On February 3, 1913, the Sixteenth Amendment to the Constitution was ratified, giving Congress the power to tax income "from whatever source derived." The first Form 1040, filed that year, was four pages long. Today, the Internal Revenue Code runs over 2,600 pages, and the regulations interpreting it fill roughly 9,000 more.
For the Series 7, you don't need to be a tax attorney. But you absolutely need to understand how different securities are taxed—because tax treatment is often the deciding factor in whether a particular investment is suitable for a client. A municipal bond yielding 4% might actually put more money in a high-bracket investor's pocket than a corporate bond yielding 6%. Understanding why is the point of this chapter.
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Section 1: Tax Basics & Taxation of Equity
The Internal Revenue Service is part of the Department of the Treasury. It collects taxes and enforces the Internal Revenue Code. But here's a distinction the exam tests: the IRS doesn't prosecute tax evaders. That's the Department of Justice. The IRS identifies and audits; the DOJ takes people to court.
Types of Income
Earned income — salaries, wages, bonuses, tips, commissions. Subject to
FICA taxes.
Portfolio (investment) income — dividends, interest, capital gains. NOT
subject to FICA.
Passive income — rental income, limited partnership income. Can only
offset passive losses.
These categories matter because the IRS restricts how losses in one category can offset income in another. You can't use a loss from a limited partnership to reduce your W-2 wages.
Capital Gains and Losses
When an investor sells a security for more than they paid, the profit is a capital gain. The tax rate depends entirely on how long the security was held:
| Holding Period | Classification | Tax Rate |
|---|---|---|
| 12 months or less | Short-term | Ordinary income rate |
| More than 12 months | Long-term | 0%, 15%, or 20% |
Short-term losses offset short-term gains first. Long-term losses offset long-term gains first. If there's a net capital loss remaining, up to $3,000 per year can be deducted against ordinary income. Any excess carries forward indefinitely.
Test Tip: The holding period is "more than 12 months" for long-term treatment—not "12 months or more." One extra day matters.
Test Tip: Profits from short sales are always treated as short-term capital gains, regardless of how long the short position was held open.
Determining Cost Basis
Cost basis is the purchase price plus commissions. Three methods for identifying which shares were sold:
- Specific identification — investor tells broker exactly which shares to sell
- FIFO (First In, First Out) — the IRS default
- Average cost — available only for mutual fund shares
You own 100 shares at $100 each (total basis: $10,000). After a 2-for-1 split, you own 200 shares. Your total basis is still $10,000, but your per-share basis is now $50. In a 1-for-5 reverse split: 20 shares at $500 each. Same $10,000 total basis.
Taxation of Dividends
Qualified dividends from corporate stock are taxed at the preferential capital gains rate (15%, or 20% for the highest bracket). Nonqualified dividends are taxed at ordinary income rates.
Interest from corporate bonds does NOT receive the qualified dividend rate—it's always ordinary income.
Stock Dividends and Splits
Stock dividends and stock splits are not taxable when received. They simply change the per-share cost basis.
Dividends-Received Deduction
Corporations receiving dividends from other corporations get a dividends-received deduction of 50% or more—making preferred stock attractive for corporate investors.
Tax Reporting Forms
Portfolio income is reported to the IRS by the payer. Dividends are reported on Form 1099-DIV, which details cash dividends, qualified dividend amounts, capital gains distributions, and REIT distributions. Interest income is reported on Form 1099-INT, broken into taxable and nontaxable (municipal) interest.
Mergers and Conversions
Shareholders receiving stock in a merger generally face no taxable event. Converting convertible preferred or bonds to common stock is also not taxable.
No Capital Events in Retirement Accounts
Transactions inside tax-deferred retirement plans (IRAs, 401(k)s, etc.) are not capital events. Buying and selling within the account does not generate taxable gains or losses. After-tax (Roth) contributions are also not considered capital events. Only distributions from the account create a tax obligation.
Section 2: Taxation of Options
Three possible outcomes for an option position, each with different tax consequences:
Expiration: Long position = capital loss. Short position = capital gain.
Closeout (traded): Gain or loss = difference between premiums.
