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Understanding The New Tax Rules That Apply To Capital Gains And Qualifying Dividends

by Bradley J. Frigon, JD LLM

Income tax advice is not always provided as part of an elder law plan. Generally, elder law attorneys will provide counsel on estate planning matters, guardianship, conservatorships, and maximization of public benefits, such as Medicaid. Practicing in these areas will often involve advising clients in the sale or transfer of assets, or the transmutation of a non-exempt asset into an exempt asset, such as the purchase of an annuity or a principal residence. In a situation where counsel is given to sell an asset, full analysis of the long-term and short-term capital gain treatment and the timing of a sale can be paramount. In a situation where a non-exempt asset is being used to obtain an exempt asset such as an annuity, consideration should be given to the negative income tax consequences of the annuity (ordinary income tax treatment for distributions, and the lack of a stepped-up basis at the death of the annuitant) before the final decision is made. This article will analyze the calculation of net capital gain or loss, and the new tax rules that apply to long-term capital gains and qualifying dividends.

Ordinary Income and Capital Gain

The distinction between "ordinary" income or loss and "capital" gain or loss is a fundamental element of income tax law. Generally, everything that can be owned and used for either personal purposes or investment purposes is a capital asset. In fact, under the Internal Revenue Code , all property is a capital asset except for the eight classifications of property which are specifically excluded from the definition of a capital asset.

Understanding the tax treatment of capital gains became more critical with the enactment of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (Act). The Act significantly reduced the tax rates on long-term capital gains, dividends, and widened the gap between the top federal tax rate on ordinary income and long-term capital gains. Additionally, the Act lowered the rate on qualifying dividends from the ordinary income rate to the special capital gains rate.

Example. In 2004, a taxpayer earning $150,000 in wages(ordinary income) will have ordinary income of $150,000 taxed at a 33% rate which produces $49,500 of income tax for Taxpayer A. However a taxpayer who earns no wages but realizes a gain of $150,000 from the sale of stock held for more than twelve months will pay tax at the maximum capital gain rate of 15% resulting in an income tax of $22,500. Although both taxpayers have received consideration of $150,000, the taxpayer whose income is comprised of long-term capital gain proceeds will pay $27,000 less in tax because of the preferred tax treatment for long-term capital assets.

Holding Period

A fundamental element of the capital gain and loss rules is the distinction between "short term" and "long term" capital gains and losses. The determination of whether the sale or exchange of property yields a short term or long term gain or loss depends on the taxpayer's "holding period." Property held for more than one year produces long term gains or losses when sold or exchanged. Property held for less than one year produces short term gains or losses. In most cases, the taxpayer's holding period starts the day after the property is acquired and ends on the day of disposition. For publicly traded securities, the holding period begins on the day after the trading date (and not the settlement date) on which the securities are bought, and ends on the trading date that they are sold.

A sale or exchange of a capital asset held for less than a year will produce either short-term capital gain or a short-term capital loss. A sale or exchange of a capital asset held for more than one year will produce a long-term capital loss or a long-term capital gain.

Example. Taxpayer A, who is in the 33 percent tax bracket, bought 1,000 shares of XYZ stock on June 1, 2003. If Taxpayer A sells the stock on June 1, 2004, the stock will be held for less than a year since the holding period is treated as beginning on June 2, 2003, the day after the purchase and ends on June 1, 2004, the day of the sale. Thus, any gain on the sale will be a short-term capital gain that is taxed at the taxpayer's ordinary income tax rate. However, if the stock is sold on or after June 2, 2004, the taxpayer will have held the stock for more than a year and the gain on the sale will be a long-term capital gain taxable at a maximum rate of 15%.

Special rules apply where the taxpayer acquires the property by gift or by certain tax free exchanges which permit the taxpayer to tack the holding period of the transferor to his own holding period. Applying the same facts as in the above example, assume that the taxpayer gave 1000 shares of XYZ stock to a family member on March 1, 2004. If the family member sells the stock at a gain on or after June 2, 2004, that family member will have a long-term capital gain on the sale. Even though the family member has owned the stock for approximately three months, her holding period is more than twelve months because it includes the grantor's holding period.

