Capital Gains Measure May Work This Way

The House this week endorsed a capital gains tax cut. Great news if you own stocks, rental property or other assets that have appreciated in value.

What should you do?

Right now, probably nothing. First, to become law, the House must officially pass the measure--expected early next week--and then it must win approval in the Senate, which is not assured. Revisions could slip into the final law.

Also, even if the House version is enacted as is, you must hold assets at least a year to qualify for lower capital gains rates. So if you haven’t held assets that long, it also may be wise to wait.

“If you’re not pushing for a sale, and as long as the market is stable, you can sit back and watch,” suggests Stan Ross, co-managing partner at the Los Angeles accounting firm of Kenneth Leventhal & Co.

Here’s how the House measure would work if it becomes law:

Capital gains under current law are taxed at the same rates--either 33%, 28% or 15%--as wages and other ordinary income. Under the House proposal, the rate on capital gains would drop to 19.6% for taxpayers in the 33% or 28% brackets (achieved by excluding 30% of capital gains from taxes). It would drop to 10.5% for those in the 15% bracket.

The cut would apply to virtually all capital assets, including stocks, bonds and other securities; real estate, including your personal home or rental properties, and timber, livestock and some other raw materials. It would not apply to works of art, gems, stamps, coins (including American Eagles and other bullion coins) and other collectibles.

The lower rates would be effective for assets held at least one year and sold between Sept. 14, 1989, and Dec. 31, 1991 (although House Republicans vow to fight to enact a permanent 19.6% rate).

Starting in 1992, capital gains rates would rise to 28% and 15%. But the “tax basis” on assets bought in 1992 or later, and held for more than a year, will be indexed for inflation. That means you won’t have to pay tax on paper gains attributable to inflation.

So if you buy a stock worth $1,000 in 1992, hold it for two years and sell it for $2,000--and inflation in the meantime totals 10%--then $100 of the gain (10% of $1,000) will be excluded from tax.

But not all assets eligible for the capital gains tax cut will also be eligible for indexing. Indexing will apply to stocks of corporations or tangible property that is either a capital asset or held for productive use in a trade or business. But bonds, promissory notes, debentures, options, preferred stock, and stock in S-type corporations and non-publicly traded foreign corporations will be excluded.

Shares in mutual funds and real estate investment trusts will be eligible for indexing only to the extent they hold assets that are eligible.

That’s most of it. So what does it mean?

If the House measure becomes law, investors with long-term gains will have a big incentive to sell before Dec. 31, 1991, to qualify for the lower rate. In other words, if you don’t sell, you don’t get it. There’s also another incentive to sell before that date: The indexing rules will apply only to assets acquired after Dec. 31, 1991. So it may be wise to sell assets before then, pay the lower tax on any gains, and reinvest the proceeds in 1992 to qualify for indexing.

But don’t rush out right now to take advantage of these provisions. Sales of assets should be primarily dictated by their economics and profit outlook, not taxes, experts say.

Although the outlook for passage of a bill in the Senate is positive, it could be drawn-out fight, observers say.

Even if a final bill does pass and become law, it could carry major revisions that could make the current House version unrecognizable. Such was the case with the 1986 Tax Reform Act, which bore little resemblance to the initial House-passed version.

One of the most likely changes could be in the Sept. 14, 1989, effective date. It could end up being later, such as when final legislation clears a Senate-House conference committee. That may not be until November or later.

The possibility of a later effective date is a major reason not to rush out and sell your capital assets now, unless you were planning to do so for other reasons.

Another reason not to rush: Provisions governing what qualifies for capital gains tax cuts could change. So you may sell a piece of real estate now, only to find later that it doesn’t even qualify.

What if you think your assets will go down in value while you wait?

If you haven’t held the asset at least a year, you still might hold on if you think the price decline will be minor.

The lower capital gains rate is significant enough that you could even take a 10% loss on your capital gain and still break even on an after-tax basis, says William G. Brennan, partner at the accounting firm of Ernst & Young in Washington. So if you have a stock that you bought for $1,000, and it’s now worth $2,000, you could see the value fall $100 (10% of the $1,000 gain) and you still will be OK.

For securities that you have held for more than a year, you could consider a hedging strategy called “shorting against the box.” This allows you to lock in your gain without having to sell the securities.

Under this ploy, you simply borrow shares equal to those you already own from a brokerage and sell the borrowed shares short. If the price falls, you can repurchase shares at less cost to replace the borrowed shares. The resulting profit will offset the loss on your original shares. If the price rises, the gain in your original shares will offset the loss on the short sale. Either way, you won’t lose.

You also can buy put options, the type of option that allows you to profit if the price of a security falls in value.

But remember that either of these techniques will cost you money, in brokerage commissions for going short, or in premiums if you buy options.

And the use of these strategies will freeze the period you have owned the underlying securities, Brennan says. So if you haven’t owned the underlying securities at least a year, you can’t qualify for the lower capital gains rate once you short against the box or buy put options, he says.

What if you want to sell real estate now, perhaps because you have a buyer already lined up?

The key is to keep your buyer but not trigger the capital gain right away, Kenneth Leventhal’s Ross explains.

To do that, you can sell using the installment method, Ross suggests. The buyer simply pays you later instead of now. You could have the payments come due next year and in 1991.

But beware, under the House measure, installment payments received after 1992 will not qualify for the 19.6% rate. And Congress, in passing a final bill, can always exclude installment payments from eligibility for lower capital gains treatment.

Other delaying strategies, Ross says, include an extended or long-term escrow; option payments in which the buyer writes you a big check that gives him an option to purchase your property later; joint venture agreements; and financing arrangements, such as when the buyer takes over the property by making you a loan that can be converted into equity later.

Bill Sing welcomes readers’ comments and suggestions for columns but regrets that he cannot respond individually to letters. Write to Bill Sing, Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.