New Five-Year Capital Gain Rates

Many people have forgotten that Sec. 1(h)(2) provides that a new capital gain rate becomes effective on Jan. 1, 2001. Marketable securities and certain other capital assets acquired after 2000 and held for more than five years will be taxed at 18% instead of 20%. (For taxpayers in the 15% tax bracket, who would have a 10% capital gain rate, the rate for assets held longer than five years will be 8%. While the five-year holding period applies to taxpayers in the 15% bracket, assets do not have to be purchased after 2000.)

While to qualify for the 18% rate, the actual gain cannot occur until after 2005, it may seem premature to discuss this issue. However, taxpayers will have to make decisions sooner than that; under Sec. 1(h)(2), they can elect to have qualifying assets acquired on or before Dec. 31, 2000 treated as if the assets were purchased on Jan. 1, 2001. However, this election comes with a price. As is clearly explained in the Conference Report to the Taxpayer Relief Act of 1997, "[A] taxpayer holding a capital asset or asset used in the taxpayer's trade or business on January 1, 2001, may elect to treat the asset as having been sold on such date for an amount equal to its fair market value, and as having been reacquired for an amount equal to such value. If the election is made, any gain is recognized (and any loss disallowed)." Thus, there are two important things to note:

1. An election cannot be used that results in a loss for an asset; and

2. An election is made on an asset-by-asset basis.

Example: On Dec. 31, 2000, A owns 10,000 shares of Company B, which he purchased in 1998 for $10 per share. On Jan. 1, 2001, the shares are worth $12 each. A makes an election and reports a long-term capital gain of $20,000 (10,000 x ($12 – $10)). At a 20% rate, he will pay a $4,000 tax. A sells his B shares in 2006 for $30 per share and reports a gain of $180,000 (10,000 x ($30 – $12)). The sale qualifies for the reduced rate of 18%. A's tax in 2006 is $32,400; his total tax on his B shares is $36,400.

If A had not elected to treat the B shares as sold as of Dec. 31, 2000, he would have incurred a $40,000 tax (10,000 x ($30 – $10) x 0.20). Making the election resulted in a net savings of $3,600, 2% of the gain—a modest return of approximately 15% for the payment of $4,000 in taxes.

Is a 2% differential enough to warrant the extra reporting and recordkeeping? That is a personal decision. What is important is that the election exists. While there are no definitive guidelines, it appears that taxpayers will not have to file the actual election until they file a 2001 tax return. Thus, they have some time to make this decision. In addition, taxpayers in the 15% tax bracket can use the 8% rate for assets held more than five years, beginning in 2001.

From Michael D. Koppel, CPA, Gray, Gray & Gray, Westwood, MA