February 2001

New Capital Gains Tax Rates—Thanks to Old Legislation

Much attention was given to provisions in the Taxpayer Relief Act of 1997 which cut the maximum capital gains tax rate to 20 percent (10 percent for individuals in the 15 percent tax bracket). TRA ’97 also provided for special lower rates for post-2000 transactions for property held more than five years. Given the delayed effective date for these special rates and the potential for future legislative changes, many have probably forgotten about these rules. Credit should be given to the IRS, therefore, for its recently released instructions detailing certain elections related to the new rates that should remind practitioners and their clients of the new laws. These elections also allow for creative tax planning.

Background: Rate Cuts for Noncorporate Taxpayers

Eight percent capital gains tax. Pursuant to TRA ’97, gain from the sale or exchange of property held more than five years that would otherwise be taxed at the 10 percent rate instead will be taxed at an 8 percent rate, effective for tax years beginning after Dec. 31, 2000.

Eighteen percent capital gains tax. Also pursuant to TRA ’97, gain from the sale or exchange of property held more than five years that would otherwise be taxed at the 20 percent rate instead will be taxed at an 18 percent rate, effective for property whose holding period begins after Dec. 31, 2000. The holding period of property acquired by an option exercise includes the holding period of the option; a sale of property acquired after 2000 under an option acquired before 2001 will preclude 18 percent rate treatment.

The special rates do not apply to collectibles gain (28 percent maximum rate), unrecaptured section 1250 gain (25 percent maximum rate), and qualified small-business stock or section 1202 gain.

As long as an asset is held for more than five years, the 8 percent rate will apply for post-2000 gains of qualifying taxpayers, regardless of when the holding period begins. This contrasts to the provisions of the 18 percent rate, which state that the holding period must begin after 2000.

In order to qualify for the 18 percent rate a taxpayer may irrevocably elect to treat any pre-2001 asset as having been sold on Jan. 1, 2001, (or the next business day) at its fair market value and then reacquired on the same day. Any tax due on the gain from this deemed asset sale must be paid. Losses, however, are not recognized.

IRS Explains Deemed Sale: Repurchase Election

The IRS recently released the 2000 version of the Form 4797 instructions. Included in the instructions are details on the who, what, when, and how of the election.

Who. The election can be made by individuals and pass-through entities (regulated investment companies, real estate investment trusts, S corporations, partnerships, estates, trusts, and common trust funds). For grantor trusts, the grantor must elect.

What. The election can be made for readily tradable stock acquired before 2001 and not sold before Jan. 2, 2001, under the election the stock will be deemed to have been sold on Jan. 2 at its closing market price and reacquired on that date for the same amount. Readily tradable stock includes open-end mutual fund shares. Any other capital asset or section 1231 asset held on Jan. 1, 2001, for which the election is made is deemed to have been sold and reacquired on that date for fair market value. Pass-through entity owners can elect with respect to their interests; if the entity also elects, the entity’s election is deemed to immediately precede the owners’ elections.

When and how. The election is made by reporting the deemed sales on a timely filed return (including extensions); calendar year taxpayers make the election on a 2001 tax return. A loss sale should be reported as zero gain/loss. A statement should be attached to the return indicating that an election under section 311 of TRA ’97 is being made and listing the assets covered by the election. Amended returns filed in order to make a late election are allowed in certain cases.

Planning for the New Rates

Taxpayers holding assets that haven’t appreciated substantially may wish to make the deemed sale and repurchase election—assuming that they will hold the asset for at least five more years and will realize further appreciation. Assets that have substantially appreciated may not be good candidates for the election, as a large tax bite could be realized immediately in return for only a 10 percent future tax rate reduction (20 percent to 18 percent)

Some other planning thoughts include: