2010 mock paper Rual Investment portfolio

CFA Level III
#1

Hi Guys,

I would seek advise with regard to his particular questions. (2010 Mock paper question 1)

During a recent review with Rual, DuBord notes that tax law changes, effective next year, will lower the tax on capital gains to 15% but eliminate the ability to offset income with realized losses. To minimize Rual’s tax liability, DuBord is considering the optimal location (tax deferred or taxable) for her assets prior to the tax law changes. DuBord and Rual agree to maintain Rual’s current asset allocation. Rual’s investment portfolio and asset location are shown in Exhibit 2. Taxes deferred account Bond $250,000 Equities: $500,000 Total $750,000 Taxable account Bonds: Current value: $500,000 , cost basis:550,000 Equities: Current value $250,000, cost basis $150,000 Total: $700,000

Question 1. Determine the “sell” amount of bonds and the “sell” amount of equities to achieve the most tax-efficient allocation in each account (tax-deferred and taxable).

CFA answer: Sell US$500,000 equities from Tax deferred account, sell $500,000 from taxable account

Selling the bonds in the taxable account results in realizing taxable losses equal to USD 50,000 at the current tax rate of 25%, which can then be used to offset income. After the tax law change, the loss cannot be used to offset or reduce taxable income. Under the new tax laws, interest income will continue to be taxed at 25%, realized capital gains will be taxed at 15% and dividends will not be taxed. These trades place the higher taxed incomeoriented assets in the tax-deferred account and the lower taxed capital gain and dividend paying assets in the taxable account. In addition, choosing to defer sales of equities that appreciated in value is justified because gains will be taxed at a lower rate in the future.

My question is on the equities side, why must i sell equities from tax deferred account?

i rather not sell anything from the equities side and defer paying any taxes on the Tax deferred account

Thanks you

#2

Sorry there a typo error on the taxable account, the total amount is also $750,000

#3

Hi,

Does anyone know why i must sell $500,000 equities?

Thank you

#4

This is my guess.

"DuBord and Rual agree to maintain Rual’s current asset allocation."

The total bond and total equity are pretty much 50-50 so if you sell only bonds, you will deviate from current alllocation.

What is unclear to me is what is the cost basis of that $500,000 equity in diferred tax acount? Because you are realizing a loss from sale of bond, where will you offset that? Nothing mentioned about tax loss carry forward either.

I have to assume Equity has gained in value so we can offset $50,000 loss.

#5

Although without looking at your answer, I wouldn’t have figured out that from which account should I sell equities? and that how much of it… I totally ignored the current asset allocation point until you asked the question…

#6

  1. equity earns dividends - there is no change in the dividend tax rate.

  2. returns - on either before or after scenario - there is no change in the tax rate.

  3. Bonds on the taxable account have a “loss” - which can be used for offsetting any gains elsewhere - but only in the current year since the law change does not permit those losses to be used later.

So it makes sense to sell the bonds from the taxable portfolio. No doubt about this one.

since you have sold the 500K in the taxable - you need to sell the 500K from somewhere else - and to match the current allocation 50% equity, 50% bonds - you need to sell the 500K from the tax deferred.

#7

Hi Guys,

Maybe my questions that i paste was not clear enough, there are a two part questions to this

So sorry about it. I just don want to bother you guys with too much words.

i would paste the full question here.

During a recent review with Rual, DuBord notes that tax law changes, effective next year, will lower the tax on capital gains to 15% but eliminate the ability to offset income with realized losses. To minimize Rual’s tax liability, DuBord is considering the optimal location (tax deferred or taxable) for her assets prior to the tax law changes. DuBord and Rual agree to maintain Rual’s current asset allocation. Rual’s investment portfolio and asset location are shown in Exhibit 2. Taxes deferred account Bond $250,000 Equities: $500,000 Total $750,000 Taxable account Bonds: Current value: $500,000 , cost basis:550,000 Equities: Current value $250,000, cost basis $150,000 Total: $750,000

Question 1. Determine the “sell” amount of bonds and the “sell” amount of equities to achieve the most tax-efficient allocation in each account (tax-deferred and taxable).

