Capital Gains Tax: More Changes to Come in 2001?

By Neil A. Ringquist, C.P.A., J.D., Senior Writer Analyst, CCH FEDERAL TAX GUIDE and CCH U.S. MASTER TAX GUIDE

istory shows that Congress loves to tinker with the details of how capital gains are taxed. If Congress isn’t changing the holding period for long-term gains, it is raising or lowering the applicable tax rates, or changing the carryover rules for unused capital losses. For example, in the early 1980s, a long-term gain arose from an asset that an individual had owned for more than 12 months. Then, in the mid-1980s, a long-term gain was possible if the individual had held the capital asset for “more than six months.” A few years later, Congress restored the “more than 12 months” rule. In the late 1990s, a taxpayer had to hold a capital asset for more than 18 months in order to achieve the lowest possible capital gains tax rate. A year later, Congress restored the “more than 12 months rule.” In the latest of this long history of changes, starting in 2001, some individuals may be able to achieve a special low capital gains rate if they owned the asset more than five years.

A conservative estimate shows that Congress, over the past 20 years, has changed the rules governing the taxation of capital gains about 12 times. Based on this past record and the fact that Congress is again considering major tax legislation, it should come as no surprise that the capital gains rules may change again in 2001.

CURRENT RULES FOR 2001

The Taxpayer Relief Act of 1997 (TRA ‘97) brought the most recent substantial changes to the tax treatment of long-term capital gains. In addition to changes in holding periods and the creation of special capital gains rates for certain assets (e.g., a maximum rate of 28 percent for collectibles), TRA ‘97 ensured that the maximum capital gains rate for most long-term assets will not exceed 20 percent (10 percent for individuals in a 15-percent bracket).

Striking a strong blow in favor of tax complexity, TRA ‘97 also enacted special rules for assets held more than five years. Low capital gains rates of 18 percent or 8 percent may be applied to gains from certain assets depending upon such factors as the individual’s tax bracket, when the asset was acquired, and if the individual made an election regarding when the holding period commenced.

Tax year 2001 will be the first year that the 8-percent, long-term rate may apply. The 18-percent rate will not go into effect until 2006 due to the five-year holding period requirement.

Example 1

On December 10, 1994, Mary purchased one share of Azet Corporation for $100. On January 8, 2001, she sold the share for $200. When she prepares her 2001 tax return, Mary, who files as “single,” finds that her taxable income is $24,000 and that all her taxable income comes within the 15% tax bracket. Because she held the Azet share for more than five years, she will pay $8.00 ($100 gain x 8% long-term rate) in capital gains tax.

Example 2

Assume the same facts as above, except that when Mary prepares her 2001 tax return she finds that her taxable income is $65,000. Because the $100 gain would fall within the 28% tax bracket, her capital gains tax would be $20 ($100 gain x 20% long-term rate). Mary is not eligible for the five-year holding period rate because the gain came within a tax bracket higher than 15%.

Example 3

Assume the same facts as in Example 1, except that Mary calculated her 2001 taxable income to be $27,100. In this situation, the 15% tax bracket extends to her first $27,050 in taxable income, and the last $50 of taxable income is taxed at 28%. Because her $100 in long-term capital gain straddles two tax brackets, the first $50 in gain would qualify for the 8% long-term rate, while the remaining $50 would be taxed at the maximum rate of 20%.

Under current law, an individual in a marginal tax bracket higher than 15 percent must acquire an asset after December 31, 2000, in order to have the lower capital gains rate apply to “more than five-year property.” However, these individuals may make an election to treat assets acquired before January 1, 2001, as being acquired on January 1, 2001. Under this election, the asset is deemed to have been sold on January 1, 2001 (or the next business day). The individual would pay the applicable income tax with the 2001 tax return. As a result of this deemed election, the taxpayer would be able to sell the asset after December 31, 2005, and calculate the maximum capital gains tax at 18 percent. If the asset were sold before January 1, 2006, the maximum long-term capital gains rate of 20 percent would generally be used.

CHANGE COMING IN 2001?

The coming year promises to be a busy one for significant tax legislation. The House has approved a proposal that would reduce the lowest tax rate bracket from 15 percent to 12 percent for 2001. In the next few years, the lowest rate would be further reduced until it reached 10 percent in 2006.

Some members of Congress have also promised a reduction in the overall maximum rate on capital gains.

With all the talk of general tax rate reductions, the question has to be asked whether the complex rules dealing with “more than five-year property” will survive the legislative process. It has to be remembered that these rules only became part of TRA `97 as an eleventh hour compromise in order to ensure its passage. Given the fact that these rules have no real tax effect until individuals file their 2001 tax returns, Congress has ample time to replace them with a less complex method of capital gains taxation. Congress may well take this opportunity to tinker with the capital gains rules yet again.