Death & Taxes

Super-long term Capital Gain Rates and Strategies

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By Roy Lewis
February 2, 2001

As you are aware, the Taxpayer Relief Act of 1997 included two provisions lowering the tax rate on gains from the sale of stock or mutual funds (and certain other property) held more than five years. The "normal" 10% long term capital gain rate (for those paying income taxes at or below the 15% rate) drops to 8%. And the "normal" 20% long term capital gain rate (for those paying income taxes at or above the 28% rate) drops to 18%.

One of the "kickers" in the new tax law is that the stock must generally be purchased after January 1, 2001, and held for at least five years to qualify for the new super-long term capital gains rates. You'll note that I said "generally," because the new 8% super-long term rate will apply as long as the shares have been held for five years -- regardless of when they were originally purchased. So, some of you might benefit from the new 8% super-long term gain rate as early as 2001.

But, how about you higher-bracket taxpayers? What if you have a stock that you don't really want to actually sell, but you still want to show a "purchase" in 2001 to qualify for the 18% super-long term capital gain rate in 2006 or later? What can you do? Well, you can play "let's pretend."

The Deemed Sale Election
The tax law says that if you hold a stock on January 2, 2001, you can elect to deem it "sold" effective on that date and then deem it "repurchased" on the same date to begin your five-year holding period on January 2, 2001. You don't actually have to sell and repurchase the shares and incur brokerage commissions on the actions. You simply "deem" the shares sold and repurchased at their fair market value on January 2, 2001.

If you deem the shares sold and repurchased, any capital gain will be treated as a taxable capital gain, but any loss will be ignored for tax purposes -- both in 2001 and any future years. In effect, the loss will be completely lost, with no basis adjustment for the future and no tax benefit for that loss either in 2001 or in the future.

In effect, if you sell the stock via the deemed sale election, your new holding period will begin on January 2, 2001, and your basis for the stock will be the fair market value of the shares on that date. If the shares are held until at least 2006, you'll then qualify for the new 18% super-long term capital gains rates.

Does the Election Make Sense?
Obviously, an 18% tax rate is better than a 20% rate, but it ain't that much better. So should you consider creating a tax liability in 2001 (for a deemed sale with a gain) when the 2% tax differential isn't available to you until 2006? It just doesn't seem like a very good deal, especially when you consider the time value of money (paying taxes to Uncle Sammy right now, when you'll not see the benefit of your 2% tax savings until 2006).

And, it gets worse: if the stock takes a dive, and you sell it at a loss some time in the future, the 2% rate differential offers no advantage. Or, if you make the deemed sale election and ultimately sell the shares before 2006, you'll still not receive the advantage of the 2% savings, since you won't have held the shares for the required five years. In both of these cases, you would be paying taxes early for nothing. Your tax benefit would be zilch.

There are cases when the election might make a bit more sense -- when your cost basis in the shares is close to the fair market value on January 2, 2001.

One of the beautiful things about making the election is that you're not required to do so until you file your 2001 individual income tax return in mid-April 2002. So, this is one of the very few times that you can take advantage of perfect 20/20 hindsight. You'll have about 14 months or so to watch the performance of your shares (from January 2, 2001, until you file your tax return for 2001) to see if the election might make sense for you.

How To Make the Election
According to the instructions for the 2000 Form 4797 (the only official guidance we have on this issue at this time), you simply make the election by reporting the sale on your tax return. When dealing with readily tradable stock (which includes shares issued by an open-end mutual fund), the deemed sale date is January 2, 2001. For qualifying assets other than readily tradable stock, the deemed sale date would be January 1, 2001.

If you have a gain on the deemed sale, you'd report the gain on the appropriate schedule (Schedule D for stocks and mutual funds). If you have a loss on the deemed sale, you would simply report a big, fat "goose egg" (zero) in the loss column. And, remember again that your loss is gone forever.

What sale price would you use for stock? The opening price? The closing price? The bid or ask price? Something else? Without specific guidance from Uncle Sammy, it's impossible to know, but my personal guess is that you would be required to use the average between the high and low prices for the trading day of January 2nd. We'll have to wait for the regulations to know for sure, but don't fret that the regulations aren't out quite yet. The election doesn't have to me made until early 2002... when you are preparing to file your tax return for 2001.

You fast thinkers out there might have come up with another case where a deemed sale would be beneficial. If you work the timing right and sell the deemed shares some time in 2001, it is possible to convert a short term capital gain into a long term capital gain, right? That would have been right had the Community Renewal Tax Relief Act of 2000 -- H.R. 5662 -- signed into law by the President on December 21, 2000, not come about. The tax law states that the deemed sale election isn't available for assets eventually sold in 2001. Let's see how the twist might have worked if those clever law makers hadn't spoiled it:

Example: Oliver bought $10,000 worth of XYZ, Inc. stock a number of years ago. On January 2, 2001, the stock was worth $15,000, but Oliver decides not to make the deemed sale election. In July 2001, Oliver sells the stock for $12,000. Earlier in 2001, Oliver sold another stock in his portfolio (not XYZ) for a $3,000 short term capital gain. If Oliver has no other sales for the year, he has a $2,000 long term capital gain ($12,000 - $10,000) and a $3,000 short term capital gain.

But suppose Oliver decided to make a deemed sale election for his XYZ stock. This would create a $5,000 long term capital gain on January 2, 2001, and a $3,000 short term capital loss when the shares were actually sold in July (because his new "cost basis" in the shares is the $15,000 fair market value as of January 2, 2001).

So, for the year, he would have a $5,000 long term capital gain, and no short term capital gain or loss (because the $3,000 short term loss from the XYZ shares sold would offset the $3,000 short term capital gain from the non-XYZ shares sold). In effect, this would convert his $3,000 short term gain from his other stock sale into a long term gain. It's a wonderful idea! But, sadly, this planning opportunity won't work because of the changes made by the tax bill.

Obviously, the deemed sale election isn't for everybody. In fact, most of you will simply ignore the election and will be better off just holding your shares. But, in the right circumstances, it can provide a benefit... primarily because you have until the time you file your 2001 tax return to see if the election works for you. That hindsight will help you make the right decision!

Roy Lewis lives in a trailer down by the river, and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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