The CPA Journal

Tax Planning with the New Capital Gains Rate

By Vincent J. Cosenza, CPA, Diamond Wohl Fried Roth & Company, CPAs, P.C.

Beginning January 1, 2001, there will be three holding period categories for capital gain taxation purposes:

Short term: less than one year
Mid-term: one year to less than five years
Long-term: greater than five years.

A new 18% long-term capital gains rate takes effect (at the same time for taxpayers in the top three brackets) for capital assets held longer than five years and acquired after January 1, 2001. For capital assets acquired before January 1, 2001, capital gains will be taxed at the 20% rate whenever realized in the future unless the taxpayer elects to pay the accumulated capital gains as of January 1, 2001, at the 20% rate. Under this irrevocable election, the asset’s basis becomes its January 1, 2001, deemed sales price; if it is held until after January 1, 2006, any additional appreciation will be taxed at the 18% rate when the asset is sold. For taxpayers in the 15% bracket, the new capital gains rate on capital assets held more than five years will be 8% (down from 10%), regardless of the holding period.

Losses are not recognized with this election. Only noncorporate taxpayers (individuals, trusts, and estates) are eligible. The at-risk basis rules disallow the election for flow-through entities (partnerships, S corporations, and LLCs) because a deemed sale is not for cash, disallowing any deemed capital gain or basis adjustment.

Assets eligible for the reduced rates (and the election) consist of long-term capital assets and real or personal property held in a trade or business that would have been taxed at the 20% (10%) rates under the old law [IRC section 1(h)]. Other capital assets to which the new rates (and election) will not apply include the following:

Small business stock and closely held stock eligible for the section 1219 exclusion
Collectibles
Real estate not held in a trade or business
Unrecaptured section 1250 property.

The election for the deemed sale of a capital asset is made on Form 1040 by showing the sale on Schedule D as of January 2, 2001, attaching a statement to the return that the taxpayer is making an election under Section 311 of the Taxpayer Relief Act of 1997, and listing the assets deemed sold under the election. Any assets actually sold during 2001, however, are not eligible for the election and the original basis must be used in calculating the capital gain.

Examples. A single taxpayer in the 15% bracket purchased 100 shares of IBM stock on 12/15/96 for $100 per share and sells it on December 20, 2001, for $110 per share. The gain will be taxed at the 8% rate, even though the stock was purchased before January 1, 2001, because she is in the 15% bracket.

Planning Ideas

Taxpayers can gift appreciated stock held for longer than five years to a minor over 14. The minor can sell the stock and pay the lower 8% rate if in the 15% bracket. Children under 14 are taxed at their parents’ rate.
If a taxpayer has large unrealized losses that he has not been able to offset, the deemed sale election provides an opportunity to clean up a portfolio without actually selling the stock with unrealized gains.
Take care that the long-term capital gains taken through the deemed sales do not trigger the alternative minimum tax with an effective rate of 26% or 28%.
Before making the election, a taxpayer should analyze whether it would be preferable to use the money saved from not paying the taxes on deemed sales to invest in additional shares of stock.
Consider that most investors do not hold stock for five years or longer because of the risks involved, including the following:
The company could go out of business or cease to exist.
The company’s prospects could change rapidly.
If the stock owner dies within the five-year period, the stock would be valued in the estate at the step-up, deemed basis but the beneficiaries would not benefit from the lower 18% rate.

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

Stephen Sacks, CPA, JD, LLM
Ernst & Young, LLP

Ira H. Inemer, CPA

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FEDERAL TAXATION