Exercise: No immediate tax event. Premium is folded into cost basis or sale
proceeds.
| Position | Closed Out | Expires | Exercised |
|---|---|---|---|
| Long Call | Gain/loss on premiums | Loss = premium | Cost basis = strike + premium |
| Long Put | Gain/loss on premiums | Loss = premium | Proceeds = strike − premium |
| Short Call | Gain/loss on premiums | Gain = premium | Proceeds = strike + premium |
| Short Put | Gain/loss on premiums | Gain = premium | Cost basis = strike − premium |
Puts and Holding Periods
Buying a put on stock held short-term wipes out the holding period—it resets to zero. If the put is exercised, the gain is short-term regardless of how long you held the stock.
Married Put
Buy stock and a put on the same day = a married put. The IRS treats the put premium as part of the stock's cost basis. Holding period is based on the stock.
Test Tip: Most options expire within a year, so gains and losses from expired options are typically short-term.
Section 3: Taxation of Bonds
The tax exemption for municipal bond interest dates back to the Supreme Court's 1895 ruling in Pollock v. Farmers' Loan & Trust Co., which held that taxing state and local bond interest was equivalent to taxing the states themselves. The exemption has survived for over a century—making municipal bonds one of the most tax-advantaged investments available.
Bond Interest Taxation
Interest from corporate bonds is taxed as ordinary income at all levels. However, bond interest paid by a corporation is deductible against corporate taxes—unlike dividends paid on stock. This is a powerful advantage for companies choosing to raise capital through debt rather than equity.
| Bond Type | Federal Tax? | State/Local Tax? |
|---|---|---|
| Municipal | Exempt | Depends on residency |
| Treasury | Taxable | Exempt |
| Corporate | Taxable | Taxable |
Bonds issued by U.S. territories (Puerto Rico, Guam, U.S. Virgin Islands) are triple-tax-exempt.
Test Tip: Agency securities (GNMAs, CMOs from GSEs) are fully taxable at all levels—even though they're backed by the government. Don't confuse agency bonds with Treasuries.
Comparing Yields
Investor in the 30% bracket comparing a 10% corporate bond to a 7% muni:
Corporate
net yield: 10% × 0.70 = 7%
Muni taxable equivalent: 7% ÷ 0.70
= 10%
They're equivalent. If the muni yields anything above 7%, it
wins.
Premium and Discount Bonds
Premium bonds (above par): holder can amortize the premium, reducing cost basis to par at maturity.
Jane purchases a $1,000 par, 10-year bond on the secondary market for $1,100. The bond is redeemable in 7 years. Premium = $100. Annual amortization = $100 / 7 ≈ $14.29/year. Each year, Jane's adjusted cost basis decreases by $14.29 until it reaches $1,000 at maturity—eliminating any capital loss.
Discount bonds (below par): discount is accreted (added to cost basis). Accreted discount is taxed as ordinary income.
Municipal Bond Specifics
- Premium on munis must be amortized
- OID on munis: accretion treated as tax-exempt interest
- Bank qualified bonds: issuers offering ≤$10M/year in tax-exempt bonds. Banks deduct 80% of carrying costs.
Section 4: Taxation of Mutual Funds
The 90% Distribution Rule (Subchapter M)
If a regulated investment company distributes at least 90% of net investment income to shareholders, the fund itself pays no tax on distributed income.
Three Taxable Events for Fund Investors
- Dividend distributions — from dividends and interest earned by the fund
- Capital gains distributions — from profits on securities the fund sold
- Redemption — when the investor sells their shares
Test Tip: Capital gains distributions are based on the fund's holding period, not the investor's. If the fund held a stock for 3 years, the distribution is long-term—even if the shareholder just bought the fund yesterday.
Funds never distribute net capital losses. Losses stay in the fund and reduce NAV.
| Fund Type | Federal | State | Local |
|---|---|---|---|
| Corporate bond fund | Yes | Yes | Yes |
| Agency (GNMA/CMO) fund | Yes | Yes | Yes |
| Treasury fund | Yes | No | No |
| Municipal bond fund | No | Maybe* | Maybe* |
*Depends on whether the investor resides in the issuing state.
Reinvestment and Cost Basis
Automatically reinvested dividends and capital gains are still taxable in the year received. Reinvestment increases your cost basis (you're purchasing more shares at NAV).
