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The new capital gain tax rate.

As part of the Taxpayer Relief Act of 1997 (TRA '97), Sec. 1(h), involving adjustment of capital gain rates, was implemented as of Jan. 1, 2001. Since that time, there has been a dearth of IRS guidance and professional articles on Sec. 1(h). The smattering of guidance comes principally from the instructions to Schedule D, used for flowthrough entities, and Form 4797, Sales of Business Property. The few articles on Sec. 1(h) have not been in professional journals, but rather have been generic pieces in newspapers, general public magazines and newsletters. While surely the Service will have to issue more specific guidance either before or early during the 2001 return filing season, taxpayers should have already begun planning.

Sec. 1(h) institutes an 18% (versus 20%) capital gain rate (eight percent, instead of 10%, if the taxpayer is in a tax bracket of less than 25%) for most (but not all) capital assets acquired (purchased, inherited, etc.) after 2000 and owned for more than five years. Therefore, except for low-income taxpayers, 2006 is the earliest year in which the 18% rate applies.

For applicable assets owned on Dec. 31, 2000, the taxpayer (individual, partnership, S corporation--but not C corporation--trust or estate) can elect to apply the new rates on the return that spans the Jan. 1, 2001 implementation date. For calendar-year taxpayers, the "magic" 2001 filing date is April 15, 2002 (March 15, 2002 for an S corporation), or the extended due date.

Tax Planning Considerations

The election is available on a share-by-share or an asset-by-asset basis. The taxpayer can make the election on part or all of the shares owned in a corporation. The asset generating the most interest is a personal residence.

Example. A married couple has owned a principal residence for over two years. In that time, the residence has appreciated by $450,000. They make the election on their 2001 return, but avoid paying a tax as a result of the Sec. 121 exclusion. Due to the election, the couple's tax basis increases by $450,000, without an out-of-pocket cost, and they can start anew toward another $500,000 exclusion.

The above example may not be within the spirit of the statute. The IRS may have legislative authority to issue guidance disallowing a tax-free election for a personal residence (or other similar situations) (see the TRA '97, Section 311(e)(2)(A)).

The election works well when there is little or no tax and administrative cost (e.g., appraisal or accounting fees). It also works well when (1) the taxpayer has assets with little or no appreciation that would cause a tax to be due or (2) the taxpayer can offset the gain generated from an election with a capital loss carryover, a current or past unallowable passive activity loss (PAL) or a net operating loss (NOL) carryover. This is also an economic decision, because use of a PAL or NOL, which might otherwise reduce income taxable at 39.1% (the new 2001 maximum personal income tax rate) to offset a capital gain, is costly. As noted, there is a possibility that the IRS may have the ability to impose limits on the use of such carryover losses against the capital gain generated by the election.


Asets not eligible for the 18% capital gain rate include:

* Collectibles;

* Gain to the extent of accumulated depreciation on real estate; and

* Small business C stock eligible for taxation at half of the normal capital gain tax rate.

The taxpayer cannot make the election on an amended return, except under extremely limited circumstances. Fiscal-year flowthrough entities need to make the decision earlier because, depending on the fiscal year-end, the return's due date has either passed or will arrive shortly. The election requires the taxpayer to pay a tax based on the phantom built-in gain at Jan. 1, 2001 (January 2 for publicly traded property). A new holding period begins as of the election date, and a new basis, equal to the asset's fair market value on Jan. 1 (or 2), 2001, is established. Taxpayers should not make the election for loss property, even though there is a new acquisition date, because the loss is lost (i.e., the taxpayer can never deduct it and cannot add the disallowed loss to the asset's basis). Instead, the taxpayer should sell the property and repurchase it after 31 days (to avoid the wash-sale rule). If a wash sale is triggered, it would be doubtful that the taxpayer will qualify for a post-2000 acquisition date, because the holding period reverts to the original pre-2001 holding period.

Practitioners should advise clients to:

* Start to acquire cost-basis information immediately. For example, the calculation of basis of mutual fund shares presents particular difficulties and can be time-consuming.

* Ascertain Jan. 1 or (or 2), 2001 fair market values at this time (or retain an adviser to amass the data).

* Obtain appraisals for nonpublicly traded property.

* Maintain a permanent schedule of the new bases established from the election. The holding period for such property begins as of Jan. 1 (or 2), 2001.

Taxpayers should consider the effect of an election on 2001 and 2002 Federal and state (if applicable) tax estimates. Paying a current tax (Federal and state) to save two percent in the future (but not before 2006) is very speculative and not economically wise. The taxpayer who made the election and paid a tax should be in good health, living long enough to take advantage of the two percent tax savings.

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Article Details
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Author:Moore, Philip E.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Oct 1, 2001
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