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A Capital Idea?

Uncle Sam’s promise of a cut in the tax on long-term capital gains has helped re-energize the battered Nasdaq market of smaller stocks and the stock market in general, sending many key indexes to new highs Monday.

But the tax cut pledge, an agreement between President Clinton and congressional Republican leaders last week within the long-term balanced-budget plan, also is creating massive confusion among investors in securities markets, real estate and small businesses.

The reason: None of the details of the tax cut have yet been worked out. And as usual with anything that must be decided in Washington, the devil is certain to be in the details.

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Moreover, despite the apparent initial euphoria on Wall Street about a capital gains tax reduction from the current 28% top rate, many analysts worry that a cut will actually hurt stocks once it takes effect--by fueling pent-up selling by long-term investors.

Whether that turns out to be true, however, remains to be seen. Some Wall Streeters note that the bulk of stock market assets still are in the hands of big institutions, most of whom don’t pay much attention to tax issues.

And in the long run, experts note that a capital gains tax cut is inherently good for stocks, by further enhancing the appeal of asset appreciation versus, say, interest income.

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For now, the advice that most tax advisors are giving their individual-investor clients is simply to stand pat: Don’t sell stocks or other long-term, appreciated capital assets, or if you do, use a transaction that will allow you to postpone realizing your capital gain until beyond the effective date of the tax cut.

“It’s certain death for an advisor to be recommending an asset sale now,” said Robert Willens, tax strategist at Lehman Bros. in New York.

Here are some of the issues investors in securities, real estate and small business should consider in light of the tax cut promise:

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* The cut is expected to be significant. Currently, Uncle Sam takes as much as 28% of any gain you realize on a long-term investment (i.e., a capital asset held more than one year). That compares with a 39.6% top federal tax rate for ordinary income, such as wages, interest or dividend income.

Although Clinton and Republican leaders did not specify what they want the new capital gains tax rate to be, Senate Majority Leader Trent Lott (R-Miss.) said Monday that he believes Congress’ tax-writing committees will get it “into that range of under 20%.”

Senate Republicans earlier this year had proposed a top rate of 19.8%. Under that plan, investors would simply exclude 50% of any long-term gains from taxation, and include the other 50% with ordinary income--thereby effectively taxing capital gains at half the top ordinary tax rate of 39.6%.

Democrats, however, could push for a smaller exclusion that might make the effective top gains tax rate 21% or 22%, Willens said.

In any case, a new rate in the 20% range would mean investors would pay about 30% less tax on a capital gain than under current law--a nice sum by any measure.

* The effective date of the cut is the big unknown. Congress could make the tax cut retroactive to any date it chooses. The date obviously is of major importance to investors.

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If Congress were to allow the lower tax rate on any long-term asset sold since, say, May 1, investors would be free to sell assets now and know they’ll benefit from the tax cut. But so far, no effective date has been publicly discussed.

Rather than make it retroactive, Congress could set a date in the future. But that would risk a torrent of selling of stocks and other assets immediately on that date.

Until a date emerges, many experts believe that investors who care about tax issues will do the logical thing: refrain from selling.

* If sellers hold back, stocks could continue to surge. If buyers are eager to get into stocks to reap future capital gains, while sellers are suddenly scarce, it would be logical for prices overall to continue to rise, or at least not to fall.

But that’s a gross generalization, experts note. For one thing, the biggest investors in the market, including pension funds and mutual funds, care little about taxes.

“Mutual fund managers don’t even think about taxes,” said Jeffrey Petherick, co-manager of the Loomis Sayles Small Cap stock fund in Boston.

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Still, for perhaps the smallest stocks--those whose prices are determined more by the actions of individual investors than by institutions--the waiting game for the effective tax cut date may indeed help prop up prices, Petherick said.

More important, however, is the general sentiment toward smaller issues. Because that sentiment had been so negative in recent months, pushing smaller stocks down far more than blue chips, many investors believe there are plenty of bargains among smaller issues.

Jim Collins, head of money management firm OTC Insight in Walnut Creek, Calif., said the rebound in smaller stocks over the last week has less to do with proposed tax changes than that many smaller stocks had fallen to their cheapest levels relative to earnings since 1990.

With buyers returning to those stocks, “we’ve got a ways to go” in their potential, given the extent to which they were crushed in the early spring, Collins said.

* When the tax cut specifics are finally known, stocks could quickly get whacked. “Once that tax rate change occurs, a lot of people who have been waiting to sell will start selling,” said Preston Athey, money manager at T. Rowe Price Associates in Baltimore.

He doesn’t just mean people who’ve been waiting in recent weeks or months. Wall Street assumes that many individuals would be eager to take some of the huge profits they’ve racked up on their buy-and-hold positions in the 1990s.

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But which sectors of the market would be hurt most? Some analysts believe that because the biggest gains over the last three years have been in blue-chip issues, rather than in smaller stocks, blue chips would be targeted for profit taking by individual investors.

Whether selling by individuals would be enough to make much of a dent in such very liquid stocks is a point of debate, however.

Although many smaller stocks might escape being targeted, Collins worries that technology issues would not be spared--because so many employees of tech firms have large ownership positions in their companies’ stocks, via options.

In addition, tech issues have scored some of the biggest price appreciation over the last few years, even accounting for this year’s slump, Collins noted.

Hence, he thinks investors eager to buy tech shares might be able to pick them up cheaper after the tax cut details are announced.

But would-be stock buyers who are tempted to wait also should remember that the whole point of a gains-tax cut would be to encourage long-term investment. That may bring a lot of additional buying power into market--including by investors who are taking profits on certain stocks. That money may just flow back into other stocks. The result may be that the market doesn’t decline all that much, or for very long, other things being equal.

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* If you need to sell an asset--securities, real estate or a business--there are ways to do so and still be in line for the tax cut’s benefit. In the case of an appreciated security, Willens notes that investors can “sell short against the box”--borrow shares of the same security, sell them in the open market and plan to close out the transaction later by repaying the loan with shares already owned.

For tax purposes, no gain would be recorded until the entire transaction is closed out, which could be after any gains-tax cut takes effect.

Although Uncle Sam is expected to do away with this strategy in the future, Willens and other advisors believe it is a safe way now to take a gain and still get the benefit of a future tax cut.

As for other assets, such as real estate or a small business, sellers should consider strategies that would seal a deal now but allow for closing the transaction later, said Stan Ross, managing partner at E&Y; Kenneth Leventhal’s real estate group in Century City.

That may be particularly important in the case of residential real estate. One proposal in Washington is to allow married people to exclude up to $500,000 in profit on their primary residence from any capital gains tax.

Ross suggests that real estate owners who want to lock in a sale should consider a plan to let the buyer rent for a few months, before closing the transaction.

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The important thing is “don’t lose the buyer,” Ross said.

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Nasdaq’s Turnaround

The Nasdaq composite index of mostly smaller stocks has soared 10.8% over the past six trading sessions, after plunging in February, March and April as Wall Street struggled with concerns over interest rates and corporate earnings growth. Weekly closes since last May and and latest: Monday: 1,339.24, + 33.91

Source: TradeLine

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History of the Gains Tax

The federal government has changed the effective top tax rate on long-term capital gains many times over the years. Here’s how the rate has fluctuated since 1969.

1997: 28%

Source: Cato Institute

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