Tax Considerations

Tax Considerations

Tax decisions sit alongside every investment decision: which account holds which asset, when to realize gains and losses, how to handle inherited or gifted securities, what entity structure passes income through, and how lifetime transfers compound across generations. This chapter is the CANONICAL tax treatment for the Series 66 (other chapters have referenced tax mechanics in passing; this is where they're developed). Five sections: individual income tax foundations (marginal/effective, AMT, NIIT); capital gains and dividends (LT/ST rates, qualified-dividend holding periods, loss limits); cost basis methods and the wash sale rule; wealth transfer (gift tax, estate tax, step-up at death, GST); and entity taxation (K-1 pass-through, 1031 exchanges, REIT specifics). Two interactives anchor the math: a cost-basis calculator for purchased/inherited/gifted scenarios, and a capital-gains tax calculator for short-term/long-term tax outcomes.

Marginal vs. effective tax rate — the distinction that decides outcomes

The US federal income tax is PROGRESSIVE: income is divided into bands, and each band is taxed at its own rate. The Series 66 tests recognition that two different rates apply to every taxpayer:

• MARGINAL rate. The rate that would apply to the NEXT dollar of income. Determined by the top bracket the taxpayer reaches. Used for any DECISION about additional income, deductions, or taxable-equivalent yield calculations.
• EFFECTIVE rate. Total tax owed divided by total taxable income. Always LOWER than the marginal rate (because lower brackets are taxed at lower rates). Used for AVERAGE tax burden and budgeting.

Worked example: a single filer with $100K taxable income (2024 brackets, illustrative): pays 10% on the first $11,600 ($1,160), 12% on the next $35,550 ($4,266), 22% on the next $53,375 ($11,743) — total tax ~$17,169. Effective rate = 17,169 / 100,000 = ~17.2%. Marginal rate = 22% (the top bracket reached). The 22% applies to a tax-equivalent yield calculation; the 17.2% does not.

Alternative Minimum Tax (AMT) — the parallel calculation

AMT is a PARALLEL tax calculation that runs alongside the regular tax. Taxpayers compute tax BOTH ways and pay the HIGHER. AMT was designed to ensure high-income filers can't use legal deductions and preferences to escape paying tax entirely. The mechanics:

• Start with regular taxable income. Add back certain “preference items” that the regular tax allows as deductions but AMT does not.
• Common preference items. State and local tax deductions, certain accelerated depreciation, large miscellaneous itemized deductions, incentive stock option (ISO) bargain element when exercised but not sold, certain tax-exempt interest from private-activity municipal bonds.
• Subtract the AMT exemption. A fixed amount that phases out above income thresholds (the exemption is what shields most middle-income filers from AMT).
• Apply AMT rates. Two flat brackets: 26% on the first portion and 28% on the rest (above a threshold). Compare to regular tax; pay the HIGHER amount.

The Series 66 emphasis: recognize WHAT triggers AMT (preference items added back) rather than computing the tax. Two scenarios commonly tested: (1) an investor holding PRIVATE-ACTIVITY MUNICIPAL BONDS may owe AMT on the interest even though it's federally tax-exempt for regular-tax purposes; (2) an executive exercising ISOs without selling in the same year may trigger AMT on the bargain element (FMV minus strike price). Both are testable triggers, not the computation.

Net Investment Income Tax (NIIT) — the 3.8% surtax

The Net Investment Income Tax (NIIT) is a 3.8% surtax on investment income for high-income taxpayers, enacted in 2013 to help fund the Affordable Care Act. It applies IN ADDITION to regular income tax and capital gains tax. The Series 66 tests recognition of triggers, base, and calculation:

• Trigger thresholds. Single filer with MAGI above $200,000; married filing jointly above $250,000; married filing separately above $125,000. Below the threshold: NIIT does not apply.
• NIIT base. Applied to the LESSER of (1) net investment income or (2) the amount by which MAGI exceeds the threshold. Investment income includes interest, dividends, capital gains, rental income (passive), and royalties.
• Excluded from NIIT base. Wages and salary, self-employment income, distributions from qualified retirement accounts (IRA/401(k) withdrawals), tax-exempt municipal interest, gain from the sale of an active business.
• Rate. Flat 3.8% on the applicable base. Added on TOP of the underlying LTCG or ordinary income tax.

