Deciphering the New Cap-Gains Rates
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But naturally, Congress has made implementing these new rates inexplicably complicated. For starters, while the new 8% rate starts this year and can be applied to investments you bought five years ago, the 18% rate doesn't kick in until 2006, so in this case, it's only your holding period that starts this year. Also, you can't take advantage of either rate for any of the following: 1) collectibles gains; 2) real-estate gains to the extent of depreciation write-offs claimed on the property; or 3) gains from certain small-business stock.
Of course, I suppose I shouldn't complain. It's tax rules like this that keep CPAs like me in business. So let me do what I do best — and tell you how to take advantage of these new rates.
The New 8% Rate for Low-Bracket Taxpayers
If you're in the 15% federal tax bracket, you're now eligible for a low, low rate of only 8% on capital gains from stock and other investment securities held more than five years ("five-year gains"). This compares with the standard 10% rate low-bracket taxpayers pay on long-term gains from investments held more than one year but not more than five years.
Keep in mind, if you receive stock or other investment securities as gift (say from a parent or grandparent), you get to count the giver's ownership period plus your own. That can make it much easier to meet the more-than-five-year rule and thereby qualify for the 8% rate. That said, this rock-bottom rate applies only to five-year gains triggered by sales on or after Jan. 1 of this year. So you won't reap any tax savings with your 2000 return.
Are You Eligible?
To have any chance of taking advantage of the 8% rate on your 2001 return, your taxable income — before counting any standard long-term gains (from assets held for more than one year) or any five-year gains — must be less than the applicable figure below. (These are the upper boundaries of the 15% bracket for tax year 2001.)
Remember, your taxable income figure is after subtracting write-offs for personal exemptions and the standard deduction or itemized deductions. So you can actually be in the 15% bracket even with a pretty healthy salary. (See the examples below.)
The maximum amount of five-year gain eligible for the 8% rate in 2001 is the lesser of: 1) your actual five-year gain amount for the year or 2) the difference between your taxable-income figure and the applicable number from above.
Have I lost you? Let me give you a couple of examples to (hopefully) clear things up.
Example 1: Say you're single and your 2001 salary income will be $32,000. Your only tax write-offs are a personal exemption for yourself ($2,900) and the standard deduction ($4,550). So your taxable income is $24,550 before counting any standard long-term gains or five-year gains ($32,000 - $2,900 - $4,550 = $24,550). You have a $3,300 five-year gain from selling some stock given to you by your grandmother (bless her heart). In your case, the maximum amount of a five-year gain that can possibly qualify for the 8% rate is $2,500 ($27,050 - $24,550). This is less than your actual five-year gain of $3,300. Bottom line? You'll owe only 8% on the first $2,500 of your five-year gain. But the balance of your five-year gain ($800) falls outside the 15% bracket, so you'll pay 20% on that..
Example 2: Say you're married and file jointly with your wife, who stays home with your new baby. Your 2001 salary income will be $55,000. Your only tax write-offs are personal exemptions for you, your wife and the baby ($2,900 x 3) and the standard deduction ($7,600). So your taxable income is $38,700 before counting any standard long-term gains or five-year gains ($55,000 - $8,700 - $7,600 = $38,700). You also have a $5,000 five-year gain from selling some long-held Microsoft (MSFT) stock plus a $3,800 standard long-term gain from selling some other stocks you held for more than one year.
In your situation, the maximum amount of five-year gains that can possibly qualify for the 8% rate is $6,500 ($45,200 - $38,700). This means your entire $5,000 five-year Microsoft gain will be taxed at only 8%. (You've gotta love that.) We've now accounted for $43,700 of taxable income ($38,700 + $5,000) and we're still $1,500 under the $45,200 top end of the 15% bracket. What does that mean for that $3,300 long-term gain you racked up from selling that other stock? That you'll pay 10% on the first $1,500, but the $2,300 balance ($3,800 - $1,500) falls outside the 15% bracket and is therefore taxed at 20%
Got it? Don't worry, this won't seem nearly so complicated when you actually fill out your tax return. All the stuff I've explained here will automatically be taken care of provided you correctly fill out your Schedule D. (Unfortunately, the 2001 version of Schedule D won't be released by the IRS until late this year.)
