Capital gains after the TRA '97 - tax relief or mental strain?

While the Taxpayer Relief Act of 1997 (TRA '97) lowered capital gains tax rates, it also extended the holding period needed to qualify for the lowest rates, and added enormous complexity to the capital gain/loss calculation. This article explains the TRA '97's changes in the capital gains area and related issues for noncorporate taxpayers, such as alternative minimum tax, installment sales and sales of qualified small business stock.

Among the many changes made by the Taxpayer Relief Act of 1997 (TRA '97) were the enactment of new capital gains tax rates and holding periods. This article explores these changes and offers planning suggestions for noncorporate taxpayers.(1)

Rates and Holding Periods

The changes to rates and holding periods are intended to boost economic growth and reward long-term investment by more equitably taxing the increase in the value of capital assets.(2) Generally under Sec. 1 (h), as amended by TRA '97 Section 311 (a), for sales and exchanges after July 28, 1997, a 20% long-term capital gain/loss rate applies to capital assets held 18 months or more (the rate is 10% for taxpayers in the 15% bracket, to the extent of that bracket; excess gains are taxed at 20%).

The taxpayer's regular income tax rate still applies to gains from the sale or exchange of capital assets held for one year or less; a maximum 28% rate applies to assets held for one year and no more than 18 months.

For sales before May 7, 1997, the pre-TRA '97 rates and holding periods still apply. For sales between May 7,1997 and July 28, 1997 (inclusive), the 20% rate applies if the asset was held for more than one year. The table on page 400 summarizes the new rules.

Example 1: J, who is single, purchased 1,000 shares of G Co. for $50,000 on Jan. 15, 1997. J sold 250 shares of G on each of the following dates: Jan. 2, 1998 for $25,000; March 1, 1998 for $30,000; Aug. 1, 1998 for $35,000. These are J's only capital gains for 1998; his ordinary income for 1998 is $25,350. J's 1998 income tax liability, $16,703, is computed as follows:

Number
of shares sold   J's basis        Holding period
    250          $12,500     One year or less (short-term)
    250          $12,500     More than one year, but no more than
                             18 months (mid-term)
    250          $12,500     More than 18 months (long-term)

Number
of shares sold   Sales price   Gain on sale
    250            $25,000      $12,500
    250            $25,000      $17,500
    250            $25,000      $22,500

   Regular income: $25,350 x 15% =                $ 3,803
   Short-term capital gain: $12,500 x 28% (*) =     3,500
   Mid-term capital gain: $17,500 x 28% =           4,900
   Long-term capital gain: $22,500 x 20 =           4,500

   J's total tax liability                        $16,703

(*) J's regular income tax rate after filling 15% bracket.

Holding period begins the day after the property was acquired and ends on the date of disposition. The holding period is computed in terms of calendar months, not days. Trade date, rather than settlement date, is used to determine holding period.(3)

Under Sec. 1(h)(2), for sales occurring in 2001 and thereafter, the long-term capital gains rate is reduced to 18% (8% for those in the 15% bracket) if the asset has been held for more than five years. The five-year period includes any option (or other tight or obligation) to acquire the property.

Electing the 18% Rate

A taxpayer can elect to apply the 18% rate to gain on the sale or exchange of a capital asset purchased before 2001. Under TRA '97 Section 311(e), the taxpayer must treat the capital asset as though it was sold and reacquired on Jan. 1, 2001 (Jan. 2, 2001, if the asset is readily tradable stock) at its fair market value (FMV) (for readily tradable stock, closing market price) on that date. The election is available for "qualified five-year gain" (defined by Sec. 1(h)(9) as gain on property held by the taxpayer for more than five years, but not collectibles gain, unrecaptured Sec. 1250 gain, Sec. 1202 gain or mid-term gain).

Any tax on the deemed sale must be paid with the return on which the election is made; further, the election is irrevocable. The adjusted basis immediately after the deemed sale is the asset's FMV used to compute the gain; any loss resulting from the election is not allowed for any tax year. In the absence of an election, the 18% rate is available for sales of five-year assets beginning Jan. 1, 2006. The tax rate on the deemed sale gain is the taxpayer's applicable rate of tax for the holding period at the time of the deemed sale.