Worked example: a single filer with $300K AGI ($240K wages + $60K LTCG). Excess over the $200K threshold = $100K. Net investment income = $60K. NIIT base = lesser of ($100K, $60K) = $60K. NIIT = $60K × 3.8% = $2,280. This is ON TOP of the 15% LTCG tax ($9,000) on the same gain. Total federal tax on the $60K gain = $11,280, an effective rate of 18.8% — not the 15% LTCG headline rate.

Long-term capital gains — the 0/15/20 bracket structure

Long-term capital gains (LTCG, holdings of MORE THAN one year) receive PREFERENTIAL rates compared to ordinary income. Three rate brackets apply based on taxable income:

Bracket boundaries adjust annually for inflation; the percentages (0/15/20) are stable. Two important mechanics:

• LTCG “stacks” on top of ordinary income. Ordinary income fills the brackets first; LTCG fills any remaining 0% / 15% / 20% capacity. A retiree with $30K ordinary income and $20K LTCG (total $50K, single) pays 0% on most of the LTCG because the combined income stays mostly below the $47K boundary.
• SHORT-TERM capital gains (held 1 year or less) are taxed as ORDINARY income. No preferential rate. Marginal rates up to 37%. Plus NIIT may apply on top. This is the canonical reason holding for >1 year matters: a 37% ordinary rate vs. a 15-20% LTCG rate is a massive difference on a large gain.
• NIIT 3.8% applies on top for high-income filers (MAGI above $200K single / $250K MFJ), making the effective top LTCG rate 23.8% rather than 20%.

Qualified collectibles (art, gold, certain coins) and unrecaptured Section 1250 gain (real-estate depreciation recapture) are LTCG-class but taxed at higher special rates (up to 28% collectibles, 25% unrecaptured 1250). The exam rarely tests these specifically; the 0/15/20 structure for general LTCG is what's tested.

Qualified vs. ordinary dividends — the holding-period rule

DIVIDENDS are classified as either QUALIFIED (taxed at LTCG rates: 0/15/20) or NON-QUALIFIED / ORDINARY (taxed at ordinary income rates up to 37%). The Series 66 tests the holding-period requirement:

• Qualified dividend requirements. Paid by a US corporation OR qualified foreign corporation, AND the recipient must hold the stock for MORE THAN 60 days during the 121-day period that BEGINS 60 DAYS BEFORE the ex-dividend date. The 60-out-of-121 rule is the holding-period test.
• Ordinary (non-qualified) dividends. Dividends that fail the qualified test — including REIT dividends (most are ordinary because REITs don't pay corporate tax), most MLP distributions, dividends from money market funds, and any dividend where the holding-period test wasn't met.
• Form 1099-DIV reporting. Brokers report both totals separately: Box 1a (total ordinary dividends) and Box 1b (qualified dividends — a subset of 1a). The investor doesn't classify these; the broker does, and the broker tracks the holding period.

The most common holding-period failure: an investor buys a stock immediately before the ex-dividend date to capture the dividend, then sells right after. If the total holding is 60 days or less in the 121-day window, the dividend is ORDINARY, taxed at the full marginal rate. Dividend-capture strategies that ignore the holding-period rule produce a higher tax bill than expected.

Cost basis methods — which lots get sold matters

When an investor sells PART of a position acquired in multiple lots at different prices, the SPECIFIC LOTS sold determine the realized gain or loss. The IRS allows several methods for designating which lots are sold:

• FIFO (First In, First Out). Default method for most brokers if no specification is made. Oldest lots are sold first — usually the LOWEST cost basis, producing the LARGEST realized gain (or smallest loss). Typically the WORST tax outcome for the investor.
• LIFO (Last In, First Out). Newest lots are sold first. Permitted but RARELY USED for securities (more common in inventory accounting). Some brokers don't support it for equities.
• Average Cost Method. Required default for MUTUAL FUNDS (unless investor elects otherwise). All shares of the same fund are averaged into one cost basis per share. Simple to administer; less flexibility for tax planning.
• Specific Identification (SpecID). Investor designates EXACT LOTS to sell at the time of sale. Most tax-efficient — allows selecting high-basis lots to minimize gain or specific loss lots for harvesting. Requires the broker to track lots and the investor (or adviser) to identify them at trade time.
• Highest In, First Out (HIFO). A variant of Specific ID where the highest-basis lots are sold first. Minimizes realized gains. Not a separate IRS method — it's SpecID applied with a high-cost-first rule.

The default-versus-elected distinction matters: BROKERS apply FIFO automatically for securities (Average Cost for mutual funds) unless the investor specifies otherwise BEFORE the trade settles. Best practice for active accounts: standing instructions to broker for SpecID with a HIFO-style rule for harvest opportunities and a low-basis-first rule when realizing losses to harvest.

