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Tax Preferences and Tax Shelters
1.1. Tax preferences I.
Tax preference: Any exclusion or deduction that results in taxable income understating a taxpayer's true economic income a. Section 103 excludes of municipal bond interest income. b. Example i. You are choosing between 100 municipal bond with 7%
annual rate/ corporate bond 10% interest rate ii. Mtr 30%
iii. Municipal bond 7 dollars interest income, tax liability 0 iv. Corporate bond 10 dollars interest income, tax liability 3, 7 after tax income v. Suppose mtr is 20%, corporate bond is preferable for the 20% mtr tax payer
1.2. Tax shelters II.
Tax shelters: tax shelters refer to an investment or transaction that produces artificial tax losses, which can be used to avoid tax on income from other unrelated income Debt financed shelter a. 265(a)(2) provides that no deduction shall be allowed for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from the taxes imposed by this subtitle. b. This disallows the interest expense deduction when a taxpayer uses borrowed money to buy muni bonds. c. It also applies when a taxpayer who already owns muni bonds takes out a loan secured by the bonds, and then uses the money to pay some unrelated expense. d. It does not apply merely because a taxpayer happens to have outstanding debts at the same time he owns municipal bonds. The statute requires some nexus between the bonds and the debt before the disallowance kicks in Passive loss rule a. Section 469 prohibits taxpayers from deducting losses from passive activities, defined as losses from businesses in which the taxpayer does not "materially participate," against either salary income or portfolio income. b. The Act provides that deductions from passive trade or business activities, to the extent they exceed income from all such passive activities (exclusive of portfolio income), generally may not be deducted against other income. Suspended losses and credits are carried forward and treated as deductions and credits from passive activities in the next year. Suspended losses from an activity are allowed
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