1997 tax changes: capital gains tax and sale of a primary residence.
Capital Gains Treatment
The Tax Act amended many of the rules relating to the taxation of capital gains for many taxpayers(2) (excluding C corporations). The following example will assist in illustrating how the new rules apply to individual taxpayers.
Sam and Sally Smith are husband and wife and are U.S. citizens. They own the following capital assets:(3)
Date Fair Market Property Acquired Value 100 shares of AT&T stock June 1, 1997 $ 10,000 50 shares of IBM stock Aug. 12, 1990 $ 5,000 stamp collection May 20, 1991 $ 65,000 apartment building Dec. 30, 1984 $200,000 qualified small business stock Sept. 25, 1993 $100,000
The Smiths purchased the AT&T stock for $2,000; the IBM stock for $100; the stamp collection for $5,000; the apartment building for $100,000 ($10,000 for the land, and $90,000 for the building with total depreciation taken of $90,000); and the qualified small business stock for $10,000.
The Smiths are particularly concerned about whether to sell the assets in 1997 or 1998 and, consequently, whether it would be to their advantage to utilize the amendments to the IRC. After contacting their tax attorney, the Smiths were informed that the Tax Act added provisions affecting the timing, characterization, and rates applicable to the sale of the capital assets.
Mr. Smith told his tax attorney that he understood how the old capital gains rules worked. The length of time that he held an asset (i.e., the taxpayer's holding period)(4) would determine the prevailing tax rate for the gain. The two possible holding periods were short term, assets held for one year or less, which were taxed at ordinary income tax rates; and long term, assets held more than one year, which were taxed at the capital gains rate of 28 percent.
The tax attorney then advised the Smiths that in 1997, Congress added new categories and holding periods regarding the treatment of capital gains tax. Under the Tax Act, there are three holding periods: 1) short term (assets held for not more than one year); 2) midterm (assets held more than one year and not more than 18 months; and 3) long term (assets held more than 18 months).(5)
Mr. Smith inquired about the change in tax rates as it applies to each holding period. The tax attorney explained that the new rates would be based not only on the holding period but also on the type of capital asset. Short-term capital gains are still taxed at ordinary income tax rates which are capped at 39.6 percent.(6) Midterm capital gains are taxed at a 28 percent tax rate and long-term capital gains are taxed at a 20 percent tax rate, but under certain circumstances could be reduced to 10 percent, depending upon the Smiths' tax bracket.
Naturally, the Smiths wanted to know how the new rates would apply to their portfolio of assets. They stated that in 1997, they would have gross income of $250,000, and in 1998 they could reduce their gross income to $30,000. The following table identifies the Smiths' asset portfolio and assumes that the assets are sold on December 31, 1997.
Holding Capital Property Period Gain AT&T stock 6 mos, 30 days $8,000 IBM stock 88 mos, 19 days $4,900 stamp collection 79 mos, 11 days $60,000 apartment 13 yrs, 1 day $190,000 building qualified small 51 mos, 5 days $90,000 business stock Capital Property Gains Rate Tax AT&T stock 39.6% 3,168 IBM stock 20.0% 980 stamp collection 28.0% 16,800 apartment 25.0%(7) 47,500 building qualified small 20.0%(8) 18,000 business stock
The Smiths understand that the AT&T stock is considered a short-term capital gain asset subject to ordinary income tax rates which are capped at 39.6 percent. The IBM stock will be taxed at the new long-term capital gains rate of 20 percent. Even though the Smiths owned the stamp collection for more than 18 months, the collection will be taxed at the old 28 percent capital gains rate. This results because the stamp collection is an asset which is part of a list of specific types of assets that are still subject to the old 28 percent capital gains rate.(9) With respect to the sale of the apartment building, the Smiths were pleased to learn that the portion of the proceeds from the sale of the building equal to the accelerated depreciation is no longer subject to the ordinary income tax rate, and is now only taxed at the rate of 25 percent. The remaining portion of the sale proceeds will be taxed at the new reduced capital gains rate of 20 percent. Because the Smiths were familiar with the 1993 tax act,(10) they asked why they could not exclude the full 50 percent of the capital gains due on their qualified small business stock which they held for the required five-year period.(11) Again, their tax advisor explained that Congress limited this exclusion to 50 percent of the old 28 percent capital gains rate instead of the new 20 percent capital gains rate.
The following table summarizes the capital gains tax treatment for the AT&T stock and the IBM stock assuming that they are sold on December 31, 1998:(12)
Holding Capital Capital Property Period Gain Gains Rate Tax AT&T stock 18 mos, 30 days $8,000 10.0% 800 IBM stock 100 mos, 19 days $4,900 10.0% 490
The Smiths' effective tax rate for 1998 will be 15 percent if their adjusted gross income(13) is less than $40,000, after including 20 percent of the gains from the sales of capital assets. Thus, the above stock sales would be taxed at the 10 percent capital gains rate.