After a sale, the basis method becomes LOCKED for those lots — an investor can't retroactively reclassify which shares were sold. This is why front-loading the method choice matters more than the post-hoc accounting.

Gift tax — annual exclusion, lifetime exemption, mechanics

Gifts above a threshold trigger a GIFT TAX RETURN (Form 709), though actual gift tax is rarely paid because of the lifetime exemption. The Series 66 expects recognition of three concepts:

• Annual gift tax exclusion. Each donor can give up to a specified amount (approximately $18,000-$19,000 in recent years; indexed annually) to EACH donee EVERY YEAR without filing a gift tax return or using lifetime exemption. A married couple can effectively give $36,000+ per donee per year via gift-splitting. Gifts to UNLIMITED donees each year are permitted under the per-donee exclusion.
• Lifetime gift and estate tax exemption. A combined lifetime amount (approximately $13.6M+ per individual in recent years; indexed) shields cumulative lifetime gifts and the estate at death from federal estate tax. Gifts above the annual exclusion REDUCE this lifetime exemption pro tanto. Only after the lifetime exemption is fully used do actual gift taxes apply (at rates up to 40%).
• Direct payments to educational institutions and medical providers. Unlimited gift tax exclusion for amounts paid DIRECTLY to schools (tuition only, not room/board) or medical providers (for medical care/insurance) on behalf of any individual. Bypasses both annual exclusion and lifetime exemption. Must be paid DIRECTLY to the institution, not to the beneficiary.

Common exam framings: (1) recognizing that gifts to a 529 plan can be FRONT-LOADED with 5 years of annual exclusion at once (the 5-year election lets a donor contribute ~$90,000 in one year and treat it as 5 years of $18,000 each); (2) recognizing that a married couple's gift-splitting effectively doubles the annual exclusion per donee; (3) distinguishing the annual exclusion (per-donee, every year) from the lifetime exemption (cumulative).

Estate tax and the step-up in basis — the wealth-transfer cornerstone

At death, an individual's assets are valued and (1) subject to estate tax above the lifetime exemption, AND (2) receive a STEP-UP IN BASIS for income tax purposes. These are two separate consequences of death; both are tested:

• Step-up in basis. An heir inherits the asset at FAIR MARKET VALUE on the date of death (or alternate valuation date 6 months later). All gains that accrued during the decedent's lifetime are PERMANENTLY ELIMINATED for income tax purposes. The heir only pays tax on gains ABOVE the date-of-death value when they eventually sell. This is the most important provision in the tax code for high-net-worth families and the canonical reason to HOLD low-basis appreciated assets until death.
• Step-DOWN at death. Less commonly mentioned: if FMV at death is BELOW the decedent's original basis, the heir's basis steps DOWN to FMV. The loss that would have been available to the decedent is permanently lost — another reason to harvest losses BEFORE death for terminally ill clients with depreciated assets.
• Estate tax. Applies to the gross estate above the lifetime exemption (~$13.6M+ in recent years). Federal rate up to 40% on amounts above the exemption. Most estates DO NOT owe federal estate tax due to the high exemption. State estate taxes may apply at lower thresholds in some states (Massachusetts, Oregon, New York have separate state estate taxes).
• Portability between spouses. The surviving spouse can inherit the deceased spouse's UNUSED lifetime exemption (the “DSUE” — deceased spousal unused exemption) by filing Form 706. Effectively doubles the lifetime exemption to ~$27M+ for married couples. Requires an estate tax return even if no tax is owed.

The Series 66 most-tested concept here: STEP-UP IN BASIS at death and the resulting tax planning — HOLD appreciated assets in taxable accounts; let them step up at death; the heir owes nothing on the accumulated gain. Compare to: SELLING during life and paying LTCG; or GIFTING during life (which transfers the donor's carryover basis without step-up).

