below Interest Loan Example: Parent (35% tax bracket) makes $100,000 interest-free gift loan to child (10% tax bracket). Child deposits funds, earns 5% interest ($100,000 X 5% = $5,000). Tax parent would have paid $1,750 Tax child pays 500 Savings to family $1,250 Congressional Response - Imputed interest rules § 7872 § 7872 applies to: Gift loans Compensation-related loans Corporation loans to shareholders Tax avoidance loans Imputed Interest on Gift Loans Imputed interest rules on gift loans – 4 deemed (imaginary) transactions Lender recognizes interest income Borrower has interest expense Lender is deemed to have made a gift Borrower is deemed to have received a gift Imputed Interest on Gift Loans- Deemed Transactions Parent Child Interest Income == Interest Expense Gift Made ===== Gift Received Example of Gift Loan Parent loans Child $200,000 at no interest; government rate is 4% for the entire year. Interest for first 6 months $ 4,000 ($200,000 X .04 X 1/2) Interest for last 6 months 4,080 ($204,000 X .04 X 1/2) Total imputed interest $ 8,080 Parent - $8,080 interest income and $8,080 gift made Child $8,080 interest expense and $8,080 gift received Effect of Below Market Loans Type Step Lender Borrower Gift 1 Int. inc. Int. exp. 2 Gift made Gift rec’d Compensation 1 Int. inc. Int. exp. 2 Comp. exp. Comp. inc. Corp./s’holder 1 Int. inc. Int. exp. 2 Div. paid Div. inc. Exceptions and Limitations to Imputed Interest Rules Loans of $10,000 or less Gift loans – unless proceeds are used to purchase income-producing assets Employer/employee loans–unless the principal purpose is tax avoidance Corporation/shareholder loans–same as employer/employee loans Exceptions and Limitations to Imputed Interest Rules Loans of $100,000 or less between individuals–imputed interest is limited to the borrower’s net investment income (NII) If NII<$1,000, no interest is imputed Exception is not available if principal purpose is tax avoidance Computation of Imputed Interest Example: Parent loans Child $100,000 at no interest; Child invests money and earns $5,000; government rate is 3% for first 6 months and 4% for last six months. Interest for first 6 months $ 1,500 Interest for last 6 months 2,030 Total imputed interest $ 3,530 Apply limitation: Parent - $3,530 interest income and $3,530 gift made Child $3,530 interest expense and $3,530 gift received What if child earned $2,000? $800? Tax Benefit Rule Recovery of amount that was previously deducted is income in the year of recovery (to the extent of tax benefit in the prior year). Example – Bad debt for accrual taxpayer Exclusion for Interest on State and Local Government Bonds Only for interest on state and local government bonds Proceeds used to finance private business N/A for gains on sale of municipal bonds Improvements on Leased Property No income for improvements unless in lieu of rent The landlord’s basis for the improvements is zero Life Insurance Proceeds Generally excluded from beneficiary’s income Exceptions Owner cancels policy Transfers for valuable consideration Exceptions to the exception Buy-sell agreements Income from Discharge of Indebtedness A taxpayer must report income when Appreciated property is used to satisfy the taxpayer’s debt A creditor cancels the taxpayer’s debt Income from Discharge of Indebtedness Common Exceptions Creditors’ gifts Federal Bankruptcy law Debtor is insolvent Seller’s cancellation of a buyer’s indebtedness Forgiveness of certain loans to students Property Transactions Formula for gain or loss Amount realized (cash + FMV property) -Adjusted basis (basis + additions - reductions) =Realized gain (loss) Some realized gains are postponed (not recognized) Some realized losses are not deductible Capital Gains & Losses Sales of capital assets generate capital gains (losses) Netted to arrive at net capital gains or net capital losses Individual taxpayers Net long-term capital gains are taxed at lower rates Net capital losses may offset up to $3,000 in ordinary income Corporate taxpayers Net long-term capital gains receive no special treatment Net capital losses are carried back 3 years or forward up to 5 years Exam Thursday You may bring a 3” X 5” index card with notes, formulas, etc. All writing must be in your original handwriting. All cards will be collected with the exam.
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