Therefore, if the Smiths' adjusted gross income in 1998 was $20,000, they could sell up to $100,000 worth of stock and still be subject to the 10 percent capital gains tax, because 20 percent of the taxable gain of $100,000 would be included in their adjusted gross income. Since their adjusted gross income would now be $20,000 plus $20,000 (20 percent of 100,000) or $40,000, they would still be taxed at the 10 percent capital gains rate. If the Smiths sold $110,000 worth of stock, $100,000 would be subject to the 10 percent capital gains rate, and $10,000 would be subject to the 20 percent capital gains rate.
Sale of Principal Residence
The Tax Act amended the provisions pertaining to the treatment of the sale of a primary residence. The following example illustrates how the new rules apply to individual taxpayers.
Bill and Mary Johnson are husband and wife and are U.S. citizens. They were married on January 1, 1950. On February 5, 1951, they purchased a house in Chicago, Illinois, for $30,000. In March 1985, they decided to move to Florida and purchase a beach house located on Longboat Key for $150,000. They sold their house in Illinois for $200,000 and excluded the $125,000 gain pursuant to IRC [sections] 121 and rolled over the remaining gain pursuant to IRC [sections] 1034.(14) Their current tax basis is $105,000.(15) The Johnsons now wish to sell their current house (which they have lived in continuously since the time they purchased it) for $800,000(16) and buy a condominium in 1997 for $250,000. They consulted with their tax attorney on April 15, 1997, to determine the tax consequences of the transaction.
The Johnsons told their tax attorney that they used their one-time capital gains exclusion in 1985 when they sold their home in Illinois. Due to their previous experience in selling a house, they believed that they would have to pay additional capital gains tax now, because they were not purchasing a condominium of greater or equal value.
The tax attorney explained that Congress changed the rules governing the sale of a principal residence. He stated that under the old rules, the Johnsons would not be required to pay capital gains on the sale of their primary residence provided that they: 1) purchased a house of equal or greater value within the 24 months prior to the sale of the old residence or within 24 months after the sale of the old residence; and 2) that the property being sold is the Johnsons' primary residence.(17)
Then the tax attorney explained that the old rollover provisions contained in IRC [sections] 1034 and the one-time $125,000 gain exclusion on the sale of a primary residence contained in IRC [sections] 121 were repealed and replaced by the new IRC [sections] 121.
New IRC [sections] 121 provides that the Johnsons can exclude up to $500,000(18) of taxable gain on the sale of their principal residence. In order to qualify, the Johnsons must meet three separate tests: 1) the ownership test; 2) the use test and 3) the one-sale-in-two-year test.(19) Under the ownership test, the Johnsons must have owned the property for a minimum of two years out of the five years prior to the sale of the primary residence. Under the use test, the Johnsons must have used the residence for a minimum of two years out of the five years prior to the sale of the primary residence. Finally, under the one-sale-in-two-year test the Johnsons cannot exclude gain from the sale of their primary residence if they previously sold another primary residence within two years of the date that they intend to sell their current residence.
There is, however, a transitional rule that would allow the Johnsons to choose, for exclusion purposes, either the old IRC [sub sections] 121 and 1034 rules or the new IRC [sections] 121. This narrow exception applies to the sale of a primary residence that occurred between May 6, 1997, and August 5, 1997; or a closing that occurs after August 5, 1997, if a binding contract is executed before August 5, 1997, to sell the primary residence.(20)
Assuming that the Johnsons sold their house during the 1997 effective period under the transitional rule, the question then is: Which method would produce the best tax results? The amount realized upon sale is $695,000 (sales price $800,000 less tax basis of $105,000). Under the old rules, the Johnsons could not roll over this gain, because they are purchasing a condominium that does not equal or exceed the selling price of their house. Therefore, the Johnsons would be required to pay capital gains tax on their $695,000 gain.
Under the new rules, the Johnsons satisfy all three of the foregoing tests contained in IRC [sections] 121. Consequently, they would be entitled to exclude $500,000 of the taxable gain upon the sale of their primary residence and would pay capital gains tax on $195,000 (sales price $800,000 less tax basis of $105,000 less $500,000 IRC [sections] 121 exclusion).
The requirements of the three-prong test as well as the applicable Tax Act can be better understood through another example. Ted and Susan Green were married on February 7, 1997. Ted, who was previously single, owns a house that he purchased on November 15, 1989, for $100,000 that is now worth $400,000. Susan recently sold her house on July 5, 1996, in anticipation of her marriage to Ted. The couple wants to sell Ted's house on October 12, 1997, and purchase another house for $450,000. The Greens believe that they will not have to pay any capital gains tax, because they will qualify for a tax-free rollover pursuant to IRC [sections] 1034. They decided to consult with their tax attorney prior to the sale of Ted's house to make sure that they are correct.
It is noted that the transitional rules period has expired, and, therefore, the new IRC [sections] 121 will apply. The tax attorney explains that the Greens must meet the three tests described above in order for each of them to qualify for two $250,000 exclusions ($500,000 in the aggregate). Ted meets all three tests. However, Susan cannot use her $250,000 exclusion, because she fails all three tests. Ted can exclude his $250,000 gain. This means he has to pay capital gains tax on $100,000 (sales price of $450,000 less basis of $100,000, less $250,000 IRC [sections] 121 exclusion). If the Greens wait until February 8, 1999, to sell Ted's house, then both Ted and Susan will meet all three tests and be able to exclude the full $500,000 pursuant to IRC [sections] 121.
