Coming Soon: New Super-Foolish Tax Rates [Tax Q&A]

Death & Taxes

Coming Soon: New Super-Foolish Tax Rates

By Roy Lewis
September 24, 1999

Here's something you should keep in mind as you plan your investing. In addition to the recently reduced capital gains tax rates, an even lower rate will soon be available to you.

Beginning January 1, 2001, the maximum capital gains rates for assets held more than five years are 8% and 18% (rather than 10% and 20%). If you're normally in the 28% (or higher) tax bracket, if you qualify, your capital gains rate could be reduced from 20% to 18%. Likewise, if you're in the 15% tax bracket, your long-term capital gains rate could fall as low as 8%. (Keep reading, though. As with most tax-related topics, this isn't as simple as it might appear. Sigh.)

Those in the 15% and higher-than-15% tax brackets are treated a little differently in terms of when they can start taking advantage of the new rates.

The 18% rate only applies to assets with holding periods that begin on or after January 1, 2001 -- no sooner. Using simple math, you can see that your long-term benefit will not kick in until 2006 at the earliest -- when you could actually sell the qualifying asset and meet your more-than-five-year holding period requirement.

For taxpayers in the 15% tax bracket, the five-year holding period begins on the date of actual purchase -- and you are not required to wait until 2001 or later to make your purchases. It is very possible, if you're in the 15% bracket, that a stock you bought in 1996 will be subject to the lower capital gains rates if you hold it for more than five years and sell it after January 1, 2001.

But, what about those in the normal 28% (or higher) bracket? What if you already have a long-term holding that you bought before 2001 and don't want to add to your position? How can you participate in the new capital gains rates?

In effect, you would have to "sell" and then "repurchase" those shares. The law says that if you have shares that you hold on January 1, 2001, you may 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 turn right around and treat those same shares as if they were originally purchased on January 1, 2001 for an amount equal to the fair market value. (You read that right. You're pretending that you sold and then repurchased the shares on the same day, at fair market value.) Note that according to current law (which may 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 gain is recognized (and taxable). And, any loss would not be allowed. It's really all 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 over your stock and pretend that it has been sold. Confused? Let's look closer.

Example: Jeb bought 100 shares of medical supply company Smooth Operations (ticker: SMOOP) on October 11, 1996, for $15 per share. January 1, 2001 rolls around, and he still owns those shares. (Way to buy and hold, Jeb!) He wants to participate in the new, lower 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 gain will amount to $50 per share, or a total gain of $5,000. That 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.

Note that transferring your holdings to take advantage of the extra low rate isn't necessarily 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. It's certainly not for everybody.

Another example: Let's begin with the same facts as above, except that we'll put Jeb in the normal 15% bracket when he sells his shares in 2001. If he waits until at least October 12, 2001 (to qualify as a more-than-five-year holding period for the shares he bought October 11, 1996) to make the sale, Jeb can receive the benefit of an 8% capital gains rate. Why? Because he is in the 15% bracket when the shares are sold, which allows him to begin his holding period for the shares sold on the actual date of purchase -- rather than on January 1, 2001.

One very large question may 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% gain? 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 that will clarify this (and other) points regarding the new "super" capital gains rates. But, as of this writing, I can only guess at what the rules might be in such a circumstance. The good news is that there's still about a year before this provision actually kicks in. And that should allow the IRS to write regulations that will offer a clue on how the rules will work. Until then, all we can really do is watch and wait.

So, that's all of the good news. And you thought you didn't have anything to look forward to after year 2000, eh?

Please note that Roy cannot answer individual questions via e-mail. If you have tax questions, please ask them on the taxes message board. Thanks!

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