Fed Tax--The Post: "Understanding New Rules on Capital Gains"
Please consult your tax advisors for details.
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washingtonpost.com
>>> Understanding New Rules on Capital Gains
By Albert B. Crenshaw
Sunday , September 24, 2000 ; H01
Tucked away in the 1997 Taxpayer Relief Act, and perhaps forgotten by many taxpayers, is a provision that further lowers capital gains tax rates.
But while most investors will welcome lower taxes, this reduction is a classic example of how Congress can never do anything the easy way. Indeed, certain aspects of the law might best be described as odd, even wacky.
However, because parts of it begin to take effect next year, some investors can benefit by understanding it and taking steps to align themselves with it.
Under the provision, rates will fall for some taxpayers as early as this coming Jan. 1, while others will have to wait until 2006 to benefit and then only for assets acquired after this year. But investors who have older assets and would like the new rates to apply to them in the future can elect to recognize gains to date, pay taxes on those now and lock in the lower rate on future appreciation.
Got all that? No? Well, let's take it again, slowly.
First, gains on the sales of stocks, bonds and certain other assets are now taxed at two rates: 10 percent for gains that would be taxed in the 15 percent bracket if they were ordinary income, and 20 percent for income that would be taxed at 28 percent or higher were it not capital gain. (Certain other assets, such as collectibles and some real estate, are taxed at higher rates and will not be eligible for the new lower rates, either.)
Second, to qualify for these preferential capital gains rates, assets must be held longer than a certain time, known in tax talk as the holding period. The current holding period for long-term gains is a year; gains on assets held less than a year are short-term gains and are taxed at ordinary income rates.
The law adds another holding period of five years, and it is to assets held five years or more that the new rates apply.
Beginning Jan. 1, 2001, the 10 percent rate falls to 8 percent for assets held five years or more. The rate takes effect immediately, so investors who have assets they have owned for five or more years can save 2 percentage points on their tax rate by selling next year, rather than in 2000.
High-income taxpayers face a much more complicated situation.
Under the law, the 20 percent rate falls to 18 percent on assets held more than five years, but in this case the holding period must begin in 2001 or later. In other words, assets acquired next year would get the lower rate if sold in 2006 or later. Assets owned now don't qualify.
Unless.
To prevent investors from having to sell their assets and buy them back, thus incurring transaction costs as well as taxes on current gains, the thoughtful lawmakers put in an option known as a "deemed sale and repurchase election." Under it, a taxpayer after Jan. 1 can pretend to have sold an asset and bought it back. The taxpayer will have to pay taxes on whatever gain he or she has accumulated since the asset was originally acquired, but any future appreciation will be taxed at 18 percent instead of 20 percent when the asset is finally sold.
Experts say the new rules create an incentive for some taxpayers to hold off at least until next year in selling assets. But they caution that because of the way the brackets work, moderate-income taxpayers with large gains will see the 8 percent rate apply to only a portion of the gain. The rest will be taxed at 20 percent.
In an example provided by RIA, a New York tax analysis and software firm, suppose a couple with $35,000 of ordinary income also realizes a capital gain of $30,000 next year on sale of stock they had held for more than five years.
Assuming that the 15 percent bracket on a joint return next year goes up to $45,000, they would pay $5,250 (15 percent) in tax on their $35,000 of ordinary income, and $800 (8 percent) on the first $10,000 of their capital gain. The rest of their gain is taxed at 20 percent, or $4,000 on the remaining $20,000.
However, that's still a savings of $200 that they would realize by selling in 2001 rather than this year.
Remember, of course, that these examples assume no change in asset value. If you have reason to think the value will decline, then you could be better off selling now, taxes notwithstanding.
Higher-income taxpayers who expect to hold an asset, say a stock, for many years should similarly consider waiting until after Jan. 1 to buy it, assuming there is no pressing market reason to buy it now. Deferring the purchase will qualify the stock for the 18 percent rate after 2006--potentially a substantial saving on a big gain.
The really tricky part of the new rates is the "deemed sale" provision. Exercising this option could result in savings, but it could also be a booby trap.
"You have to be an optimist about the future of your capital gain property," said Bob Trinz, an editor of RIA's Federal Taxes Weekly Alert. "You have to believe it will accelerate in value substantially over the long term. You've got a long way to go to overcome the time value of" the money you'd pay in taxes now.
David M. Bradt Jr. of the Arthur Andersen accounting firm said because you know the potential tax savings--2 percentage points--the option "lends itself to a pretty quantifiable break-even point," but the answers depend entirely on what assumptions you make.
There are a few other instances in which paying taxes now instead of later can be advantageous, but "most tax planning is focused on deferral of taxes" so you get to keep your money longer, Bradt said.
Trinz noted that the Internal Revenue Service has not yet issued guidance on exactly how this election will work. Details such as how long you have to make it--the end of the calendar year, for instance, vs. the due date of your return--have not been officially addressed.
However, IRS officials said they will provide guidance in the instructions to various forms and in publications beginning around the middle of next month, and will say that the election must be made on a timely filed return, including extensions--which would give taxpayers well into 2002 to decide.
Trinz and others urged great caution in using this election because it is irrevocable and you have to guess not only about the asset's future performance but also about what tax bracket you will be in.
For instance, prepaying tax on assets held less than a year will result in ordinary income (with rates up to 39.6 percent). "A worst-case scenario would be you prepaid tax on a short-term gain . . . then years down the road you are only in the 15 percent bracket," Trinz said.
However, there are circumstance where it could be advantageous. If, for instance, you have a stock that's been flat or slightly higher but you expect it to turn up later on, you could use the deemed-sale option and pay little or no tax and lock in the lower rate for years in the future (2006 and beyond).
On the other hand, if you have a loss at this point, it would probably be better to sell the stock and recognize the loss (because you can't recognize a loss under the deemed-sale provision) and buy it back next year (taking care to avoid the wash-sale rules, which bar selling at a loss and buying substantially the same security 30 days before and 30 days after the sale).
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