Question 2. Determine the “buy” amount of bonds and the “buy” amount of equities toachieve the most tax-efficient allocation in each account (tax-deferred and taxable).

CFA answer Q1: Sell US$500,000 equities from Tax deferred account, sell $500,000 BONDS from taxable account

CFA answer Q2: Buy $500,000 Bonds from Tax- deferred account, buy $500,000 of Equities from Taxable account

Selling the bonds in the taxable account results in realizing taxable losses equal to USD 50,000 at the current tax rate of 25%, which can then be used to offset income. After the tax law change, the loss cannot be used to offset or reduce taxable income. Under the new tax laws, interest income will continue to be taxed at 25%, realized capital gains will be taxed at 15% and dividends will not be taxed. These trades place the higher taxed incomeoriented assets in the tax-deferred account and the lower taxed capital gain and dividend paying assets in the taxable account. In addition, choosing to defer sales of equities that appreciated in value is justified because gains will be taxed at a lower rate in the future.

My question is on the equities side, why must i sell equities from tax deferred account?

To CPK123, Please correct if i am wrong; Even if i don’t sell the $500,000 equtiies from the tax deferred account, my asset allocation would not change. Cause when i sell $500,000 bond from the taxable account, i would buy back $500,000 of bonds in the Tax deferred account. I would not do any moderation on the equities side thus asset allocation remain unchanged. Thanks To the rest. Thanks you for helping

#8

Part 1 of the question is Sell ONLY

Part 2 of the question is BUY only.

500 K of Bonds on Taxable Account needs to be sold because it has a carry forward tax loss, which is immediately useful. Now if you plan to buy 500K of Bonds to keep your portfolio matched and unchanged - you would buy it on the other account - so 500K Bonds are bought on the Tax Deferred account.

That leaves

Tax Deferred - 750K Bonds, 500K Equities

Taxable - 250 K Equities.

To make 750K of equities - you need to sell th e 500K on the Tax Deferred and buy it on the Taxable.

The answer:

applies to both Q1 and Q2

#9

Hi CPK 123,

Hmm, i am actually still puzzled about this.

If i don’t sell $500K equities in the Tax deferred account. i still would have $750,000 equities in total also ($500K in tax deferred accunt and $250K in taxable equities). Why must i sell $500K in the tax deferred and buy $500K back in the taxable account. Why must i sell equities?

If the new tax law state that realized capital gain will be taxed at 15% and dividend will not be taxed, does it applied to tax deferred account also? So what happened if i don sell the equities?

Thanks alot

#10

the tax law is not separated by the type of account, it is standard across all accounts.

If you kept the equities across the Tax deferred and taxable accounts (500 in one and 250 in the other) - you are not selling equiies at all. That and the fact that you would then have the 50% across accounts violated - when you bought the bonds (since you sold them from taxable - you cannot buy them back there at a higher cost basis) - if you did that - you would be paying more taxes anyways.

#11

Hi CPK 123,

Which part of the question did you interprete from “50% account across account violated from” ?

One sentence of the question mentioned:

“To minimize Rual’s tax liability, DuBord is considering the optimal location (taxdeferred or taxable) for her assets prior to the tax law changes. DuBord and Rual agree to maintain Rual’s current asset allocation”

Does current asset allocation stated above mean to just maintain 50% of equities and 50% bond?

Thanks again

#12

Before:

Taxes deferred: Bond $250,000; Equities: $500,000 Total $750,000 Taxable account: Bonds: $500,000 , Equities: $250,000, Total: $750,000

Tax Deferred 750, Taxable 750, Equities 50%, Bonds 50%

After: Tax deferred 750 Bonds, Taxable 750 Equities, Equities 50%, Bonds 50%

you have to sell the 500K bonds in entirety to achieve the tax minimization. once you sell bonds in entirety - on one portfolio - you have to buy the bonds on the other portfolio in entirety. and once you do that - to maintain the equities - full equities has to be sold on one portfolio and bought for that amount on the other one.

I interpret it to mean 50% equities + 50% bonds, and 50% tax deferred + 50% taxable as well.

#13

Hi CPK123,

It seem very clear now.

Thank you so much