NEW CAPITAL GAIN RULES

            The 1997 Taxpayer Relief Act (1997 TRA) reduced long-term capital gains tax rates.  For capital assets sold at a gain after being held more than one year), the 1997 TRA provides reduced tax rates of 10 percent and 20 percent.  The 10 percent tax rate applies to long-term capital gain generated by taxpayers in the 15 percent ordinary income tax bracket.  The 20 percent tax rate applies to long-term capital gain generated by taxpayers in an ordinary tax bracket that is higher than the 15 percent bracket; that is, to taxpayers who are in the 28 percent, 31 percent, 36 percent, or 39.6 percent ordinary income tax bracket

            The 1997 TRA also established new five-year capital gains tax rates of 8 percent and 18 percent beginning after 2000, and a special election that can be made with regard to the 18 percent five-year tax rate.  Different rules apply to the two new five-year tax rates.  As a result, taxpayers who are in the 15 percent ordinary income tax bracket have different considerations than taxpayers who are in a higher income tax bracket.  In certain cases, taxpayers will have to take both sets of rules into account in order to make the best use of the new five-year tax rates.

            In addition, there is a special election, discussed below, that can be made in 2001 that allows capital assets acquired prior to 2001 to enjoy the benefit of the reduced 18 percent five-year tax rate.  Three simple calculations made for each capital asset can assist taxpayers in deciding whether to make the special election.

 

The 8 Percent Five-Year Capital Gains Tax Rate

            Beginning in 2001, the new 8 percent long-term capital gains tax rate is available for capital gains generated on the sale of capital assets held for more than five years.  The new tax rate is available in 2001 to the extent that a taxpayer is in the 15 percent ordinary income tax bracket.  For 2001, a single individual is in the 15 percent ordinary income tax bracket if their taxable income is not over $27,050.  For 2001, a married couple filing a joint return is in the 15 percent ordinary income tax bracket if their taxable income is not over $45,200.  Thus, a married couple filing a joint return who have taxable income of less than $45,200 for 2001, and who sell a capital asset in 2001 (at a gain) that they have held for more than five years, can benefit from the new 8 percent five-year tax rate.  The problem and planning consideration--is that this 8 percent tax rate benefit may be limited.  In order for the married couple to enjoy an 8 percent tax rate on their entire capital gain, their total capital gain combined with their other income cannot result in total taxable income exceeding $45,200.  If their total taxable income (consisting of the five-year capital gain and other income) exceeds $45,200 for 2001, only the portion of the five-year capital gain that is a part of taxable income up to $45,200 receives the benefit of the reduced 8 percent tax rate.  The remaining portion of the five-year capital gain (the portion of the five-year capital gain that represents taxable income in excess of $45,200) is taxed at the 20 percent long-term capital gains tax rate.

            It is important to note that the 20 percent rate, and not the new 18 percent rate, applies in this instance.  This is because the new 18 percent five-year capital gains tax rate is not available until 2006.  Taxpayers in the 15 percent ordinary income tax bracket in 2001 who wish to use the 8 percent five-year tax rate in 2001 should be careful to measure their potential five-year capital gains as part of their total taxable income for the year.  This is especially important if they believe that they will remain in the 15 percent ordinary income tax bracket for 2002.  If their total potential five-year capital gains will push their total taxable income for 2001 out of the 15 percent ordinary income tax bracket and into the 28 percent (or higher) ordinary income tax bracket, they should consider making only a partial five-year capital gain sale in 2001.

            For example, a taxpayer that has owned shares of stock for more than five years should sell only enough of these shares so that the favorable 8 percent rate will apply to the sale; that is, the taxpayer should sell only enough shares so that none of the gain from the sale will be taxed at the higher 20 percent rate.  Then, in 2002, another partial sale of the five-year capital assets can be made and taxed at the lower 8 percent rate (subject to the same 15 percent ordinary income tax bracket limitations).  Of course, before making a partial sale rather than a complete sale, a taxpayer should consider the likelihood of a drop in the asset’s value occurring before the taxpayer is able to complete the sale in the following year.  Partial sales (in order to enjoy a more extensive use of the favorable 8 percent tax rate multiple years) should only be considered if a taxpayer is confident that the value of the asset will not drop as the taxpayer continues to hold it.

 

The 18 Percent Five-Year Capital Gains Tax Rate

            Unlike the 8 percent tax rate available for taxpayers in the 15 percent ordinary income tax rate bracket, the 18 percent five-year capital gains tax rate is not available for 2001. The earliest year the 18 percent rate will be available is 2006.  This new rate is available for capital assets acquired after 2000.  Thus, this new rate is primarily for taxpayers that acquire capital assets beginning in 2001, and hold these assets for more than five years.  Since 2001 is the statutory starting year for the five-year holding period, 2006 is the earliest year that the benefit of the 18 percent tax rate will be available.