It will often be prudent to use this election for capital gain property with little or no current appreciation if the asset's value is expected to increase significantly between the year of deemed sale and the actual sale or exchange. The election is even more enticing if the taxpayer anticipates being in a higher long-term capital gains tax bracket in five years.

Regardless of holding period, a 28% rate applies to gain on the sale of collectibles (e.g., artwork, coins), under Sec. 1(h)(5). An exception applies under Secs, 1(h)(5) and 408(m)(3) for certain Federal- and state-issued coins. Under Sec. 1(h)(4)(B), a 25% rate applies to long-term unrecaptured Sec. 1250 gain.

Example 2: T is in the 31% tax bracket in 1998; she sells a building with an adjusted basis of $100,000 for $300,000. The building was purchased in 1990; $75,000 of modified accelerated cost recovery System depreciation had been taken before the sale. The $75,000 unrecaptured Sec. 1250 gain is taxed at a maximum 25% rate; T's remaining $125,000 of sale gain is taxed at a maximum 20% rate.

Netting Gains and Losses

According to Notice 97-59,(4) taxpayers must first divide capital gains and losses into their respective groups: short-term (including short-term capital loss carryovers (CLCs)); 28% (including collectibles held for more than one year and long-term CLCs); 25% (including unrecaptured Sec' 1250 gain); and 20% (or 10%) groups. Within each group, gains and losses are netted to arrive at a net gain or loss; thus, the short-term gains and losses are netted; the mid-term gains and losses are netted, and the long-term gains and losses are netted.

A net short-term capital loss is first applied to reduce long-term capital gain in the 28% group, then to reduce gain in the 25% group, and finally, to reduce gain in the 20% group. Any net short-term gain is taxed at ordinary income rates. A net loss from the 28% group first reduces gain from the 25% group, then reduces gain from the 20% group. A net loss from the 20% group first reduces net gain from the 28% group, then from the 25% group. Excess short-term capital losses also may offset up to $3,000 of regular income per year.

Example 3: In 1998, B is in the 39.6% tax bracket and has a $50,000 net gain from 28% assets; a $20,000 net gain from 25% assets; a $10,000 net loss from 20% assets; a $5,000 net short-term capital loss, and a $15,000 long-term CLC. B first reduces the $50,000 28% net gain by the $15,000 CLC, then by the $5,000 net short-term capital loss, then by the $10,000 20% net loss; thus, the 28% net gain is $20,000 ($50,000 -- $15,000 -- $5,000 -- $10,000). B's total capital gains tax for 1998 is $10,600 (($20,000 X 0.28) -- ($20,000 X 0.25)).

Installment Sales

The 28% rate also applies to installment sale payments received either (1) before May 7, 1997 or (2) after July 28, 1997, for assets held more than one year but not more than 18 months. The 20% rate applies to installment payments received after May 7, 1997, if the holding period was 18 months or more (for sales occurring after May 6, 1997 and before July 29, 1997, if the holding period was at least 12 months).

The treatment of installment sales of depreciable real property is still being considered. One possibility is to tax the gain proportionally between the depreciated portion and the remainder; however, this would pose a problem for taxpayers with incomplete information. Form 6252, Installment Sales, does not indicate which portion is depreciated; because some sales occurred many years ago, the information needed to bifurcate the sale between the depreciated portion and remainder may be unavailable.

Another possible answer is to apply the 25% rate to the extent of accumulated depreciation; the remainder would then be taxed at the appropriate rate for the applicable holding period. This method bodes well for older installment sales, in which the higher-rate portion of the gain has already been taxed and the lower-rate portion remains. Incomplete information may be an issue here, too.

Constructive Sales of Appreciated Financial Positions

Effective for constructive sales after June 8, 1997, the TRA '97 removed from sophisticated investors the tax-deferral component inherent in "selling short against the box," futures contracts, forward contracts, equity swaps and notional principal contracts. Under prior law, a deferral occurred when the investment was structured to substantially reduce (or eliminate) the risk of loss without a taxable disposition.

TRA '97 Section 1001 (a) requires taxpayers to recognize gain from the constructive sale of an "appreciated financial position," defined by Sec. 1259(b)(1) as any position with respect to any stock, debt instrument or partnership interest if there would be gain were that position sold, assigned or otherwise terminated at its FMV.

Specifically excluded from this definition by Sec. 1259(b)(2)(A) is straight debt that unconditionally entitles the holder to receive a specified principal amount if (1) the interest payments meet the requirements of Sec. 860G(a)(1)(b)(i) and (2) the debt is not convertible (directly or indirectly) into stock of the issuer or a related person (as defined in Sec. 267(b)). Marked-to-market positions are also excluded from the definition, by Sec. 1259(b)(2)(B).

A constructive sale occurs when the taxpayer enters into:

* A short sale of the same or substantially identical property.

* An offsetting notional principal contract as to the same or substantially identical property.

* A futures or forward contract to deliver the same or substantially identical property.

* A short sale, offsetting notional principal contract, futures or forward contract to acquire the same or substantially identical property.

* Any other transaction that has substantially the same effect as one of the transactions described above.

Although "substantially identical" is not defined, it appears that it has the same meaning as for Sec. 1091 wash sales. Under Sec. 1259(c)(1), a constructive sale is not a contract for the sale of nonmarketable securities (as defined in Sec. 453(f)) if it settles within one year after the date the contract is entered into. The constructive sale rules do not apply to sales that close within 30 days after the end of the tax year, if the taxpayer holds the appreciated financial position throughout the 60-day period beginning on the date the transaction is closed, and his risk of loss is not reduced at any time during the 60-day period (as described in Sec. 246(c)(4)). Finally, the new provision does not apply to loss positions.

AMT

Prior to the TRA '97, the applicable alternative minimum tax (AMT) rate was either 26% or 28% for all income taken into account in the AMT calculation. This was not a major issue, because the overwhelming majority of taxpayers affected by AMT had long-term capital gains tax rates of 28%. The TRA '97 changed this by reducing the capital gains tax rates.

To provide additional relief for capital gains transactions, TRA '97 Section 311(b) amended Sec. 55(b)(3) to apply the capital gains tax rates for AMT purposes for transactions after May 6, 1997, when the capital gains tax rate is lower than the applicable AMT rate. The capital gains portion of the AMT calculation is computed first; the AMT exemption is then applied to the remaining income.

Example 4: A and V, married filing jointly, have alternative minimum taxable income of $150,000 for 1998, of which $10,000 is 20% capital gain, $15,000 is 25% capital gain and $20,000 is 28% capital gain. A's and V's tentative minimum tax is $26,550 (($10,000 X 0.20) -- ($15,000 X 0.25) -- (($125,000 -- $45,000 exemption amount) X 0. 26 AMT rate)).

Taxpayers with large capital gains will be more likely to find themselves owing AMT. In most states, capital gains produce a state tax liability (and, for many taxpayers, a local tax liability as well). While such taxes are generally deductible for regular tax purposes, they are a preference item added back when calculating AMT.(5)

Taxes are a permanent AMT difference and do not give rise to a minimum tax credit carryover; thus, taxpayers should plan either to accelerate or postpone income to tax years in which they will not be subject to AMT. Further, the timing of state tax payments should be monitored with AMT in mind.

Charitable Remainder Trusts

Charitable remainder trusts (CRTs) follow the Notice 97-59 netting rules in determining net short- and long-term capital gains. Regs. Sec. 1.6641(d)(1)(i)(b)(2) and (3) continue to apply in computing the capital gains or losses carried forward to the succeeding tax year.

The ordering and taxation of distributions from a CRT follow Sec. 664(b) and the regulations thereunder, which provide that a CRT distribution is first deemed to come from income subject to the highest Federal income tax rate in effect at the time of the distribution, and then from income subject to progressively lower (or no) Federal income tax rate(s) in effect at the time of distribution. According to Notice 98-20,(6) in applying this rule to capital gains when multiple rates apply, the distribution is deemed to come first from the highest capital gain tax rate group, then from the next highest rate group, etc. Undistributed CRT pre-1997 long-term capital gains are included in the 20% group.

