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Happy New Year! Get Ready for the Cut in Capital Gains Tax

To maximize the benefits, you should start planning now.

The capital gains rates are dropping.

Well, not until Jan. 1. But the rates will drop 2% on any capital gains generated from assets held for more than five years. And while it's too early to do anything, there are some matters you should be aware of that can shrink your tax bite down the road. So consider this a sneak peek at the rules and some planning techniques.

The immediate benefits of the rate drop will depend on your tax bracket. As an example, for 2000, income taxpayers qualify for the 15% bracket if their taxable income is less than $26,250 as a single person or less than $43,850 if they are married filing jointly. Typically, if you're in this bracket, long-term capital gains are taxed at 10%. But starting Jan. 1, any gains from the sale of property held more than five years will be taxed at 8%. So if you sell something you've held for at least five years on Jan. 2, 2001, you would owe only 8% on any profit.

Taxpayers with higher taxable incomes fall into the higher brackets. They pay 20% on their long-term capital gains. For these taxpayers to take advantage of the rate drop, the rules are more stringent: Any assets purchased

after

Jan. 1 and held for five years will be taxed at 18% if sold at a gain. So taxpayers in this bracket won't really feel the effect of the decrease until 2006.

Big note on stock options for folks in the higher tax brackets: The holding period of your options technically begins on the day of your grant. So if you were granted options prior to 2001, they won't be considered to have been purchased after 2001, says Martin Nissenbaum, director of income tax planning at

Ernst & Young

.

A Somewhat Generous Election

There is a potential upside, thanks to a taxpayer-friendly election included in the

Taxpayer Relief Act of '97

, which details this eventual decrease in the capital gains rates. Check out

Section 1(h)(2)

of the tax code for the particulars.

If you are in a 28% or higher tax bracket and you have a holding you'd like to qualify for the 18% capital gains rate, you can make a "deemed-sale-and-repurchase election" in early 2001.

This election is a pretend sale. It allows you to treat a holding as if you sold it and bought it back the next business day for the closing market price on that date, says Bob Trinz, editor at

RIA

, an information provider to tax professionals. "It's like you're marking your trades to market on that day." You will owe taxes on any gains generated from this fake sale and your new tax basis in the securities will be the closing market price on the day you "repurchased" them.

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Why do this? By making this election, you allow the holding period to start over in 2001 and then you'll qualify for the 18% rate in five years. Even better, you avoid transaction costs that you would've paid if you actually sold stock and bought it back on the open market.

On the flip side, you should never make this election if the "sale" results in a loss, since you cannot use that loss on your tax return. "The losses are disallowed in this instance," says Nissenbaum. You'd be better off selling the stock on your own, say, at the end of November and waiting the requisite 31 days to avoid the

wash sale rule, which, in simplest terms, says that if you sell at a loss, you can't use that loss on your tax return if you buy that same security back within 30 days. So just wait and buy the shares back in January.

So when would this election work best? If you have an asset that has appreciated or stayed flat and you expect it to rocket over the next five years.

Trinz helped with an example. Let's say you own 1,000 shares of a stock on Jan. 1, 2001. You paid $20,000 for the stock in June 1999. At the close of business on Tuesday, Jan. 2, 2001, the market price of the 1,000 shares is $40,000.

If you make the election, you'll recognize a long-term capital gain of $20,000, or $4,000 (20% of $20,000) in capital gains tax. Your new cost basis of the stock is $40,000, assuming that's the fair market value of the shares the day you "repurchased" them.

Now let's say you expect the stock to double in five years. You'll sell the shares for $80,000 on Jan. 4, 2006. You have a $40,000 gain since your basis now is $40,000. At 18%, you'll owe $7,200. That's a $800 savings from what you'd have to pay at 20%.

So you must decide if it's worth it to pay $4,000 now to save $800 five years down the road.

In this example, if instead of paying capital gains tax now, you had invested the money at a net after-tax rate of only 5% compounded annually, you'd make $866, or $66 more than the tax you'd save, says Trinz. Even worse, what if you find yourself in the 15% tax bracket in five years? If you make the election now, you'll owe 20% on your long-term capital gains for nothing.

So for this election to be worth it, you have to assume that you'll be in the same tax bracket or higher in 2006. In addition, you have to expect large gains from your stock down the road.

Some Planning Considerations

Here are some things to consider in the coming months in light of the capital-gains changes:

  • Give appreciated assets to your kids, especially since children over age 14 most likely are in the 15% tax bracket (kids under 14 are taxed at their parents' tax rate). Your child also inherits your holding period, Nissenbaum reminds us. So once the asset is held for five years in total, your child will owe only 8% on the gains when she sells it.
  • If you're in the 15% tax bracket or will be in 2001 and are considering selling some assets, wait until 2001 to get the 8% rate.
  • If you're in the 28% or higher tax bracket, consider waiting until 2001 to make large asset purchases. Of course, don't miss a buying opportunity. You can always make the election.
  • Start paying closer attention to your mutual fund purchases, especially if you make automatic purchases each month. The new capital gains five-year holding period soon will become a reporting nightmare for your fund companies, so be sure you double check their work.

No surprise, the

Internal Revenue Service

hasn't issued anything explaining how these rules are going to work, says Trinz. So stay tuned between now and the end of the year for more details.

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TSC Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.