Pass-through entities and K-1 reporting

PASS-THROUGH entities don't pay tax at the entity level — income, losses, deductions, and credits flow through to owners who report them on their own returns. The Series 66 tests several pass-through structures:

• S-Corporations. Pass income to shareholders on Schedule K-1 (Form 1120-S). Income retains its character (ordinary, capital gain, dividend, interest). Limited to 100 shareholders, US citizens/residents only, one class of stock.
• Partnerships and LLCs. Pass income to partners/members on Schedule K-1 (Form 1065). Most flexible structure. Active partners may owe self-employment tax on their share; limited partners typically don't.
• Master Limited Partnerships (MLPs). Publicly traded partnerships, mostly in energy infrastructure. Issue K-1s annually (not 1099s). Distributions are largely “return of capital” that reduces basis rather than creating current tax — until basis reaches zero. Complex tax reporting.
• REITs (Real Estate Investment Trusts). Required to distribute 90%+ of taxable income to shareholders. Distributions reported on 1099-DIV, typically as ORDINARY income (not qualified) — because REITs avoid corporate tax by passing income through. Best held in TAX-DEFERRED accounts to shelter the ordinary-rate distributions.
• BDCs (Business Development Companies). Similar pass-through structure to REITs, focused on lending and investing in middle-market companies. Distributions are usually ordinary income.

K-1 timing problem: K-1s are typically issued LATE (often March-September), well after the early-January 1099 mailings. Clients holding MLPs or partnerships often need to FILE TAX EXTENSIONS because the K-1 hasn't arrived by April 15. Advisers should warn clients about this when recommending pass-through holdings.

1031 like-kind exchanges (post-TCJA) and REIT taxation specifics

Section 1031 LIKE-KIND EXCHANGES allow deferral of capital gains tax when one property is exchanged for similar property. The 2017 Tax Cuts and Jobs Act (TCJA) substantially narrowed Section 1031:

• Post-TCJA: REAL ESTATE ONLY. Before 2018, like-kind exchanges applied to a wide range of property types (vehicles, equipment, intangibles, collectibles, etc.). The TCJA restricted Section 1031 to REAL ESTATE HELD FOR INVESTMENT OR BUSINESS USE only. Equipment, vehicles, art, and collectibles no longer qualify.
• Strict timing rules. The replacement property must be IDENTIFIED within 45 days of the sale and ACQUIRED within 180 days. Both deadlines are absolute — missing them disqualifies the exchange and triggers full taxation of the original gain.
• “Like-kind” is broad for real estate. Any real property held for investment or business use qualifies for exchange with any other real property. Raw land can be exchanged for a commercial building; an apartment complex for a warehouse.
• Boot is taxable. Any non-like-kind value received (cash, debt relief, dissimilar property) is “BOOT” and triggers gain recognition up to the amount of boot received, even within an otherwise valid exchange.
• The exchange DEFERS, doesn't eliminate. The original basis CARRIES OVER to the replacement property. When the replacement is eventually sold without another 1031, the cumulative gain is recognized. Step-up in basis at death erases the deferred gain entirely — the canonical “swap till you drop” strategy.

REIT taxation specifics. REITs avoid corporate tax by distributing 90%+ of taxable income annually. The trade-off for investors: most REIT distributions are NON-QUALIFIED (ordinary income rates). Three categories of REIT distributions reported on 1099-DIV:

• Ordinary dividends. Taxed at marginal ordinary rates (up to 37%). Most REIT income.
• Return of capital. Reduces cost basis; not currently taxable. Increases gain when REIT shares eventually sold.
• Capital gain distributions. Passed through long-term capital gains from REIT's own property sales. Taxed at LTCG rates.

For Series 66 purposes: REIT income is MOSTLY ORDINARY (not qualified dividend), and the 199A pass-through deduction (a TCJA provision) gives a 20% deduction on qualifying REIT dividends — effectively reducing the top rate from 37% to ~29.6%. REITs are TAX-INEFFICIENT relative to qualified-dividend stocks; asset location matters.

Individual income tax fundamentals — baseline summary

Capital gains.

• Short-term capital gains (held ≤ 1 year): Taxed as ORDINARY income (marginal rates up to 37%).
• Long-term capital gains (held > 1 year): Taxed at PREFERENTIAL rates (0%, 15%, or 20% depending on income).
• Capital losses offset capital gains; up to $3,000 of net losses can offset ordinary income annually. Excess carries forward indefinitely.

Qualified dividends.

• Dividends from US domestic corporations and qualified foreign corporations.
• Taxed at the same preferential LTCG rates (0/15/20).
• Requires holding period of MORE THAN 60 DAYS during the 121-day window beginning 60 days before ex-dividend date.
• NON-QUALIFIED dividends (most REITs, money-market funds, MLPs) taxed at ordinary rates.

Tax-exempt interest.

• Municipal bond interest is generally EXEMPT from federal income tax.
• Treasury interest is exempt from STATE income tax.
• Both still report on tax returns even though excluded from regular taxable income.