Municipal Bond Fund Caveat
Dividends from a municipal bond fund may represent tax-free income, but if the fund buys and sells bonds at a profit, those capital gains are taxable to shareholders. Tax-free applies only to the interest income, not to the fund's trading profits.
Additionally, a fund's NAV may decline while investors still owe capital gains taxes—if the fund sold appreciated securities inside the portfolio, those gains are distributed even though the overall fund price dropped.
Switching Funds
Exchanging shares between funds in a fund family is a taxable event. Don't confuse with switching inside a 401(k), which is tax-sheltered.
Section 5: Annuities, Life Insurance & Retirement Plans
Annuities
Nonqualified annuity contributions are made with after-tax dollars. Earnings grow tax-deferred. Withdrawals during accumulation follow LIFO—earnings come out first (taxable), then principal.
Early withdrawal before 59½: 10% penalty plus ordinary income tax on earnings.
Death Benefit During Accumulation
If the annuity owner dies during the accumulation phase, the beneficiary pays ordinary income tax on the gain—the amount above the original cost basis.
Losses During Accumulation
If the annuity's value drops below the cost basis and the contract is fully surrendered, the loss may be deductible.
Non-Qualified Annuity RMDs
Non-qualified annuities have no required minimum distributions during the owner's lifetime. (Beneficiary distribution rules apply upon death.)
Tax-Qualified Variable Annuities
Qualified variable annuities are funded with pre-tax dollars. Because contributions were never taxed, all distributions are taxed as ordinary income—both the contributions and the earnings.
1035 Exchange
A 1035 exchange allows a tax-free swap of one annuity for another, or life insurance to annuity. You cannot exchange annuity to life insurance—that direction is taxable.
Life Insurance
- Cash value growth: tax-deferred
- Death benefit: generally tax-free
- Policy loans: not taxable (unless policy lapses)
Traditional IRA vs. Roth IRA
| Traditional IRA | Roth IRA | |
|---|---|---|
| Contributions | Pre-tax (deductible) | After-tax (not deductible) |
| Growth | Tax-deferred | Tax-free |
| Distributions | Ordinary income | Tax-free (if qualified) |
| RMDs | Required at age 73 | None during lifetime |
| Early penalty | 10% + income tax | 10% + tax on earnings only |
Test Tip: Converting Traditional to Roth triggers ordinary income tax—but no 10% penalty and no income limit on conversions.
IRA Rollovers
Must complete within 60 days. One rollover per 12-month period. Direct trustee-to-trustee transfers are unlimited and have no tax consequence.
Section 6: REITs & DPPs
REITs
REITs distributing at least 90% of net investment income avoid entity-level taxation (Subchapter M). Distributions are generally taxed as ordinary income.
Direct Participation Programs (DPPs)
DPPs are pass-through entities. The partnership pays no taxes. Income, gains, losses, and deductions flow to partners via Schedule K-1.
DPP income is passive income. Passive losses can ONLY offset passive
income—never earned or portfolio income.
Exception: up to $25,000 from
active participation in real estate rental can offset other income.
Tax Basis in a Partnership
Tax basis = maximum deductible losses. Established by: initial investment, cash contributions, share of recourse debt, partnership income. Reduced by: distributions, losses, debt reductions.
Tax Credits vs. Tax Deductions
- Tax deduction: reduces taxable income (value depends on bracket)
- Tax credit: reduces tax liability dollar-for-dollar (always more valuable)
Depreciation in DPPs
Most real estate or equipment leasing partnerships generate deductions primarily through depreciation. For residential real estate, the IRS allows straight-line depreciation over 27.5 years. For example, a building acquired at $2,500,000 generates approximately $90,909 per year in depreciation deductions.
At-Risk Rules and Nonrecourse Debt
The IRS at-risk rules limit loss deductions to the amount the investor has "at risk"—generally the initial investment plus their share of recourse debt (debt for which the investor is personally liable).
Exception: Real estate partnerships can include nonrecourse debt in their tax basis. This exception does not apply to other types of DPPs (oil/gas, equipment leasing, etc.).
Disposing of a Partnership Interest
When a partner disposes of their interest, any suspended passive losses become fully deductible.
Section 7: Other Tax Issues
Charitable Donations
Long-term securities: deduct fair market value. Short-term securities: deduct cost basis only.