If a taxpayer inherits a capital asset, the holding period will automatically be for more than one year regardless of the time the taxpayer actually held the capital asset before sale. Thus, all inherited capital assets automatically generate long-term capital gains or losses when sold regardless of the holding period of the taxpayer.

Netting Rules

Under the netting rules, like kind gains and losses are netted against one another. Short-term gains are netted against short-term losses to calculate the total short-term gain or loss. Likewise, long-term gains are netted against long-term losses, to calculate the total long-term gain or loss. Once the total short-term gain or loss and the total long-term gain or loss is calculated, the total short-term gains or losses are netted against their long-term counterparts. This will result in either net short term or net long term gains or losses. Thus, in a given taxable year, the taxpayer will have, at the most, only two of the four categories of net gains and losses:

  1. either a net short term capital gain or a net short term capital loss, and
  2. either a net long term capital gain or a net long term capital loss.

Example. In one year taxpayer A has the following transactions:

  1. Sells stock in XYZ company purchased less than 1 year before for a gain of $4,000;
  2. Sells stock in ABC company purchased less than 1 year before at a loss of $1,000;
  3. Sells a painting purchased more than 1 year before at a gain of $2,000; and
  4. Sells bonds that were purchased more than 1 year before at a loss of $3,000.

Taxpayer A has a $4,000 short term capital gain, a $1,000 short term capital loss, a $2,000 long term capital gain, and a $3,000 long term capital loss. The application of the netting rules produces a $3,000 net short term capital gain ($4,000 $1,000) and a $1,000 net long term capital loss ($2,000 $3,000). As a result, the taxpayer would have a total net-short-term capital gain of $2,000.

Short-Term Capital Gain
XYZ Stock $4,000

Short-Term Capital Loss
ABC Stock $1,000

Net Short-Term Gain
$3,000

Long-Term Capital Gain
Painting $2,000

Long-Term Capital Loss
Bonds $3,000

Net Long -Term Capital Loss
$1,000

Example. In one year taxpayer B has the following transactions:

  1. Sells bonds that were purchased less than 1 year ago at a gain of $2,000;
  2. Sells stock options that were purchased less than 1 year ago at a loss of $5,000;
  3. Sells shares of a mutual fund that were purchased more than one year ago at a gain of $6,000; and
  4. Sells stock that was purchased more than 1 year ago at a loss of $4,000.

Taxpayer B has a short-term capital gain of $2,000; a short-term capital loss of $5,000; a long-term capital gain of $6,000; and a long-term capital loss of $4,000. The netting rules produce a total net short-term capital loss of $3,000 ($2,000 - $5,000) and a total net long-term capital gain of $2,000 ($6,000 - $4,000). As a result, the taxpayer would have a total net short-term capital loss of $1,000.

Short-Term Capital Gain
Bonds $2,000

Short-Term Capital Loss
Options $5,000

Net Short-Term Gain
$3,000

Long-Term Capital Gain
Mutual Fund $6,000

Long-Term Capital Loss
Stock $4,000

Net Long -Term Capital Loss
$2,000

Example. In one year taxpayer C has the following transactions:

  1. Sells stock purchased less than 1 year ago at a gain of $3,000;
  2. Sells stock purchased less than 1 year ago at a loss of $4,000;
  3. Sells bonds purchased more than 1 year ago at a gain of $7,000; and
  4. Sells bonds purchased more than 1 year ago at a loss of $2,000.

Taxpayer C has a $5,000 net long-term capital gain, a $1,000 net short-term capital loss, and a net long-term capital gain of $4,000.

Short-Term Capital Gain
Stock $3,000

Short-Term Capital Loss
Stock $4,000

Net Short-Term Gain
$1,000

Long-Term Capital Gain
Bonds $7,000

Long-Term Capital Loss
Bonds $2,000

Net Long -Term Capital Loss
$5,000

Limitation on Deduction of Capital Losses

An individual taxpayer may deduct short-term or long-term capital losses to the full extent of short-term and long-term capital gains. In other words, there is no restriction on the use of capital losses to offset capital gains. If capital losses exceed capital gains in a tax year, a maximum of $3,000 of the excess capital loss may be deducted against ordinary income. Net short-term or long-term capital losses that are not deducted in the current tax year may be carried forward indefinitely, and used to offset capital gains or ordinary income in future years. The capital losses that are carried forward retain their character as short-term or long-term capital losses for future tax years.

