The CPA Journal

By Larry E. Farmer, J. Phillip Harper, and Betty Harper

IRC section 1(h) reduces capital gains tax rates from 20% to 18% for capital assets acquired after January 1, 2001, and held longer than five years. In addition, section 311(e) of the Taxpayer Relief Act of 1997 allows taxpayers to elect to report capital assets as if they were sold and repurchased on January 1, 2001 (January 2, 2001, in the case of marketable securities).

In the July 2001 issue, The CPA Journal reported that the election for the “deemed sale and repurchase” must be made no later than the due date for the 2001 tax return, including extensions. For calendar-year taxpayers, the deadline to amend a 2001 return to take advantage of this election will be October 15, 2002.

Late summer and early fall provide the perfect time to review client records to determine appropriate candidates for an amended return to take advantage of this election. An amended return to take advantage of this election provides a rare opportunity to do some “after-the-fact” tax planning.

General Taxability of Capital Assets Elected

If the “deemed sale and repurchase” election is made, taxes must be paid on the capital gains. Gains on capital assets acquired in 2000 will be taxed as short-term gains. Compounding the issue is that capital losses may not be taken and that the tax basis must be adjusted to the fair market value as of January 1, 2001. Despite these somewhat ominous provisions, many taxpayers may benefit from the election.

Assets With a Holding Loss as of January 1, 2001

One of the simpler decisions to make (albeit with some prognostication involved) concerns the election involving those capital assets held with a loss as of January 1, 2001. The capital loss cannot be taken. The tax basis must be adjusted to the market value as of January 1, 2001. The difference is lost forever. If the asset value recovers and is sold after 2005 at a gain, the gain will be taxed at a 2% lower rate.

A simple example will illustrate the taxpayer dilemma. Stock in ABC Co. has a tax basis of $30,000 and its value as of January 2, 2001, is $29,000. Taxpayer expects to hold this investment through 2005. Assume the stock is sold in 2006 (or later) for $45,000. If the deemed sale and repurchase election is made now, the capital gains tax will be 18% of $16,000, or $2,880. If the election is not made now, the capital gains tax will be 20% of $15,000, or $3,000. Obviously, it was advantageous to have made the election. However, if the stock were sold in 2006 for $35,000, the reverse would be true. If the election is made now, the capital gains tax will be 18% of $6,000, or $1,080. If the election is not made now, the capital gains tax will be 20% of $5,000, or $1,000.

A simple rule of thumb can be used to anticipate the tax impact. If the rise in the asset value after January 1, 2001, will be 10 times the disallowed loss, the advantage swings in favor of making the election. This formula recognizes that the increased gain taxed at the two percentage points lower tax rate must make up for the 20% of the disallowed loss.

From the example above, the disallowed loss in 2001 is $1,000. If the stock will be sold for any amount above $39,000, the taxpayer should have made the election. Exhibit 1 shows the annual rate of increase needed for various disallowed loss percentages in order to make the election advantageous. Remember that the required increase to make the election beneficial in the example above—from $29,000 to $39,000—is from a smaller base than the disallowed loss, which was from $30,000 to $29,000. The second column of Exhibit 1 reflects the smaller bases and, consequently, larger percentages.

The important point to keep in mind is that the tenfold increase does not have to take place rapidly in order to make the election beneficial. If held for 10 years, a 5% annual stock value increase will result in a 63% cumulative return.

Any sale of the elected asset before January 2, 2006, would result in no rate reduction, but would necessitate the aforementioned reduction of tax basis. The taxpayer will have made the wrong decision to elect the “deemed sale and repurchase” if the investment is eventually sold at a loss.

Assets With a Holding Gain as of January 1, 2001

A more complicated decision involves those capital assets held with a gain as of January 1, 2001. Is the taxpayer better off by paying the 20% tax on the gain up to January 1, 2001? Alternatively, is the taxpayer better off by not making the deemed sale and repurchase election and paying 20% of the total capital gain when sold? The election requires a cash payment now. Because this becomes an “investment,” the return on which will be the tax savings when sold, the taxpayer’s required rate of return on investment must considered.

Various time increments and the related rate of return on the investment of the early tax payments are indicated in Exhibit 2. The taxpayer’s required rate of return should be considered after taxes, but not be considered risk free. The tax savings will not be taxed, but there is no guarantee that the taxpayer will realize the tax savings. As indicated in the table, low-hurdle rates of return or small gains taxed in 2001 can be negated by achieving attainable returns on an investment. Although a factor in determining the required future annual return, the effect of the holding period is somewhat negligible.

Unusual Cases

Some taxpayers fall into the unique category of being able to report increased income without an increased tax liability. For example, a taxpayer might have unused unrecoverable tax credits. A college student or recent college graduate claiming their own dependency for the first time on a 2001 return might have an unused education credit or rate reduction credit. These taxpayers should be advised to take advantage of the deemed sale and repurchase election for those investments having a holding gain on January 2, 2002.

Economic factors may cause some taxpayers that would normally pay higher taxes to fall into the 15% bracket in 2001. Because this bracket allows them to take advantage of the 10% capital gains rate in 2001, it may be more beneficial to make the deemed sale and repurchase election than the Exhibits (1 & 2) indicate. It should also be noted that an additional provision of the Taxpayer Relief Act of 1997 reduced this rate to 8% for all capital assets held five years or longer without the stipulation that the asset had to be bought on or after January 1, 2001.

For gift and estate planning purposes, some taxpayers would benefit from a stepped-up basis in assets. They may have long-term losses in sufficient quantity that the total losses will never be used while holding gains in other assets. If such a taxpayer has been reluctant to sell and buy back the assets because of the trading costs, the deemed sale and repurchase election is a good way to avoid them. This tactic might be used with capital assets other than stock, such as appreciated land.

A taxpayer with a small capital gain in 2002 from a stock sale that could have been sold early in 2001 for a larger profit might be better off making the deemed sale and repurchase election on an amended 2001 return. The taxpayer could pay the 20% capital gains tax and then claim a net capital loss in 2002, thereby receiving up to a 38.6% benefit by offsetting ordinary income with the capital loss. This same planning will not work for a fiscal year taxpayer who sold within 12 months of January 1, 2001, and wants to pay the gains tax in one year and take the loss in the next fiscal year. The provisions of the Community Renewal Tax Relief Act of 2000 preclude the election of the gain when assets are disposed of within 12 months of the deemed sale.

Caveats

Care must be used when offsetting a net capital loss in 2001 with capital gains from this election. The taxpayer received a 28% or higher tax benefit from the net capital loss, but would get only a 20% benefit from the loss if it were used to offset a capital gain.

At first glance, what seemed like an opportunity to use the election to step up the basis of personal residence and then claim nontaxability of the gain (based on IRC section 121) was quelled when Congress intervened. The Job Creation and Worker Assistance Act of 2002 requires that any capital gain resulting from the deemed sale and repurchase made on an asset that qualifies as a personal residence be included in gross income.

Any tax return electing the deemed sale and repurchase must contain a statement that the taxpayer is making the election under section 311 of the Taxpayer Relief Act of 1997.

Larry E. Farmer, CMA, CIA, CPA, is a professor, and J. Phillip Harper, JD, CPA, and Betty Harper, EdD, CPA, are associate professors, all at Middle Tennessee State University.