1997 tax changes: capital gains tax and sale of a primary residence.

• Author: Jablow, Benjamin A.

On August 5, 1997, President Clinton signed into law the Taxpayer Relief Act of 1997 (Pub. L. No. 105-34) which provided many changes to the Internal Revenue Code.(1) This article will specifically address the new capital gains tax rates and the rules pertaining to the sale of a taxpayer's 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...