The trustee must report each group of long-term capital gain separately on Form 5227, Split-Interest Trust Information Return. The trustee may use any reasonable method to determine the amount of each type of gain within a group that has been distributed when doing the required reporting or associated recordkeeping.

Sale of QSBS

Gain on the sale or exchange of qualified small business stock (QSBS), as defined in Sec. 1202(c), is 50% excludable if such stock is acquired at original issue and held at least five years. TRA '97 Section 313(a) and (b)(2) allow an individual to elect to roll over capital gain from the sale of QSBS held more than six months. The stock must be replaced during a 60-day period beginning on the date of sale, by other QSBS costing at least as much as the amount realized on the sale.

The Tax Technical Corrections Act of 1997, if enacted, would allow tax-free rollover treatment to any QSBS held more than six months by partnerships and S corporations when all the interests in the passthrough entity are owned by individuals or estates.(7)

The replacement QSBS can consist of more than one security and can be purchased on more than one occasion as long as A purchases are within the 60-day window period. The holder's basis in the replacement QSBS is reduced by the gain not recognized on the sale of the original QSBS. The nonrecognized gain reduces the basis of multiple purchases in the order purchased. The holding period of the replacement stock includes the holding period-of the original stock. This provision is effective for sales of QSBS after Aug. 5, 1997.

Related Changes

Investment Interest

According to Sec. 1(h)(3), net capital gain is reduced (but not below zero) by the amount the taxpayer elects to take into account as investment income under Sec. 163(d)(4)(B)(iii). In some situations, a taxpayer is better off paying a higher ordinary income rate in order to take an investment interest expense deduction that potentially would not otherwise be available for many years, if ever. However, given the increased spread between short-term and long-term tax rates, this option becomes less attractive.

TD 8688(8) refers to "...the election under section 163(d)(4)(B)(iii), which allows a taxpayer to take all or a portion of certain net capital gains, attributable to dispositions of property held for investment, into account as investment income" It is unclear whether a taxpayer must select only or first from higher-rate long-term capital gain pools, rather than from lower-rate capital gain pools (e.g., pre-May 7, 1997 28% gains versus post-May 6, 1997 20% gains). In the absence of IRS or congressional direction to the contrary (e.g., a requirement to take from all long-term pools on a pro rata basis), selecting first from higher-rate pools appears to be a reasonable position.

The election should be carefully considered; 1997 may be the last year to sacrifice a 28% rate (as opposed to the 20% rate in future years). Prior-year returns cannot be amended for this purpose, because, under Regs. Sec. 1.163(d)-1, the election must be made by the due date (including extensions) of the return for the tax year in which the net capital gain is recognized.

Property Acquired from a Decedent

The holding period of a capital asset acquired from a decedent begins on the date of death.(9) Under Secs. 1014(a)(1) and 2032(a)(2), the new basis is the FMV of the asset at the date of death (or the alternate valuation, date, if applicable). Sec. 1223(11) provides that the acquired property is deemed to have been held for more than one Year whenever the estate sells the property. Notice 97-59 changed this to "more than 18 months" to conform to the extended holding period now required for use of the long-term capital rate. Under the Tax Technical Corrections Act of 1997, if passed, inherited property would be deemed to have a holding period of greater than 18 months, allowing use of the 20% (and 10%) rate.(10)

Investment Vehicles

Similarly, long-term gain or loss on Sec. 1235(a) patents and Sec. 1256(a)(3) marked-to-market contracts are deemed to have a holding period of more than 18 months. Rules similar to those under Secs. 1092(f) (certain stock options) and 1233(b) and (d) (sales of substantially identical property) apply for property held more than one year but not more than 18 months.

Tax Planning

Defer Sales of Capital Assets

The benefit of the lower tax rate may justify the extended market fluctuation risk that accompanies a decision to extend a holding period to 18 months. Further, a like-kind exchange can be used to extend the holding period when deferral of the sale date or an installment sale is not a viable option.

