New Capital Gains Tax Law Can Save You Money, if You Know the Rules

Get ready. The nation’s already confusing capital gains tax laws are about to get muddier, thanks to a 1997 law that finally goes into effect at the beginning of 2001.

On the bright side, the capital gains rate for long-term holdings of certain assets is declining by 2 percentage points. By working the law to your advantage, however, you could save considerably more than that relatively small percentage indicates.

The bad news is that the law is complex. If you don’t have the right set of circumstances, you could pay more in tax preparation fees to figure out how the law could work than you’d save by using it.

“This is another of those screwy rules that somebody writes into the code without realizing what a pain in the behind it’s going to be to claim,” says Philip J. Holthouse, partner at the Los Angeles tax law and accounting firm of Holthouse Carlin & Van Trigt.

Yet people in the right circumstances can save some money by knowing the score. What’s happening, and how might it affect you and your investment strategies? Here’s a question-and-answer look.

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Q. How does this law change the capital gains tax rules?

A. If you are in the 15% marginal federal income tax bracket, you currently pay a 10% capital gains rate on profit you earn on the sale of securities. Under the law that goes into effect Jan. 1, if you have held a “qualifying asset” for at least five years, your capital gains rate will be 8% on the sale of that property.

However, if you are in a higher tax bracket and thus pay a 20% capital gains rate today, you get a lower capital gains rate only if you buy the asset after Dec. 31, 2000, and then hold it for five years. In other words, you won’t get to take advantage of the lower rate, which will be 18% for you, until 2006.

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Q. Does that mean that I can’t claim an 18% capital gains rate on assets I’ve held for a long time, even if I continue to hold them until 2006?

A. Here’s where the law gets murky. If you want the lower rate on assets you already own, you can make a special election in 2001--a “deemed sale and repurchase election”--that pretends you sold this asset Jan. 2, 2001.

That does two things. It requires you to pay capital gains tax now (at your 20% rate) on any paper profit on that phantom sale, and it starts the clock running to allow you to claim the lower capital gains rate on any additional appreciation you may realize when you later sell the asset.

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Q. Is making this election advisable?

A. Probably not if it involves the sale of securities. But in certain rare circumstances, it might make sense with the sale of residential real estate.

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Q. Why not with stocks?

A. You have to pay capital gains taxes on a profit that you won’t realize until five years from now--if at all. Then, to get any benefit from that transaction, you must hang on to the asset for five more years after you make this election--which costs you a lot of flexibility. If you do all that, your reward is just a 2-percentage-point tax cut. On a $10,000 profit, that saves you $200.

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Q. Why might it make sense with residential real estate?

A. Because each person gets to exclude up to $250,000 in profit on the sale of a personal residence (that’s where you’ve lived two of the last five years). That means you probably would not have to pay tax today by making this election with a home that you’ve lived in for at least two years, even if you’ve built up a fairly substantial paper profit.

If you know you’re going to live in the house at least two more years, you may be able to exclude another $250,000 per person when you do sell the house. That’s because the “deemed sale” is considered a real sale for tax purposes, Holthouse says. For the purposes of the residential real estate tax exclusion, it’s as if you bought a new home on that date.

And, because you can exclude up to $250,000 per person ($500,000 per couple) on the sale of your personal residence every two years, “deemed selling” a highly appreciated home for tax purposes at least two years before you actually sell it could effectively allow you to exclude up to $500,000 in profit per person, or $1 million for a couple, by using this provision wisely, Holthouse says.

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Q. What if I’m not sure whether I’ll live in the house two more years?

A. More good news, Holthouse says. The IRS recently advised taxpayers that they don’t have to send notice of this “deemed sale” election until they file their next annual tax return.

For most people, that means you have until April 15, 2002, to tell the IRS what you do Jan. 1, 2001. That gets you more than 16 months into the two-year time frame, which makes it likely you’ll know whether you will last those two years in your current residence.

If the question still appears tenuous in April, file an extension, which gives you a few more months to file your tax return, he suggests. If you’re really indecisive, you can stretch the decision-making to Oct. 15 with a second filing extension.

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Q. Does it ever make sense to make this election with stocks?

A. If you have an asset that hasn’t yet appreciated but you want to hold it, it might. But beware. If you have held this asset for less than a year before making the election, any appreciation it has already realized will be taxed at ordinary income tax rates rather than at the lower capital gains rates.

And if you sell the asset less than a year after the effective date of your “deemed sale,” you also get hit with tax at ordinary income tax rates, says Mark Luscombe, principal tax analyst with CCH Inc., a tax research and information firm in Riverwoods, Ill.

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Q. What if I have a security that’s currently held at a loss? Can I make this election to trigger the loss and both claim a deduction today and potentially get the lower capital gains rate on future appreciation if I sell the stock in 2006 or later?

A. Unfortunately, no. Though this “deemed sale” triggers a taxable capital gain, it does not trigger a deductible capital loss. If you have a loss, making this election will cause you to lose that loss as a deduction permanently.

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Q. What’s a qualified asset?

A. Any asset that’s taxed at a capital gains rate at sale. That could be stocks, bonds, residential or commercial real estate and other securities.

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Q. Are there other ways higher-income filers can get immediate mileage from this law?

A. Yes, you might be able to benefit by transferring assets from a higher-bracket parent to a child. Let’s say you have a 14-year-old daughter with college ambitions and you have stock, purchased in 1994, for $1,000 that’s worth $10,000. You give the child $10,000 in stock. (As long as you give $10,000 or less per person, there’s no estate or gift tax repercussions.)

Your daughter maintains your tax basis, or cost, in the stock. Assuming her baby-sitting money doesn’t land her in a high tax bracket, she gets the lower capital gains rate. So if she sells the stock and recognizes that $9,000 profit, she pays $720 in tax (8% of $9,000). If you sold the stock, you’d pay 20%, or $1,800. Net savings: $1,080.

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Times staff writer Kathy M. Kristof, author of “Investing 101” (Bloomberg, 2000), welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles CA 90012, or e-mail kathy.kristof@latimes.com. For past Personal Finance columns, visit The Times’ Web site at https://www.latimes.com/perfin.