The CPA Journal

Capital Gains Planning Opportunities for 2001

By Leonard J. Candela, CPA

The Taxpayer Relief Act of 1997 (TRA ’97) reduces the capital gains tax rate from 20% and 10% to 18% and 8% for certain property held for more than five years. To qualify for the 18% rate (but not the 8% rate), the holding period for the asset must begin on or after January 1, 2001. Consequently, the 18% rate will not come into effect until 2006. The 8% rate applies to property held more than five years and sold after December 31, 2000, that would have otherwise qualified for the 10% rate. In order to accommodate taxpayers, TRA ’97 allows them to avoid the costs of selling and reacquiring assets through the use of a deemed sale and repurchase of the assets by marking them to market. See the Sidebar for a summary of the deemed sale-repurchase election.

The law. Section 311 of TRA ’97 [codified as IRC section 1(h)(2)] provides for a reduced capital gains tax rate for property held for more than five years. Qualifying property includes readily tradable stock (stock tradable on an established securities market, including shares of an open-ended mutual fund), other capital assets, and property used in a trade or business. Not only do securities qualify for this treatment, but so do assets used in a trade or business that generate IRC section 1231 gains.

The lower rates are 18% and 8% on capital gains of property with a holding period greater than five years, as opposed to 20% and 10% on capital gains of property held for more than one year. To qualify for the 18% rate, the holding period must start on or after January 1, 2001. TRA ’97 provides a mark-to-market mechanism that allows taxpayers to treat readily tradable securities as if they were sold and reacquired for their market value as of January 2, 2001. (Other capital assets and property used in a trade or business are marked-to-market as of January 1, 2001.) The new holding period starts on the mark-to-market date. Any gain is recognized, but losses are not; they are lost forever. The wash sale rules are ignored for purposes of this election. An attempt to actually sell and repurchase securities that have decreased in value will not salvage the loss. Although under the wash sale rules the disallowed loss is added to the basis of the new security, the new security takes on the holding period of the old security. Thus, it would not have a holding period starting on or after January 1, 2001.

Election of the deemed sale. The election is made by reporting the deemed sale on the tax return with an attached statement that an election is being made under section 311 of the TRA ’97 and by specifying the assets for which the election is made. The election is irrevocable and can be made on a timely filed return, including extensions (i.e., October 15, 2002). If the taxpayer files a return without making the election, the election can be made on an amended return filed by October 15, 2002. Thus, the latest the election can be made, whether on an original or amended return, is October 15, 2002.

The election is available to pass-through entities and non-corporate taxpayers (i.e., individuals, trusts, partnerships, S corporations). If an election is made with respect to an interest in a pass-through entity, and the pass-through entity makes an election with respect to its assets, the pass-through entity’s election is deemed to have been made first. Stock acquired via options is deemed acquired when the option was issued. Thus, stock acquired in 2001 by exercising an option granted in 1999 has a holding period starting in 1999 and will not qualify for the reduced 18% rate.

The Consolidated Appropriations Act of 2001 attempted to eliminate the tax savings opportunities through a technical correction to TRA ’97. This act provides that the election is not effective for any property sold within one year of the effective date of the election, effectively eliminating the election for any property sold in 2001.

Tax savings opportunity. Stock market volatility and the minimal rate reduction would seem to limit the use of the election for anything other than short-term planning purposes. The election would not usually be beneficial for property that has significantly appreciated. The tax paid now for a 2% reduction on any further potential appreciation may not make economic sense. Thus, most elections made in the spirit of the law would involve property that the taxpayer intends to hold and which has not yet appreciated significantly despite significant appreciation potential. In addition, taxpayers with capital loss carryovers may be willing to make the election and recognize gains, because they will have little or no tax to pay because of the carryovers.

Although the technical correction limited the scope of the planning opportunity, it failed to eliminate it. The mark-to-market accommodation has provided an opportunity to reduce taxes in certain situations. Because the election does not have to be made until nearly 21Qs months after the mark-to-market date, there is ample time to review a taxpayer’s transactions and situation in order to convert short-term gains into long-term gains, spread gains over two years, and accelerate gains into 2001.This planning after the fact is possible because the election is valid even if the asset is not held for the entire five-year holding period. The tax advisor’s creativity, knowledge, and effort are the only limit to the opportunities.

Example 1. A taxpayer purchases security X in 1998 for $1,000. As of January 2, 2001, the market value for X is $3,000. In February 2002, the taxpayer sells X for $1,500. The taxpayer has short-term capital gains of $2,000 on other securities in 2002.

If no election is made, the taxpayer has a long-term capital gain in 2002 on X of $500 ($1,500-1,000) and a short-term capital gain on other securities of $2,000. The tax on these gains in 2002 (assuming 20% for long-term capital gains and 40% for ordinary income) is $900 ($500 ¥ 20% + $2,000 ¥ 40%).
If the election is made, the taxpayer would have a long-term capital gain on X in 2001 of $2,000 ($3,000-1,000). In 2002, there would be a long-term loss on X of $1,500 [$1,500-$3,000 (mark-to-market basis)] and a short-term gain on other securities of $2,000. Assuming the taxpayer had no other capital gains transactions in 2002, this would net to a $500 short-term capital gain. The tax for 2001 would be $400 ($2,000 ¥ 20%). The tax for 2002 would be $200 ($500 ¥ 40%). The total tax would be $600—a savings of $300 over when no election is made.

Example 2. A taxpayer purchases security Y in 1997 for $5,000. As of January 2, 2001, its market value is $55,000. In May 2002, the taxpayer sells security Y for $105,000.

If no election is made, the taxpayer has a long-term capital gain in 2002 of $100,000 ($105,000-5,000).
If the election is made, the taxpayer has a $50,000 long-term capital gain in each year, 2001 and 2002. Although the total tax at 20% would be the same, the taxpayer has been able to split the income between two years. This could result in a tax benefit if percentage of AGI limitations come into play (i.e., medical expenses, miscellaneous itemized deductions). Generating additional medical expenses of $3,750 ($50,000 ¥ 7.5%) in 2002 could save the taxpayer up to $1,500 in taxes.

Similarly, taxpayers can use the election to generate income in 2001 if that would be beneficial to their situation. This is possible even if property was not sold in 2002 before filing the return. This income could offset expiring NOLs or generate tax to use credits that would be lost. Accelerating the recognition of income could actually reduce a taxpayer’s overall taxes. There might also be nontax reasons for accelerating or shifting income.

Editors:
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Robert H. Colson, PhD, CPA
The CPA Journal

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