Capital gains after the TRA '97 - tax relief or mental strain?

• Author: Warren, Steven E.

While the Taxpayer Relief Act of 1997 (TRA '97) lowered capital gains tax rates, it also extended the holding period needed to qualify for the lowest rates, and added enormous complexity to the capital gain/loss calculation. This article explains the TRA '97's changes in the capital gains area and related issues for noncorporate taxpayers, such as alternative minimum tax, installment sales and sales of qualified small business stock.

Among the many changes made by the Taxpayer Relief Act of 1997 (TRA '97) were the enactment of new capital gains tax rates and holding periods. This article explores these changes and offers planning suggestions for noncorporate taxpayers.(1)

Rates and Holding Periods

The changes to rates and holding periods are intended to boost economic growth and reward long-term investment by more equitably taxing the increase in the value of capital assets.(2) Generally under Sec. 1 (h), as amended by TRA '97 Section 311 (a), for sales and exchanges after July 28, 1997, a 20% long-term capital gain/loss rate applies to capital assets held 18 months or more (the rate is 10% for taxpayers in the 15% bracket, to the extent of that bracket; excess gains are taxed at 20%).

The taxpayer's regular income tax rate still applies to gains from the sale or exchange of capital assets held for one year or less; a maximum 28% rate applies to assets held for one year and no more than 18 months.

For sales before May 7, 1997, the pre-TRA '97 rates and holding periods still apply. For sales between May 7,1997 and July 28, 1997 (inclusive), the 20% rate applies if the asset was held for more than one year. The table on page 400 summarizes the new rules.

Example 1: J, who is single, purchased 1,000 shares of G Co. for $50,000 on Jan. 15, 1997. J sold 250 shares of G on each of the following dates: Jan. 2, 1998 for $25,000; March 1, 1998 for $30,000; Aug. 1, 1998 for $35,000. These are J's only capital gains for 1998; his ordinary income for 1998 is $25,350. J's 1998 income tax liability, $16,703, is computed as follows:

Number of shares sold J's basis Holding period 250 $12,500 One year or less (short-term) 250 $12,500 More than one year, but no more than 18 months (mid-term) 250 $12,500 More than 18 months (long-term) Number of shares sold Sales price Gain on sale 250 $25,000 $12,500 250 $25,000 $17,500 250 $25,000 $22,500 Regular income: $25,350 x 15% = $ 3,803 Short-term capital gain: $12,500 x 28% (*) = 3,500 Mid-term capital gain: $17,500 x 28% = 4,900 Long-term capital gain: $22,500 x 20 = 4,500 J's total tax liability $16,703 (*) J's regular income tax rate after filling 15% bracket.

Holding period begins the day after the property was acquired and ends on the date of disposition. The holding period is computed in terms of calendar months, not days. Trade date, rather than settlement date, is used to determine holding period.(3)

Under Sec. 1(h)(2), for sales occurring in 2001 and thereafter, the long-term capital gains rate is reduced to 18% (8% for those in the 15% bracket) if the asset has been held for more than five years. The five-year period includes any option (or other tight or obligation) to acquire the property.

Electing the 18% Rate

A taxpayer can elect to apply the 18% rate to gain on the sale or exchange of a capital asset purchased before 2001. Under TRA '97 Section 311(e), the taxpayer must treat the capital asset as though it was sold and reacquired on Jan. 1, 2001 (Jan. 2, 2001, if the asset is readily tradable stock) at its fair market value (FMV) (for readily tradable stock, closing market price) on that date. The election is available for "qualified five-year gain" (defined by Sec. 1(h)(9) as gain on property held by the taxpayer for more than five years, but not collectibles gain, unrecaptured Sec. 1250 gain, Sec. 1202 gain or mid-term gain).

Any tax on the deemed sale must be paid with the return on which the election is made; further, the election is irrevocable. The adjusted basis immediately after the deemed sale is the asset's FMV used to compute the gain; any loss resulting from the election is not allowed for any tax year. In the absence of an election, the 18% rate is available for sales of five-year assets beginning Jan. 1, 2006. The tax rate on the deemed sale gain is the taxpayer's applicable rate of tax for the holding period at the time of the deemed sale.

It will often be prudent to use this election for capital gain property with little or no current appreciation if the asset's value is expected to increase significantly between the year of deemed sale and the actual sale or exchange. The election is even more enticing if the taxpayer anticipates being in a higher long-term capital gains tax bracket in five years.

Regardless of holding period, a 28% rate applies to gain on the sale of collectibles (e.g., artwork, coins), under Sec. 1(h)(5). An...