The Taxpayer Relief Act of 1997 is intended to provide relief to many taxpayers by implementing new capital gains tax rates. However, more meticulous records must be maintained by taxpayers to qualify. The new rules relating to the sale of a primary residence provide tax relief to many taxpayers who wish to sell their large family homes and move to new smaller homes without incurring a large tax liability. However, the new rules also create taxable gain to certain taxpayers who would have otherwise qualified for tax-free rollover treatment under the old law had they purchased a house of greater or equal value.
The Taxpayer ReliefAct of 1997 is complicated and consequently has created many potential problems for taxpayers. Careful attention must be paid to when the assets were purchased, how long they were held and what requirements need to be satisfied in order to receive favorable tax treatment.
(1) All references made to the Internal Revenue Code shall mean the Internal Revenue Code of 1986 as amended.
(2) The taxpayers include: people, partners in a partnership, shareholders of an S corporation, trusts, and estates.
(3) I.R.C. [sections] 1221 generally defines a capital asset as any property except: 1) inventory; 2) depreciable or real property used in a trade or business; 3) specified literary or artistic property; 4) business accounts or notes receivable; or 5) certain U.S. publications.
(4) I.R.C. [sub sections] 1222 and 1223.
(5) I.R.C. [sub sections] 1(h)(8) and 1222.
(6) I.R.C. [sub sections] 1(h) and 1222(11).
(7) This assumes that the real estate was depreciated on the straight-line method and that for purposes of this example the entire gain is subject to I.R.C. [sections] 1250 gain. The author notes that in the real tax world, that $100,000 would actually be subject to 20 percent capital gains rate and that only $90,000, the amount subject to depreciation which is the amount subject to I.R.C. [sections] 1250 gain, would be subject to the 25 percent capital gains rate.
(8) The current capital gains rate for the qualified small business stock is 20 percent. In order to qualify for the [sections] 1202 50-percent reduction (thereby creating a 14-percent rate), the Smiths would need to own the stock for at least five years commencing in 1993 (or no earlier than August 12, 1998). Also, I.R.C. [sections] 1(h) prohibits the Smiths from using the lower 20 percent capital gains rate to obtain a 10 percent rate (i.e., 50 percent of 20 percent new capital gains rate), instead the Smiths must use the old 28 percent tax rate (i.e., 50 percent of 28 percent) which would yield the 14 percent tax rate.
(9) I.R.C. [sub sections] 1(h)(5) and 408(m).
(10) The Omnibus Budget Reconciliation Act of 1993 (Pub. L. No. 103-66) which added I.R.C. [sections] 1202.
(11) For purposes of this example, the author assumes that the Smiths have held the qualified small business stock even though the holding period would have begun in 1993 and would not meet the five-year period.
(12) The holding period for the AT&T stock if sold after December 3, 1998, is long-term. If the stock was sold before June 3, 1998, then the holding period would be short-term and subject to ordinary income tax rates. In addition, if the stock was sold between June 3, 1998, and December 3, 1998, then the holding period would be mid-term and subject to the old 28 percent capital gains tax rate.
(13) I.R.C. [sections] 62.
(14) Pursuant to I.R.C. [sections] 1034, the Johnsons qualified for a tax- free rollover by living in their house as a primary residence and purchasing a house of equal or greater value.
(15) The Johnsons' tax computation is as follows: $170,000 gain realized on the sale of the primary residence ($200,000 sale price less $30,000 tax basis equals $170,000). Zero gain recognized ($170,000 gain less $125,000 I.R.C. [sections] 121 exclusion less $45,000 qualified tax roll over pursuant to I.R.C. [sections] 1034). The Johnsons' tax basis is $105,000 (the difference between the $150,000 cost basis and the $45,000 qualified tax rollover amount).
(16) The $800,000 is a net figure after real estate commission and expenses.
(17) I.R.C. [sections] 1034 and Treas. Reg. [sections] 1.1034-1(c)(3).
(18) The exclusion is $250,000 for a single taxpayer and $500,000 for a married couple. I.R.C. [sections] 121(b).
(19) Gregory B. Mckeen, CPA and G. Douglas Puckett, CPA, Guide to 1997 Tax Legislation, Ch. 1, p.4 (Practitioner's Publishing Company (1997)); I.R.C. [sub sections] 121(a) and (b).
(20) Taxpayer Relief Act of 1997 [sub sections] 312.
(21) McKeen and Puckett, supra, Ch. 2, p. 15.
Benjamin A. Jablow is a board-certified tax attorney who is of counsel to the Sarasota law firm of Levin & Tannenbaum, RA He received his J.D. from Creighton University and his LL.M. in taxation from the University of Florida. His practice areas include tax and estate planning, business, and real estate law.
This article is submitted on behalf of the Tax Law Section, Lauren Young Detzel, chair and Michael D. Miller and Lester B. Law, editors.
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|Author:||Jablow, Benjamin A.|
|Publication:||Florida Bar Journal|
|Date:||Feb 1, 1998|
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