Q: If I win $1 million playing a slot machine at Atlantic City and the casino offers me a choice of $1 million in a lump sum or $50,000 a year for 20 years, what are the pros and cons? Are these two choices roughly equivalent after taxes?
A: If you make a simplistic comparison of the two numbers, the $50,000 a year looks like the better deal as far as taxes are concerned. Assuming a single individual with no dependents, using the zero bracket amount and having no other income, the federal income tax will consume almost half of the lump-sum prize money -- about $485,000 using 1985 rates.
With the same assumptions, the annual $50,000 would suffer a federal tax cost of a little over $12,000, or a total of about $243,000 over the 20 years -- just about half the tax bite on the lump-sum payment.
But those numbers disregard factors such as the time value of money -- that is, the present discounted value of the future payments -- and the ravaging effect of even low-level inflation on the annual payments. (For example, without going to my calculator to work this out, I would guess that with 3.5 percent inflation, the buying power of the $50,000 would be cut roughly in half by the end of the 20 years.)
Look at it this way. If you take the $50,000 a year, you will end up with a little less than $38,000 in spending money each year, after Uncle Sam takes his share. If you opt for the $1 million, you'll have about $515,000 after federal tax.
Invested at 8 percent in tax-free municipal bonds, you'll pick up about $41,000 in untaxed money each year -- a little more than you would get the other way. And there's a big plus: At the end of the 20 years, when the annual payments would stop, you'll still have the $515,000 invested and will continue to receive that $41,000 a year for ever and ever, amen.
Now that you know which choice to make, I hope you're serious about winning the $1 million. I'm not much of a gambler type; on a cross-country trailer trip in the mid-1970s, we spent about a week in Reno, Las Vegas and Lake Tahoe -- and contributed something like a total of $8 to the various gambling emporiums (including a roll of nickels we blew on the slot machines in Harold's Club). But maybe if I were close enough to winning to start worrying about the tax bite, I'd be ready to go back. Good luck -- I hope you cash in big.
Q: There is a cap on the deductibility of interest payments on investments of $10,000 plus net investment income. Because very few real estate investments yield positive cash flow after interest and depreciation, how is it possible to invest in significant amounts of real estate unless interest/depreciation are not included in computing net income?
A: You must first distinguish between real estate held for investment as an individual and real estate held for investment as a part of a business. That is, if you are in the business of buying and selling real property, then interest expense is a cost of doing business; it is deducted on Schedule C rather than Schedule A, and is therefore not subject to the limitation you mention.
Next you must distinguish between real estate held for investment and real estate held for the production of income. If the latter (and your mention of depreciation leads me to believe that is what you're talking about), the interest expense is accounted for on Schedule E, not Schedule A, and is not restricted by the "$10,000 plus" limit.
Thus, the limitation on deduction of interest applies strictly to loans made for the purpose of acquiring investment property. This includes such things as a margin loan from your broker and a mortgage loan for the purchase of investment property (as opposed to rental property).
I think the limitation is fair. Your goal when you purchase stocks on margin or investment real estate is to sell the asset later at a profit. At that time, the profit will be taxed at the favorable capital gains rate. (It's reasonable to assume that most investment real estate and at least some securities will be held for at least six months.)
It would not be equitable to permit the taxpayer to deduct the interest expense in full against such income as wages or salary, then pay tax at the capital gains rate when the property is later sold at a profit.