Capital gains planning for 2001: an important new rule.

Under the Taxpayer Relief Act of 1997, new maximum capital gain rates became effective Jan. 1, 2001. Specifically, under Sec. 1(h)(2)(B) and 1(h)(9), the 20% capital gain rate has been lowered to 18%, provided property is held for more than five years and a taxpayer's holding period begins after 2000. Similarly, the 10% capital gain rate under Sec. 1(h)(2)(A) has been lowered to 8%, provided the property is held for more than five years; the 8% reduced rate will apply regardless of when the holding period began. The provision applies to all gains other than "collectibles gain" as defined in Sec. 1(h)(6), unrecaptured Sec. 1250 gains and Sec. 1202 gains.

Simply stated, this change means that high-income taxpayers who purchase an asset in 2001 or later will automatically qualify for the lower 18% capital gain tax rate, provided the purchased asset is held for more than five years. Additionally, taxpayers who already hold assets and plan to continue holding them at least five years beyond 2001 may elect the reduced capital gain rate by currently paying the tax on any unrealized gain.

A taxpayer who already holds an eligible asset may qualify for the reduced capital gain rate by making a deemed sale and repurchase election. An eligible asset is either "readily tradeable stock" (as of Jan. 1, 2001) or Sec. 1231 property. If the taxpayer elects to treat the asset as having been sold and then immediately repurchased for its fair market value (FMV) on Jan. 1, 2001 (or the first business day in 2001), such assets will be eligible for the reduced capital gain rate, provided the five-year requirement is met. The taxpayer recognizes any gain from the election but cannot deduct any losses or add the disallowed losses to his basis in the asset. For example, if a taxpayer has an asset with a cost of $10 and a Jan. 1, 2001 FMV of $9 and makes this election, its basis will be $9. Thus, it is anticipated that a taxpayer would not make the election for loss assets. The taxpayer may make this election for some or all of his assets.

Although the IRS has not issued official guidance on specific steps a taxpayer must take to successfully make a deemed sale and repurchase election, it plans to provide specific instructions in the future. The Service has already indicated that the election will need to be made on a timely filed individual income tax return (including extensions).

The application of this new, reduced capital gain tax rate to a client who already holds capital assets will depend on the client's unique fact pattern. Some of the questions a taxpayer should answer before making this election include:

1. Will the present value of the 2% tax savings in the future be greater than the taxes paid today?

2. Will the taxpayer sell the asset during his life or hold it until death? (A step-up in basis at death is provided under the current estate tax laws.)

3. When, and for what potential price, will the taxpayer sell the stock in the future?

4. Will the taxpayer have the ability to pay the taxes today on the deemed sale without having received any cash proceeds?

5. Is there a possibility that potential law changes could reduce or repeal the capital gain tax?

Certain fact patterns would seem likely to enable a taxpayer to benefit from the lower capital gain rate. One obvious instance is a taxpayer planning to purchase an asset that would be held for many years. Absent some compelling market reason, the taxpayer would likely be better off delaying the planned capital asset purchase until 2001, thereby qualifying the asset for the lower capital gain rate.

The deemed sale and repurchase option would also seem a logical choice for an asset that currently has minimal gain or loss, but is anticipated to have substantial gain over a holding period of five years or more. For example, a taxpayer in a post-initial public offering (IPO) situation might benefit substantially by recognizing a small capital gain now (or no capital gain if basis equals the current FMV), with an anticipated significant increased stock price in the future. Assuming the taxpayer holds the stock for over five years, he gets a 2% tax rate reduction for little or no cost today. Caution: As noted, the taxpayer would not receive any benefit of losses recognized under the election, as he may not deduct the loss nor add it to his basis. Further, restricted stock, pre-IPO stock and nonstock securities (such as real estate investment units) are not eligible.

FROM MAUREEN KERRIGAN, J.D., MBA, CPA, DEBRA SAWYER, CPA, CFP, AND LARRY RABUN, CPA, CFP, WASHINGTON, DC