The new capital gain tax rate.

• Author: Moore, Philip E.

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...