Example. Taxpayer A has a net long-term capital gain of $5,000, a net short-term capital loss of $9,000, and ordinary income of $55,000. Taxpayer A may deduct $5,000 of the capital loss against the $5,000 of capital gains, and $3,000 of the capital loss against the $55,000 of ordinary income. The remaining $1,000 of capital loss is not deductible in the current tax year and must be carried forward to following tax year.

Capital Gain Rates

Generally, the Jobs and Growth Tax Relief Reconciliation Act will tax capital gains at a 15% or 5% rate, effective for sales and exchanges that occur on or after May 6, 2003, and before January 1, 2009. The 5% rate becomes 0% in 2008. The 5% and 15% special tax rate will also apply to qualified dividend income. If not renewed by Congress, the special tax rates for capital gains and dividends are scheduled to expire at the end of 2008.

An individual in the 10% and 15% federal income tax bracket will qualify for the 5% special capital gain rate for a sale or exchange of a capital asset held for more than one year that occurs on or after May 5, 2003. An individual in the 25% or higher federal income tax bracket will pay a 15% capital gain rate for a sale or exchange of a capital asset held for more than one year that occurs on or after May 5, 2003.

For 2004, the 15% federal income tax bracket will apply to individuals with income that is below the following amounts:

Married Individuals Filing Joint Returns and Surviving Spouses:    

$58,100.00

Head of Households:

$38,900.00

Married Individuals Filing Separate Returns

$29,050.00

Unmarried Individuals:

$29,050.00

Example. For 2004, married taxpayer's joint return shows $60,000 of total income. $50,000 of income is from wages, and $10,000 is from a net long-term gain of from the sale of stock. Since the first $8,100 of gain from the sale of the stock is in the 15% federal income tax bracket for married individuals ($58,100 - $50,000) it will be taxed at the 5% capital gain rate. The remaining $1,900 of gain from the sale of the stock ($10,000-$8,100) is taxed at the 15% capital gain rate because it will fall in the 25% tax bracket for the couple.

Collectibles

The maximum tax rate attributable to long term capital gains from the sale or exchange of collectibles is 28%. To qualify for this special rate, the collectible must be a capital asset held for more than one year. The term collectible includes works of art, antiques, gems, stamps, and coins. If the taxpayer's regular tax rate is less than 28%, then the taxpayer's lower tax rate will apply to any gain recognized from the sale or exchange of collectibles. Any gain from the sale or exchange of an interest in a partnership, S corporation, or trust that is attributable to unrealized appreciation in the value of collectibles is treated as gain from the sale or exchange of collectibles.

Depreciable Real Property

The depreciation recapture rules of §1250 require a portion of the gain for which a prior depreciation deduction was claimed to be re-characterized as ordinary income. Generally, §1250 treats the amount of depreciation in excess of the amount allowable under the straight line depreciation method as ordinary income. Under the new rules, un-recaptured §1250 gain from the sale of depreciable real estate will be taxed at a maximum rate of 25%. Un-recaptured §1250 gain means the amount of long term capital gain that is not otherwise treated as ordinary income.

Qualifying Dividends

Qualified dividends received from domestic corporations and qualified foreign corporations are taxed at the same 15% and 5% rates that apply to long-term capital gains. To receive qualified dividend treatment, the stock from which the dividend is paid must be held for more than 60 days during the 121-day period that begins 60-days before the ex-dividend date. The holding period for determining the 60-day and 121-day periods will begin the day after the stock is bought and end with the day that the stock is sold.

Example. Taxpayer A is in the 33% tax bracket, buys 10,000 shares of ABC stock on April 30, 2004. ABC stock had declared a dividend of $0.10 a share on April 15, 2004, payable to shareholders of record on June 1, 2004 with an ex-dividend date of May 2, 2004. To receive the dividend, a stockholder must own the stock on or before the ex-dividend date which is a date set by the company declaring the dividend. Since Taxpayer A purchased the stock before the ex-dividend date, he will receive a dividend of $1,000 ($0.10 a share on 10,000 shares) on June 1, 2004. For this dividend to be taxed as a qualified dividend at a rate of 15%, instead of as ordinary income at a rate of 33%, the taxpayer must hold the stock for 60 days during the 121-day period beginning March 2, 2004 (60 days prior to the ex-dividend date), and ending July 2, 2004. Since the taxpayer's holding period did not begin until May 2, 2004 (the date after he bought the ABC stock), the dividends received by the taxpayer are not qualified dividends eligible for the 15% special tax rate.