Variable Annuities

Variable annuities are less attractive after the TRA '97. While there are some situations in which variable annuities may be a worthwhile part of a portfolio, the capital gains tax reduction (compounded by the Roth individual retirement account (IRA) for those who qualify) reduces the benefit of tax-deferred products for many investors.(11) A prudent investment allocation for many is to have growth stocks in taxable accounts and fixed-income investments in tax-deferred accounts (e.g., pension or profit-sharing plan, Sec. 401(k) plan or IRA).

AMT Issues

Middle-class taxpayers are much more likely to pay AMT after the TRA '97. In addition to the capital gains/AMT issue discussed above, the new per-child tax credit and the education credits reduce regular tax, but are not allowed for AMT purposes.

Investment-Netting Strategies

Long-term capital gains are potentially taxed as low as 10%, while ordinary income can be taxed as high as 39.6%. Given the fact that the ordinary income tax rate is often significantly higher than the long-term capital gains tax rate, it is best to avoid using long-term capital losses against long-term capital gains. This can be accomplished by not selling capital loss property in the same year long-term capital gains are recognized.

Conclusion

The TRA '97 made numerous changes to the capital gains area. The new rates and holding periods add great complexity, although most of the changes are taxpayer-friendly. Tax planning should carefully consider the ramifications of the TRA '97, including its effect on AMT and optimal asset allocations.

Author's note: The author gratefully acknowledges the helpful comments of Prof. Gary Carter, Associate director of Graduate Studies in Taxation, University of Minnesota.

(1) A discussion of the new gain exclusion under Sec. 121 on the the sale of a principal residence is beyond the scope of this article; see Adkins, Geisler and Thompson, "Selling a Principal Residence After the TRA '97," 29 The Tax Adviser 116 (Feb. 1998).

(2) See H. Rep't No. 105-148, 105th Cong., 1st Sess. 300 (1997).

(3) Rev. Rul. 70-344,1970-2 CB 50.

(4) Notice 97-59, IRB 1997-45, 7.

(5) State taxes are partially nondeductible for high-income taxpayers itemizing their deductions, because of the Sec. 68 phaseout.

(6) Notice 98-20, IRB 1998-13, 25.

(7) See joint Committee on Taxation (JCT), JCT Description of the Chairman's Mark of the Tax Technical Corrections Act of 1997 (JCX-56-97), Section D.2.

(8) TD 8688 (12/11/96).

(9) Rev. Rul. 59-220, 1959-1 CB 210.

(10) Note 7, Section al.

(11) See Lange, "IRAs After the TRA'97--What Hath Congress Roth?," 29 The Tax Adviser 318 (May 1998).

RELATED ARTICLE: Capital Gains Rates and Holding Periods

Asset sale date      Asset holding period

1/1/97-5/6/97        One year or less (short-term)
                     More than one year (long-term)

5/1/97-7/28/97       One year or less (short-term)
                     More than one year (long-term)

7/29/97--present     One year or less (short-term)
                     More than one year, but no more
                     than 18 months (mid-term)
                     More than 18 months (long-term)

1/1/01               More than five years
and thereafter

1/1/06               More than five years
  and thereafter

(1/1/01-12/31/05,
  by election)

                     Ordinary income tax   Capital gains tax rate
                     bracket

1/1/97-5/6/97                Any                  Some
                     15%/28% and up               15%/28%

5/1/97-7/28/97       Any                          Some
                     15%/28% and up               10%(*)/20%

7/29/97--present     Any                          Same
                     15%/28% and up               15%/28%

                     15%/28% and up               10%(*)/20%

1/1/01               15%                          8%,10%
and thereafter

1/1/06               28% and up                   18%,20%
  and thereafter

(1/1/01-12/31/05,
  by election)

(*) gains toed at 10% to extent of 15% bracket, balance taxed at 209L

RELATED ARTICLE: EXECUTIVE SUMMARY

* Effective for constructive sales after June 8, 1997, the TRA '97 removed from sophisticated investors the tax-deferral component inherent in "selling short against the box," futures contracts, forward contracts, equity swaps and notional principal contracts.

* Taxpayers with large capital gains will now be more likely to owe AMT.

* Under the Tax Technical Corrections Act of 1997, if passed, inherited property would be deemed to have a holding period of greater than 18 months, allowing use of the 20% (or 10%) rate.