Other individual tax concepts — baseline summary

Marginal tax bracket. The tax rate applied to the next dollar of income. The U.S. uses a PROGRESSIVE system — higher income is taxed at higher rates, but only the income IN each bracket is taxed at that bracket's rate. The marginal rate is used for the tax-equivalent-yield calculation (muni yield divided by 1 minus marginal rate); the effective rate is NOT.

Alternative Minimum Tax (AMT). A parallel tax system that disallows certain deductions and adds back “preference items” (state/local tax, certain depreciation, ISO bargain element when exercised but not sold, private-activity muni bond interest). Designed to ensure higher-income taxpayers pay a minimum amount of tax. The TCJA significantly raised the AMT exemption and phase-out, reducing the number of AMT taxpayers dramatically.

Kiddie tax. A child's UNEARNED INCOME above a threshold (~$2,500 indexed annually) is taxed at the PARENTS' marginal rate rather than the child's. Applies to children under 18 (or full-time students under 24). Designed to prevent parents from shifting investment income to children in lower tax brackets.

State income taxes. Most states impose their own income tax in addition to federal. Some states (Florida, Texas, Nevada, Washington, Wyoming, South Dakota, Alaska, Tennessee, New Hampshire) have no state income tax. State tax rules around capital gains, retirement income, and exemptions vary significantly — coordination with a state-licensed CPA is required for sophisticated planning.

Entity and wealth transfer taxation — baseline summary

Corporate taxation.

• C-Corporation. DOUBLE TAXATION — corporate income tax at the entity level (currently 21% flat federal rate post-TCJA) + shareholder dividend tax on distributions.
• S-Corporation. PASS-THROUGH — income taxed only at shareholder level via Schedule K-1. No entity-level tax. Eligibility limits: up to 100 shareholders, US citizens/residents, one class of stock.

Pass-through entities. REITs, MLPs (Master Limited Partnerships), partnerships, and LLCs pass income, deductions, and credits through to investors. No entity-level tax. Owners receive K-1s (partnerships, MLPs) or 1099-DIVs (REITs).

Estate and gift tax fundamentals.

• Annual gift tax exclusion (~$18,000-$19,000 in recent years, indexed annually): each donor can give to each donee each year without filing a gift tax return.
• Lifetime gift and estate tax exemption (~$13.6M+, indexed): combined cumulative shelter against federal gift and estate tax.
• Step-up in basis at death. Inherited securities receive a basis equal to FMV at date of death — eliminates lifetime accrued gains for income tax purposes.
• Portability. Surviving spouse can inherit unused exemption from deceased spouse via Form 706 (DSUE election).

Cost basis rules — complete reference table

The gifted (in-between) zone is the most-tested case. When FMV at gift is BELOW donor's basis AND recipient sells between FMV-at-gift and donor's basis, the result is NO GAIN AND NO LOSS — a unique outcome that exists only in the gifting context.

Wash sale rule — the canonical treatment

The WASH SALE RULE prevents investors from claiming an artificial tax loss while maintaining their position:

• Trigger. Sell a security at a loss AND buy a SUBSTANTIALLY IDENTICAL security within 30 days BEFORE or AFTER the sale → the loss is DISALLOWED for the current tax year.
• Disposition of the disallowed loss. Added to the cost basis of the replacement shares (the loss is DEFERRED, not eliminated). Realized when the replacement is eventually sold.
• The 61-day window. 30 days BEFORE + sale date + 30 days AFTER. Most-missed: the rule applies in BOTH directions; buying substantially identical security 25 days BEFORE the loss-sale also triggers it.
• “Substantially identical” interpretation. Same security or same-issuer security with substantially similar terms. Different mutual funds tracking the same index are usually considered DIFFERENT (acceptable replacements); preferred and common stock of the same company are usually DIFFERENT; identical CUSIPs are obviously substantially identical.
• Crossing accounts. The wash sale rule applies across the investor's accounts including spouse's accounts and controlled IRAs. Replacing in an IRA permanently disallows the loss (the basis adjustment goes to a tax-free account that doesn't track basis).

Tax-efficient investing — asset location matrix

Advisers should consider ASSET LOCATION — placing each investment type in the most tax-efficient account:

Asset location is one of the most reliably value-adding adviser activities — 25-75 basis points of after-tax return per year for clients with multiple account types. The classical errors: munis in tax-deferred (wasted exemption); REITs in taxable (ordinary-rate distributions); MLPs in IRA (UBTI).