The new capital gains rules maze.

• Author: Watkins, Frank E., Jr.

The capital asset transactions rules provided in the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSR-RA '98) and the Surface Transportation Revenue Act of 1998 (STRA '98) represent a quantum leap into complexity. While tax advisers commonly use software to calculate capital gains tax, a clear grasp of the concepts underlying the calculations is critical to providing adequate tax planning services. A review of amended Sec. 1(h) quickly reveals how challenging this objective may be.

Background

Traditionally, capital asset and related tax provisions may have been considered to be of modest difficulty. In general, the individual taxpayer was required to (1) identify capital asset transactions; (2) separate them according to holding period (short-term or long-term); (3) combine them (by adding similar gains and similar losses together, or by netting the gains and losses against each other in step (2)); and (4) net them as either net short-term gain/loss or net long-term gain/loss. Any resulting excess of net long-term gain over net short-term loss was granted favorable tax treatment. For an excess of net long-term capital loss over net short-term capital gain, the individual taxpayer would forfeit a portion of the excess net long-term capital loss as a deduction.

The Tax Reform Act of 1986 repealed the favorable and unfavorable tax treatments applicable to capital gains transactions; consequently, the capital gains provisions became simpler.

Through the years, relatively simple amendments were enacted, providing more favorable tax treatment for capital gains. The Taxpayer Relief Act of 1997 (TRA '97) introduced a new level of complexity, encompassing multiple rates, multiple holding periods, multiple asset classifications, additional terms, additional combinations of classes of gain/loss and more tiers of possible benefits. Shortly thereafter, the TRA '97 was amended by the IRSRRA '98 and the STRA '98. Exhibit 1, above, summarizes Sec. 1(h) in a formula format; Exhibit 2, on p. 312, presents the current classification and netting process of major elements; and Exhibit 3, on p. 312, demonstrates a graphical approach to the calculation of the tax.

Exhibit 1: Summary of Sec.1(h) in formula format Sec. 1. Tax imposed. (h) Maximum Capital Gains Rate (1) Shall not exceed the sum of (A) a tax computed (at regular rates) ... on the greater of: (i) TI - NCG, or (ii) the lesser of: (I) TI taxed below 28%, or (II) TI -- Adjusted NCG [Adjusted NCG = NCG - (Unrecaptured Sec. 1250 gain + 28% gain)] [Unrecaptured Sec. 1250 gain - LTCG (not otherwise treated as OI) that would be treated as OI if Sec. 1250(b)(1) included all depreciation x 100% -- excess of (Sec. 1(h)(5)(B)losses over Sec. 1(h)(5)(A) gains)](*) [28% Gain =...