Death & Taxes

Capital Gains Tax Rates

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By Roy Lewis
January 5, 2001

Capital gains tax rates have changed considerably since 1997, including some even lower, very-long-term tax rates that went into effect on January 1, 2001. What capital gains tax rate applies to you specifically? It all depends on:

  • The type of asset you sold
  • Your cost basis
  • The length of time you held the asset before selling it
  • Your income level
Qualifying for the lowest rates are stocks, bonds, mutual funds, and many other capital assets. Taxed at a slightly higher rate are business or rental real estate, collectibles, depreciation, and some other things we won't get into here.

There are three holding periods for capital assets sold:
  • Those held for one year or less are considered short-term and receive no preferred tax treatment. You'll simply pay taxes at your "normal" tax rate on those gains.

  • Those held for more than one year are considered long-term, and you will receive a tax break on the sale of those assets.

  • Those held for more than five years are considered "super-long-term" and are taxed at an even lower rate than long-term gains. But, there are restrictions about when the assets were purchased that vary depending on your tax bracket.
Here's the bottom line:

If you're in the 15% income tax bracket:
  • Capital Gains on assets held for a year or less are taxed at your ordinary income tax rate (in this case 15%).

  • Capital Gains on assets held for more than a year, but less than five years, are taxed at a reduced rate of 10%.

  • Capital Gains on assets held for more than five years are taxed at a reduced rate of 8%.
If your ordinary income tax bracket is greater than 15%:
  • Capital Gains on assets held for a year or less are taxed at your ordinary income tax rate (anywhere from 28% to 39.6%, depending on your specific ordinary tax rate).

  • Capital Gains on assets held for more than a year are taxed at a reduced tax rate of 20%.

  • Capital Gains on assets held for more than five years are taxed at a reduced rate of 18%, but only if the assets were purchased on or after January 1, 2001. Assets purchased before January 1, 2001 that fall into this holding-period range are still taxed at the 20% long-term rate. (More on this in a moment.)
When you place an order to buy or sell a security with your broker, there will be a "trade date" and a "settlement date" recorded for the order. Which one counts for tax purposes? The trade date -- the date that the order was executed. The settlement date is immaterial for tax-reporting purposes.

Getting the Super-Low Rates on Capital Assets Purchased Before 2001

What if you are in the normal 28% (or higher) bracket, have a super-long-term holding purchased before January 1, 2001, don't want to add to your position, but want the super-low rates? Can you do something about it? Well, yes... but it might not be worth the trouble.

In effect, you have to "sell" and then "repurchase" those shares. The tax law says that, if you have shares that you hold on January 1, 2001, you can elect to treat the shares as having been sold on January 1, 2001 for an amount equal to their fair market value. Then you get to treat those same shares as if they were originally purchased on January 1, 2001 for an amount equal to the fair market value on that date. (You read that right. You're pretending that you sold and then repurchased the shares on the same day, at fair market value.)

According to current tax law (which might change in the future, as always), the imaginary transfer must take place on January 1, 2001. It appears, though, that this election will not have to be made until the 2001 tax return is filed -- sometime in 2002.

Be warned, though: If you elect to "sell and repurchase," any capital gain is recognized (and taxable), and any loss would not be allowed. It's a big game of "let's pretend" -- since no money actually changes hands and nothing is really bought or sold. (Your broker is also not involved, and no commissions figure into the picture.) The IRS simply allows you to wave a magic wand and pretend that your stock has been sold and then repurchased.

Example: Jeb bought 100 shares of stock on October 11, 1996, for $15 per share. He still owns those shares on January 1, 2001. He wants to participate in the new, super-low capital gains rates, but is in the 28% tax bracket in 2001. The fair market value of the shares on January 1, 2001, is $65 per stub, and Jeb elects to treat those shares as sold on January 1, 2001. His capital gain will amount to $50 per share, or a total gain of $5,000. That capital gain will be taxable to him on his 2001 tax return (the one he will file in April 2002). As the law is currently written, Jeb will pay 20% long-term capital gains tax (or $1,000) on that gain. He will be treated as buying the same 100 shares on January 1, 2001, for a total cost basis of $65 per share -- exactly what he "sold" it for. Jeb's holding period will begin all over again on January 1, 2001. If he holds the shares for more than five years (until at least January 2, 2006), any future capital gains will be taxed at the super-low rate.

Note that transferring your holdings to take advantage of the extra low rate isn't always worth it. You get the opportunity for gains going forward to be taxed at 18% instead of 20%, but you also have to suddenly pay taxes now on your current gains. For anyone with significant gains in a holding, it might make very little sense. For those with a small gain or a loss, it's a more attractive prospect.

Computing Your Tax Bracket

One very important point to understand about capital gains income is that, to determine your normal tax bracket for capital gains, your capital gain income is added to your regular income and you use the total... not just the portion related to your earned income. Then you're able to use Schedule D to compute your tax using a preferred tax rate on your long-term capital gain.

Please don't think that if you have $100 in other income and $1 million in long-term capital gains, that you're in the 15% bracket -- and that all of your $1 million in long-term capital gains will be taxed at the preferred 10% or 8% rate. It's just not true. You have to add your $1 million to your $100 and then look at your tax bracket.

One other very large question might spring immediately to your mind:

Q: What if I'm in the "normal" 15% bracket, and my gain will push me into a higher bracket? Am I still allowed the 8% tax rate for assets held longer than five years? And, is the stock that I sold eligible to be purchased before 2001?

A. Well, I'd love to be able to give you a straightforward answer, but I can't. I'm sure that the IRS will come up with regulations in the near future to clarify this and other points regarding the new "super-low" capital gains rates. But, as of this writing, I can only guess at what the rules might be in such a circumstance.

Don't Forget About AMT Implications on Large Capital Gains

Since we mentioned a very large capital gain, we need to also mention Alternative Minimum Tax (AMT). You might have heard that the preferred tax rates for capital gains will not trigger the dreaded AMT. That's true... at least somewhat.

For AMT purposes, you'll also receive a preferred capital gain rate on long-term capital gains. But, a large long-term capital gain could trigger some AMT taxes. So, if you've done well with your long-term investments and are looking to liquidate, review your AMT issues and determine what (if any) impact such a sale would have. You might be able to minimize your AMT taxes by selling only part of the shares in each of two taxable years, for example.

Buy-and-Hold -- Foolish and Tax-Savvy

That's the lowdown on the capital gains tax rates. For Foolish investors, a quick glance at the numbers above reveals the most important implication: The longer you hold your stocks, the less tax you're probably going to pay.
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