Capital Asset Deemed-Sale Election Available until Oct. 15, 2002

Author:
Brian T. Whitlock, J.D., LL.M., CPA
Member, AICPA Trust, Estate and Gift Tax Technical Resource Panel

The Taxpayer Relief Act of 1997 (TRA '97) created a new category of five-year long-term capital gains, effective Jan. 1, 2001. The new "really long-term capital-gain" (RLTCG) rate creates a postmortem tax planning opportunity for estates of individuals dying after that date and before Oct. 15, 2002.

Background

Under the TRA '97, 8% and 18% RLTCG rates are available for the disposition of certain capital-gain assets. Taxpayers in a 15% or lower bracket can use an 8% RLTCG rate for capital gains on assets they hold for at least five years. (The regular long-term capital-gain (LTCG) rate for such taxpayers is 10%.) For calendar-year 2001, Form 1099 listed the five-year portion of capital-gain distributions made from many mutual funds as a separate item.

Taxpayers in a bracket above 15% would be eligible for an 18% RLTCG rate for gains on capital assets they hold for at least five years, if acquired after 2000. Thus, to be eligible, a taxpayer must hold such assets until after 2005 before disposing of them. (The regular LTCG rate for such taxpayers is 20%.)

Deemed-Sale Election

Under TRA '97 Section 311, higher-bracket taxpayers could make a deemed-sale election to treat one or more of the capital assets they acquired before 2001 (and thus ineligible for the 18% RLTCG rate) as if acquired on Jan. 1, 2001. A taxpayer so electing will recognize any gain on the asset(s) as of Jan. 1, 2001 and pay tax. The election cannot be used to recognize losses. It can be made by individuals and flowthrough entities (e.g., partnerships, S corporations, limited liability companies (LLCs), trusts, etc.).

The taxpayer makes the election with the return for the period that includes Jan. 1, 2001, either on an original or amended return filed by the extended due date (i.e., September 15 for calendar-year S corporations; October 15 for individuals and calendar-year partnerships, LLCs and trusts). Once made, the election is irrevocable.

Why Make an Election?

This "mark-to-market" type election creates interesting planning opportunities. Most taxpayers will use an election when the tax to be paid as a result of making the election and qualifying for the 18% RLTCG rate is negligible. Some taxpayers will also make the election as part of a strategy to carry forward charitable deductions and capital, net operating and passive losses, to shelter the capital gain recognized on the deemed-sale election. All gain arising after Jan. 1, 2001 will be eligible for the 18% RLTCG rate.

Unusual Opportunity

A less-obvious candidate for the deemed-sale election is an elderly individual or decedent who died after 2000 with a taxable estate.

Example: E, a wealthy individual of advanced years, previously transferred low-basis assets to a grantor trust for her children and grandchildren (i.e., a dynasty trust). E reports all of the income tax attributes of the grantor trust on her personal return, allowing the trust assets to grow on a pre-tax basis. The trust is irrevocable and excludible from E's estate at death.

E has been making annual-exclusion gifts to the trust for years. She elects to shelter the gifts from the generation-skipping transfer tax.

The gifting strategy sets up an age-old dilemma: the gifted assets are excludible from E's estate (a 50% savings), but the assets will not receive a basis step-up at her death (a 20% capital-gain cost). Should the trustee elect to trigger the capital-gain tax on the trust assets and step up their bases to fair market value as of Jan. 1, 2001?

There are three clear advantages to making the deemed-sale election for a grantor of advanced age (or newly deceased). First, the grantor's payment of the tax on the trust's gain will save estate tax dollars. Second, it will allow the trust to preserve its assets, rather than use them to pay income tax. Third, the assets will qualify for the 18% RLTCG rate if sold after Jan. 1, 2006; overall, a win-win result.