            For taxpayers who acquire capital assets in 2001 and later years, and hold these assets long term, the main tax issue is: Should they sell a long-term capital asset prior to end of the five-year holding period, or should they continue to hold the asset until after the five-year period has lapsed? If they sell before the five-year period has lapsed, but  after holding the capital asset for more than one year, the 20 percent long-term capital gains tax  rate rather than the reduced 18 percent rate will apply.

            Taxpayers facing this choice on an ongoing basis, especially as their holding period for a capital asset nears the end of the five-year period, should utilize the three calculations discussed below.  The same three comparison calculations can be done for the shorter period of time remaining until the five-year period has lapsed in order to determine whether it is better to sell and pay 20 percent or continue to hold and pay 18 percent.

 

The Five-Year Capital Gain Election

            As noted above, the 18 percent five-year capital gains tax rate is primarily for capital assets acquired after 2000, and held for more than five years.  But what about capital assets acquired prior to 2001?  The 1997 TRA allows taxpayers to make a special election in 2001 that allows capital assets acquired before 2001 to be eligible for the reduced 18 percent long-term capital gains tax rate.  But there is a price for this special election.  In order to make the election, a taxpayer must pay the tax due in 2001 on the asset’s built-in gain as of January 2, 2001.  If the asset has a built-in loss as of January 2, 2001, that loss is not deductible for 2001.

            The election is made on an asset-by-asset basis.  Before making the election, a taxpayer should make the following three calculations for each asset in order to determine whether or not it is appropriate to make the election for the asset in question.

            Determine the amount of tax that will have to be paid in 2001 on built-in gain. If there is a built-in loss, determine the amount of lost tax savings for 2001.  For a long-term capital gain, the tax rate will be 20 percent.  If an election is made for an asset that has been held less than one year as of January 2, 2001, the tax cost is calculated at the taxpayer’s ordinary income tax rate (28 percent, 31 percent, 36 percent, or 39.6 percent).  For loss assets, determining the lost tax savings may be more complicated.  In certain tax scenarios, a long-term capital loss can be used to reduce short-term capital gain.  Thus, a built-in long-term capital loss has the potential to save ordinary income tax as well as long-term capital gains tax. Taxpayers should be careful to determine the exact amount of tax savings that have been lost as a result of making the special election for a capital asset with a built-in loss.

            Project five years after-tax earnings on the tax that must be paid in 2001 as a result of making the special election.  Similarly, if an election is made for a capital asset with a built-in loss, project five years after-tax earnings on the tax savings that are not enjoyed in 2001 as a result of making the election.  In making these projections, taxpayers should be conservative in their lost earnings assumptions.

            Divide the amount of the five years after-tax earnings by 2 percent.  This final calculation results in the amount of growth the capital asset will have to enjoy over the five-year period in order to justify making the special election.  If it is improbable that the capital asset will enjoy this amount of growth over the required five-year period, taxpayers should not make the special five- year election.

            EXAMPLE:  John has shares of stock in a company for which he paid $2,000 more than one year before January 2, 2001.  On January 2, 2001, the fair market value of the shares is $7,000.  Thus, John has a built-in long-term capital gain of $5,000 ($7,000 less $2,000).  If John makes the special five-year election for these shares, he will have to pay a $1,000 tax on the built-in gain ($5,000 X 20 percent long-term capital gains tax rate). John projects that by investing the $1,000 conservatively, he could generate after-tax earnings of $200 over a five-year period.  He divides this $200 in after-tax earnings by 2 percent and generates a comparative growth result of $10,000.  In order to justify making the special five-year election (and paying the $1,000 tax on the built-in capital gain in 2001), the value of John’s shares will have to exceed $17,000 ($7,000 increased basis as of January 2, 2001 plus $10,000 comparative growth requirement) at the end of the five-year period.

            To consider the comparison from another perspective, assume that John makes the special election for the shares of stock and pays the $1,000 long-term capital gains tax in 2001.  After the end of the five-year period, the value of the shares of stock is $16,000. John sells the shares and recognizes a $9,000 five-year gain ($16,000 sales price less $7,000 basis as of January 2, 2001).  Using the reduced 18 percent rate, the tax on the $9,000 gain is $1,620.  Had this same gain been taxed at 20 percent, the tax would be $1,800.  Thus, use of the 18 percent rate--rather than the 20 percent rate saves John a total of $180 ($1,800 less $1,620).  And, as noted above, this tax savings is less  than what John would have earned over the five-year  period ($200), if he had conservatively invested the $1,000 in 2001 rather than using it to pay the tax required in order to make the special five-year election.

            Taxpayers who wish to make the special five-year election should consider doing so for capital assets that they have held for more than one year, that have neither increased or decreased substantially in value since they were acquired, and that are expected to increase in value substantially over the required five-year holding period.  Taxpayers should avoid making the special election for assets that they have held for less than one year as of January 2, 2001, or assets with substantial built-in losses.  In both cases, more growth in the value of the elected asset will be required in order to justify the tax cost for 2001.