Under-Age-14 Children
Depending in on their investment income, children under age 14 as of Dec. 31, 2001, may or may not be eligible for the 8% rate. Why? The dreaded Kiddie Tax. These rules state that if a child's total investment income — including all capital gains — exceeds $1,500, then some of the child's income will be taxed at his or her parent's rates. That said, if the child's total investment income is less than this amount (and the investment has been held for more than five years) then he or she is eligible for the 8% rate in 2001. But if the $1,500 limit is exceeded, all or part of the child's five-year gains may be taxed at the parent's capital-gains rate, which will usually be 20%.
Age-14-and-Older Children
Children who will be 14 or older at the end of this year are blissfully unaffected by the Kiddie Tax rules. And in most cases, all of an older child's five-year gains will fall within the 15% bracket and thereby qualify for the 8% rate. Why? Because in 2001 the 15% bracket for a child (or young adult who is unmarried) over age 14 includes taxable income all the way up to $27,050. So as long as the child's taxable income (including five-year gains) is no more than that figure, the 8% rate is in the bag.
New 18% Rate Also Debuts
There's also a new and improved 18% capital-gains rate for taxpayers in the 28% bracket and above. This is good news, but unfortunately, you need to wait until 2006 to reap any tax savings. Here's how it works.
Gains from investments acquired on or after Jan. 1, 2001, that are held for more than five years will be taxed at a maximum rate of only 18%. This compares with the 20% maximum rate on most standard long-term gains.
For investments acquired before 2001, you can choose to make a special one-time "election" and thereby become eligible for the 18% rate (eventually). Under this procedure, you pretend you sold the investment in question for its Jan. 2, 2001, market value. You also pretend you repurchased the investment for the same price on that same day. You'll owe any resulting capital-gains tax from the imaginary profit on the imaginary sale with your 2001 tax return. Unfortunately, the extra tax bill won't be imaginary.
Here's the upside on this deal. Future appreciation in the value of the investment will be taxed at only 18% (instead of the usual 20%), as long as you hold on for at least another five years before selling. The downside? You have to wait until at least 2006 to actually realize any tax savings, which is an awfully long time. That's why I think this is rarely the way to go.
However, here are a couple situations where it's worth thinking about.
Say you have shares that closed on Jan. 2, 2001, for exactly what you paid for them or just a very small amount more. You're also convinced you'll continue to own these shares for at least five more years. In this case, the "election" makes sense. Why? The 2001 tax hit from the imaginary sale transaction will be little or nothing. And if the shares in question appreciate, you'll pay only 18% on your profit when you eventually sell in 2006 or later. In other words, the cost is zero or next to nothing, and the future benefit will be substantial if the shares skyrocket. If the shares drop, you'll have a regular capital loss (no special rules apply).
Here's another situation where the election could make sense, although it's less obvious. Say you have some shares that closed on Jan. 2, 2001, for a price well above what you paid for them. Again, you're convinced you'll continue to own the shares for at least five more years. You also have an overall capital loss in 2001 or a capital-loss carryover from 2000. If you make the election, you can shelter the capital gain from your imaginary sale with your capital losses. So there's no current tax hit. And if the shares in question appreciate, you'll pay only 18% (instead of 20%) on your profit when you eventually sell in 2006 or beyond.
Smart move? That depends. If you sell short-term investments this year, you might be much better off using those losses to offset these short-term gains. That's because when short-term gains go unsheltered, you owe taxes at your regular rate (which could be as high as 39.6%).
One thing, however, is very clear. You should never make the election for shares with a Jan. 2, 2001, closing price substantially below what you paid for them. Why? Because the loss from your imaginary sale transaction is totally disallowed for federal income-tax purposes. In this case, consider making an actual sale of the shares. This gives you a real, live capital loss you can actually use to reduce your real, live taxes. You can then reacquire the shares in question and wait at least five years to sell. Your eventual profit will qualify for the new 18% rate, because you bought the shares in 2001. Just make sure you wait at least 31 days after the sale to reacquire the shares, otherwise your tax loss will be disallowed because of the "wash sale" rules.
Fortunately, you don't have to decide to make (or not make) this special election until you file this year's 1040 sometime in 2002. By then you'll know exactly what happened this year, and the pluses and minuses will be easier to assess
