Make plans for new capital gains rules
In Brief-One provision of the 1997 tax law change is just starting to hit. New lower capital gains rates will apply to property held for more than five years. For taxpayers in the 15 percent bracket, an 8 percent capital gain rate will apply to gain from property held more than five years. Under the current rules, the rate is 10 percent. If you are in the above 15 percent bracket, you will not be able to cash in on the new 18 percent rate until 2006. One exception would allow a property to be marked to market at the beginning of 2001.A 1997 tax law changed taxation of capital gains. A variety of capital gain rates were established, depending on asset classification and taxpayer bracket. Rate application depended on the holding period of various assets through new definitions of short-, mid- and long-term holding.
One provision of the 1997 law is just starting to hit, that adds a new layer of complexity to the new three-year history of capital gain rate change.
New lower capital gains rates will apply to property held for more than five years. For taxpayers in the 15 percent bracket, an 8 percent capital gain rate will apply to gain from property held more than five years. Under the current rules, the rate is 10 percent.
When taxpayers are over the 15 percent tax bracket, gain on property for this five years will be taxed at 18 percent instead of the current 20 percent rate.
For taxpayers in the 15 percent bracket, this new 8 percent rate kicks in right away. The rate applies to sales or exchanges on or after Jan. 1, 2001. It does not matter when the property was acquired, as long as it has been held for five years or more.
If you are in a greater than 15 percent bracket, watch out. The reduced rate only applies to sales on or after Jan. 1, 2001 and only if the asset was acquired on or after that date.
In other words, if you are in the above 15 percent bracket, you will not be able to cash in on the new 18 percent rate until 2006. By then, you may own property that qualifies for the five year rule and was acquired on Jan. 1, 2001 or later.
Exceptions to the rule
As with anything else in our complicated tax code, there are exceptions. The law does allow taxpayers to cash in on the rate reduction for capital gains properties they currently own (or purchased before Jan. 1, 2001), but there is a tradeoff. Such property must be marked to market (value of asset) at the beginning of 2001. You must treat the property as having been sold for its fair market value and pay tax on any paper gain at the current 20 percent capital rate.
This tax would be reported on the 2001 return, should you choose this option.
The then marked to market property will be treated as reacquired for its fair market value as of Jan. 1, 2001. Then, the reduced rate can apply to future gains provided the property is held for an additional five years.
You may elect to mark to market any readily tradable stock or capital asset or property used in a trade in business. But, the mark to market election does not apply to closely held stock that is not readily tradable.
Mark to market?
Your decision to mark capital gain property to market at Jan. 1, 2001 will involve tradeoffs. Besides, you have to be a bit of a futurist to guess what is going to happen on that particular property to estimate the best move.
If the current gain on property is small through the mark to market move, paying the tax now may be a fair tradeoff to save 2 percent in five years or later, if you can foresee substantial future appreciation.
If the built-in gain on property at the mark to market date would be large, forgoing the rate reduction and deferring tax to the higher rate may be the better bet. Besides, who knows what newly elected President George W. Bush will be able to reap through a Republican controlled Congress in regard to additional capital rate law changes.
Be aware that the current law says that any loss resulting from the mark to market election will not be allowed for any tax year. If you make the election for property with a built-in loss, you will not get a capital loss write-off in the year of election.
A big question is what happens later if you have a marked to market capital loss property.
Technically, the currently disallowed loss should be added to your basis in the property, resulting in less gain at the later sales date.
However, the IRS has not issued regulations on the mark to market election, so proceed cautiously. Unless the IRS specifically provides for an increased basis through the mark to market method, your basis in property would be stepped down to fair market value on Jan. 2, 2001. So, a paper loss could end up turning into a taxable gain when the property is sold.
What to do?
Although it is likely the IRS will address this question before the mark to market election must be made on 2001 returns, what do you do now?
A recent edition of Accountant's Tax Weekly (Dec. 1, 2000) suggests that taxpayers who want to start their holding period for built-in loss property in early 2001 might want to play it safe. Make a "real" wash sale by actually selling and repurchasing the property on January 2, 2001 to establish a loss.
This loss, under the current wash sale rules would specifically allow for the disallowed loss to be added to your tax basis for the said property.
Please talk with your tax advisor before concluding any transactions. This article cannot consider the nuances of specific and unique individual situations and should not replace advice from your engaged tax professional.
Dr. Heinke is a partner of Owen E. McCafferty (OEM), CPA, Inc., in North Olmsted, Ohio. The firm offers tax and accounting and management consulting services. E-mail can be directed to her at [email protected]; phone: (440) 779-1099.