Estate Tax and Inherited Securities (Stepped-Up Basis)
When a person dies, their estate may be subject to estate taxes—but the person who inherits assets from the estate is not subject to estate taxes. That obligation falls on the estate itself.
Beneficiaries receive a stepped-up cost basis—FMV on date of death. All subsequent sales are long-term regardless of actual holding period.
Gifted Securities
Annual gift exclusion: $18,000 (2024), $19,000 (2025-2026). A married couple can double the exclusion: $36,000 (2024), $38,000 (2025-2026). Gift tax is paid by the donor. Recipient inherits the donor's cost basis and holding period.
Wash Sale Rule
Sell at a loss and buy the same or substantially identical security within 30 days before or after (61-day window) = loss disallowed. The disallowed loss is added to the cost basis of replacement shares.
You sell 300 shares of XYZ at a $1,200 loss. Two weeks later, buy back 300 shares. Wash sale—the $1,200 loss is disallowed and added to your new cost basis.
A wash sale is not illegal—you just can't claim the loss. A municipal bond tax swap (selling one muni, buying a different one) avoids the wash sale rule because the bonds aren't "substantially identical."
Gift Tax Exclusions
| 2024 | 2025 | 2026 | |
|---|---|---|---|
| Annual Exclusion | $18,000 | $19,000 | $19,000 |
| Lifetime Exclusion | $13.61M | $13.99M | $13.99M |
Alternative Minimum Tax (AMT)
The AMT is a parallel tax ensuring high-income taxpayers pay a minimum tax. Key AMT add-backs:
- Interest from private activity municipal bonds
- State and local tax deductions disallowed entirely (vs. deductible up to $10,000 under regular tax)
- Home mortgage interest only deductible if the loan was used to purchase or improve a primary or secondary residence
- Incentive stock option exercise gains (the difference between grant price and FMV at exercise)
- Accelerated depreciation adjustments (straight-line is not affected)
Test Tip: To reduce AMT exposure, lower AGI through retirement plan contributions (401(k), 403(b), 457(b)), IRA contributions, and HSA contributions.
Key Terms Glossary
| Term | Definition |
|---|---|
| Earned income | Wages, salaries, bonuses; subject to FICA |
| Portfolio income | Dividends, interest, capital gains; not subject to FICA |
| Passive income | Rental/partnership income; can only offset passive losses |
| Short-term capital gain | Held ≤12 months; taxed as ordinary income |
| Long-term capital gain | Held >12 months; taxed at 0%, 15%, or 20% |
| Cost basis | Purchase price + commissions |
| Qualified dividends | Taxed at capital gains rate (15%/20%) |
| Dividends-received deduction | 50%+ deduction for corporations receiving dividends |
| Married put | Stock + put bought same day; premium added to cost basis |
| Triple-tax-exempt | Bonds exempt from federal, state, and local tax (territories) |
| Net yield | Coupon × (1 − tax rate) |
| Taxable equivalent yield | Muni coupon ÷ (1 − tax rate) |
| Amortize | Reduce cost basis of premium bond over time |
| Accrete | Increase cost basis of discount bond over time |
| Subchapter M | 90% distribution rule for RICs and REITs |
| 1035 exchange | Tax-free swap of annuity for annuity (or life insurance to annuity) |
| Exclusion ratio | Non-taxable portion of annuity payment |
| Stepped-up basis | Inherited securities use FMV at date of death as cost basis |
| Wash sale | Loss disallowed if same security repurchased within 30 days |
| Pass-through entity | Partnership income/losses flow to partners (K-1) |
| Tax basis (DPP) | Maximum deductible losses; set by investment + recourse debt |
| Form 1099-DIV | Reports dividend income (cash, qualified, capital gains distributions) |
| Form 1099-INT | Reports interest income (taxable and nontaxable) |
| Depreciation (DPP) | Primary deduction source; 27.5 years for residential real estate |
| At-risk rules | Limit loss deductions to recourse debt (exception: real estate) |
| AMT | Parallel tax system targeting high-income taxpayers |
Chapter 18 covers the tax treatment of virtually every security type on the Series 7. The IRS Code was designed to catch about 150 wealthy taxpayers who were paying zero federal income tax in 1969. By 2017, the AMT alone was hitting over 5 million households. Congress has adjusted the rules several times since, but the basic principle remains: the tax code giveth, and the tax code taketh away.