Back Before Quicken, Here's How Capital Gains Tax Was Calculated

In honor of Sunday's Super Bowl, Tax Forum is tackling a Titan-ic capital gains question and Ram-ming through the truth about the cost basis of the Merrill Lynch Internet HOLDRs.

Unfortunately, the reporting of gains and losses on exchange-traded index options is still under official review. But we'll give you a report from the sidelines.

Any other tax questions? Send them to [e-mail], and please include your full name.

Calculating Capital Gains

Let's say 100% of my $60,000 gross income from 1999 comes from long-term capital gains. Would I pay 10% capital gains tax on the first $43,050 (the top taxable income amount for the 15% tax bracket) and 20% on the rest?

-- Dennis Lee

Dennis,

The answer depends on your income bracket before taking into account long-term capital gains, says Rande Spiegelman, a senior manager in KPMG's investment advisory-services group in San Francisco. Special thanks to Rande for walking me through the numbers.

If you take away capital gains and your remaining income puts you in the lowest 15% tax bracket, you'll pay capital gains taxes at the graduated rate you mentioned. If, without capital gains, your income places you in the 28% tax bracket or higher, you'll pay a blanket 20% on any long-term capital gains.

That $43,050 cap you mention is for married couples filing jointly, so I'll assume you're married. I'm also assuming you have no dependents and that neither you nor your spouse has other income.

To calculate your tax, first subtract the standard deduction and personal exemptions from your total income of $60,000. The standard deduction for married taxpayers filing jointly is $7,200. Then you and your wife each get personal deductions of $2,750. The remaining $47,300 is your taxable income.

As you pointed out, the first $43,050 is taxed at 10%. That equals $4,305. The balance of $4,250 is taxed at 20%, equaling $850. Your total tax bill: $5,155.

The calculation would get more complicated if you had other taxable income. You would lose some of the benefit of the 10% capital gains rate if you added in other types of taxable income because you would be moving yourself out of the 15% tax bracket. Here's an example:

Assume your wife has $20,000 in wages. Your total taxable income is now $67,300 ($80,000 less the standard deduction and personal exemptions). Subtract the capital gain, and the remaining $7,300 is considered the remainder of your wife's salary and is ordinary income. That puts you in the 15% tax bracket.

But ordinary income is taxed first, so deduct the $7,300 from the $43,050 ceiling because it'll be taxed at the ordinary 15% rate.

Now you have just $35,750 being taxed at the 10% capital gains rate, rather than the $43,050 that got the lowest rate before. As a result, you have a higher amount taxed at the 20% rate than before, $24,250 ($60,000 - $35,750).

Your total capital gains tax is $8,425, and your total tax bill is $9,520.

So by increasing your income by 33% (from $60,000 to $80,000), your tax bill has gone up an incredible 85%.

Whew.

This is a good exercise. It'll help you better understand how your tax bill is generated and assist you in tax planning. But this tedium also is why they created tax preparation software.

Taxing Exchange-Traded Index Options

I read your article, Special Edition: Tax Rules for Exchange-Traded Index Securities, and it provided some very useful information. You mentioned the 60/40 rule for broad-based index option gains. Is this in any Internal Revenue Service document? I cannot seem to find this in Publication 550 - Investment Income and Expenses. I am writing call and put options on the Nasdaq 100 tracking stock (QQQ Quote). Is the premium I receive from these trades subject to the 60/40 rule?

-- Feng Chen

Feng,

Unfortunately, there is no definitive IRS ruling.

Officials of the American Stock Exchange, where the QQQ trades, and many securities tax professionals believe the IRS eventually will settle on the 60/40 rule as the proper way to account for gains and losses on exchange-traded index options. The rule says 60% of the gain or loss is long-term and 40% is short-term, regardless of how long the investment is held.

"So it's not unreasonable to use this rule, it's just not definitive," says Jim Calvin, an investment management tax partner at Deloitte & Touche in Boston and editor-in-chief of the Journal of Taxation of Investments.

To make matters worse, don't expect any guidance any time soon, says Gary Gastineau, senior vice president of new products at Amex.

When Uncle Sam finally gets off his butt and issues a ruling, odds are good it won't be retroactive. That would be an administrative nightmare for the IRS considering brokerages don't report your option trades to the IRS in the first place.

HOLDRs Basis Basics

Last week's Tax Forum explained how you would determine your cost basis on stock you would get from redeeming shares of Merrill Lynch's Internet HOLDRs (HHH Quote). Admittedly, the explanation wasn't complete. So let's try again.

First a quick review: HOLDRs offer ownership in a basket of 20 stocks through a single investment. Even better, you have the option to redeem these securities (in 100-share lots) and get shares of the underlying stocks in return. See a recent Dear Dagen for more details.

Now here's how to establish your cost basis, straight from Diane Garnick, equity derivatives strategist at Merrill Lynch:

Let's assume your HOLDRs shares are worth $100 when you bought them and they had the following weightings:

Company	Shares	Weighting	Value
ABC Co.	1 share	55%	$55
DEF Co.	1 share	35	35
GHI Co.	1 share	10	10

One year later, let's assume the values are as follows:

Company	Shares	Weighting	Value	Gain/(Loss)
ABC Co.	1 share	35%	$52.50	($2.50)
DEF Co.	1 share	40	60	25
GHI Co.	1 share	25	37.50	27.50
Total			150	50

If, a year later, you sell your HOLDRs at $150, you made a $50 profit on each of your HOLDRs.

But if instead you redeem the HOLDRs for the underlying shares, you'll get $52.50 worth of ABC, $60 worth of DEF and $37.50 worth of GHI. But your cost basis in those shares is the value of the stock the day you originally purchased the HOLDRs.

In this example, your basis in ABC is $55. If you sold the stock the day you redeemed the underlying shares, you would generate a loss of $2.50. "So it might be advantageous to sell ABC stock, record the loss and hold on to the rest," notes Garnick.

Currently, holders of these HOLDRs must keep track of this basis mess themselves. But Merrill says it's working on a service that will make it easier.

SecureTax.com Solution

Did you use SecureTax.com to prepare your 1998 tax return? Were you planning on using the software for your 1999 return?

Well, you're out of luck. Intuit (INTU Quote), maker of TurboTax, purchased SecureTax.com last summer.

The good news is that if you used SecureTax last year, you can transfer all your return information to TurboTax. Just go to SecureTax's Web site and click "TurboTax for the Web." You'll be asked for your SecureTax ID number, so have that handy.