Capital Gains Part of Tax Form Is Mind-Boggler of the Year

As the final crush of Americans rushed Wednesday to stuff mailboxes with their 1997 tax returns, few forms were drawing more anger and exasperation than Schedule D, the capital gains form, whose labyrinthine steps would challenge Theseus, the maze-conquering hero of Greek myth.

Taxpayers can thank the 1997 tax law for creating the new Schedule D by establishing four--count ‘em, four--tax rates for capital gains, which are the profits from sale of stock, real estate and other assets.

The capital gains form, which has rapidly expanded from a one-page, 19-line form to a two-page, 54-step Rube Goldberg machine of higher mathematics, is so complex that even the people who wrote the law are throwing up their hands.

House Ways and Means Committee Chairman Bill Archer (R-Texas), who always brags that he does his own taxes, for the first time resorted to a computer program to prepare them this year, his spokesman said.

And unfortunately, a lot of people who should have filed Schedule D did not realize it. The Internal Revenue Service is sending back more than 1 million returns because they failed to include Schedule D. That is an unusually hefty chunk of the 20 million or so taxpayers who were expected to report capital gains this year.

Republicans around the country honored the federal tax filing deadline Wednesday with press conferences and events that called for abolishing the tax code and replacing it with what they said would be a simpler, fairer system. But GOP fingerprints are all over the 1997 tax law, which is responsible not only for Schedule D but for a host of other new complications in the tax code.

The 1997 tax law created 285 new sections in the Internal Revenue Code and made changes in 824 others, according to Rep. Rob Portman (R-Ohio), a member of the Ways and Means Committee.

The law created new tax breaks for education spending, retirement savings, home office expenses and a hodgepodge of other transactions.

But the only part of the law that took effect in time to be reflected in the 1997 forms was the capital gains changes, which were designed to cut the rate for most investors from the old top rate of 28%. But to that simple concept many bells and whistles were added.

If an asset is held for less than a year, it is taxed at ordinary income tax rates. If it is held for 12 to 18 months, it’s taxed at 28%. If it’s held for more than 18 months, it’s taxed at 20% (or 10% for people in the lowest tax bracket). Then there were exceptions for artwork or other “collectibles.” And for real estate. And for assets sold before May 7, 1997.

You get the idea: This part of the tax law was more exception than rule.

The result was a form that sent taxpayers through a rapid-fire series of arithmetic instructions with no explanation of what exactly was being calculated. Multiply line 46 by 25%. Enter the amount from line 19. Add lines 32, 36, 40 and 46. Just when filers thought they were finished with line 19 (the taxable income from Form 1040, line 38), the form asked them to enter the number from line 19 again.

“If you do it step by step, and do what it tells you, you don’t have to understand what it is,” said Don Roberts, an IRS spokesman. “It works.”

Others were baffled.

“It’s enormously complicated,” said Portman, who spent lunch hour Tuesday in front of a post office in his district talking to constituents who were mailing their tax returns or picking up forms. When one man proudly told Portman that he had filled out Schedule D by himself, Portman shook his hand and roundly congratulated him.

Thanks to last year’s law, about 5 million more taxpayers had to file Schedule D this year than last, Roberts estimated. Many of those were people who had only small capital gain distributions from mutual funds.

Last year, those investors did not need to file a Schedule D if their distributions were less than $300. This year, under the new law, they did need to use and file Schedule D--otherwise they might not get the benefit of the lower tax rates. But a lot of people did not realize that this was the case.

That confusion is why the IRS estimates that it will send about 1 million forms back to taxpayers requesting the missing Schedule D.

There may be help for the beleaguered taxpayer next year. Part of the complexity of this year’s capital gains form was a result of the fact that the rate change took effect in the middle of the year. That means that, for this year only, assets sold at different times of the year were treated differently.

What’s more, Archer is hoping to get rid of one part of the byzantine structure through legislation this year. Under the 1997 law, the tax rate depended on how long the asset had been held. That formula was a compromise designed to address the Clinton administration’s desire to increase incentives for people to hold their assets longer.

Archer wants to simplify the system by having two, not three, categories: assets held more than a year or less than a year.

But that still will not make it simple, acknowledged Archer’s spokesman, Ari Fleischer.

“The capital gains form is a complicated mess,” Fleischer said, “but at least, for the first time, the complication results in taxpayers paying less not more.”

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Capital Gains Puzzler

A sample from Schedule D, the capital gains form that puzzles even the people who helped craft it.