Example. The ex-dividend date for XYZ stock is May 2, 2004. The taxpayer purchased 10,000 shares of XYZ stock on April 30, 2004. The taxpayer sold 2,000 of the shares on June 16, 2004, but continues to hold the remaining 8,000 shares. In this example, the taxpayer held 2,000 shares for 47 days (May 1, 2003 through June 16, 2003) of the required 121-day period. As a result, the dividends received from the 2,000 shares do not qualify as qualified dividend income. The dividend from the 8,000 shares will be qualified dividend income because the taxpayer held the 8,000 shares more than 60 days during the 121-day qualifying period. In this example, the qualifying period began March 2, 2004 (60 days prior to the ex-dividend date) and ends July 2, 2004 (60 days after the ex-dividend date).

Mutual funds

Special rules apply to mutual funds. If the mutual fund receives qualifying dividends from stock that it owns, and passes those dividends to its shareholders, the shareholders may apply the lower rates to those dividends provided the mutual fund company differentiates between the various classifications of dividends at the end of the year on its year end tax reporting to the shareholders.

Conclusion

The tax code gives preferential treatment to long-term capital gain income and qualifying dividends over ordinary income. As a result, any recommendations the elder law attorney makes to the client may have substantial income tax consequences. With a basic understanding of the capital gain rules, the elder law attorney will be better able to help our clients maximize their assets and meet their long term care objectives.

Call (720) 200-4025 now or email us to find out how our Elder Law attorneys can help meet your long term care objectives.




  1. All section references are to the Internal Revenue Code of 1986, as amended, and the regulations thereunder, unless otherwise specified.
  2. Under §1221, the following categories of income are excluded from the definition of capital gain:
    1. stock in trade or other inventory property and property held primarily for sale to customers in the ordinary course of your business (or property that will physically become a part of the merchandise that is for sale to your customers);
    2. accounts or notes receivable acquired in the ordinary course of your trade or business, for services rendered, or from the sale of any of the types of property described in (1), above;
    3. depreciable property used in your trade or business (even though fully depreciated) and real property used in your trade or business;
    4. a copyright, literary, musical or artistic composition, letter or memorandum, or similar property that is (a) created by your personal efforts, (b) in the case of a letter, memorandum, or similar property, prepared or produced for you, or (c) acquired from a person who created the property, or for whom the property was prepared, under circumstances in which your basis in the property is determined in whole or in part by reference to the basis of the person who created the property, or for whom it was prepared or produced (e.g., by gift);
    5. U.S. Government publications that you got from the government for free or for less than the normal sales price or that you acquired under circumstances in which your basis in the publications is determined in whole or in part by reference to the basis of someone who got the publications for free or for less than the normal sales price.
  3. 2003 Jobs and Growth Tax Relief Reconciliation Act, P.L. 108-27.
  4. Assuming unmarried taxpayer with no other deductions against income.
  5. §1222(3), (4).
  6. §1222(1), (2).
  7. §1223.
  8. §1223(11).
  9. §1211(b).
  10. §1211(b).
  11. §1212(b).
  12. §1212(b)(1).
  13. A taxpayer in the 10% or 15% income-tax bracket that holds a security for more than five years that is sold before May 6, 2003 will be taxed at an 8% rate. A taxpayer in the 10% or 15% income-tax bracket who held an investment for more than one year and sold before May 6, 2003 will be taxed at a 10% rate. For sales of long term capital assets before May 6, 2003 that do not fall within the five year property, a taxpayer will pay in the 25% or higher bracket will pay 20% on net long-term capital gains.
  14. §1(h)(1) as amended by the 2003 Jobs and Growth Tax Relief Reconciliation Act, P.L. 108- 27, §301.
  15. §1(h)(1).
  16. §1(h)(5)(A).
  17. §1(h)(5)(A).
  18. §1(h)(5)(B).
  19. §1250 property.
  20. §1(h)(1)(D).
  21. §1(h)(6).

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