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Author: TMFTaxes Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121602  
Subject: Re: Taxes on Capital Gain Date: 12/14/1997 2:41 PM
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<<I'm a newbie stock seller and can't quite wrap my mind around the IRS instructions for taxes on capital gains.
Can someone advise?

I've sold some stock, held for over 18 months, for a gain. My taxes this year will be substantially more than 90% of my tax withholdings from my paycheck (or last year, for that matter). This is based on the _sample_ 1997 tax forms on the IRS web site.

Now, I know I need to file Schedule D and 1040 for my US taxes, but...... do I file/pay estimated taxes on
the gains before the end of January? If I understand the rules correctly, I could be fined if I don't.>>

Well, I don't know if you understand the rules correctly or not. But I can certainly provide you with some additional information.

Regarding capital gains, here are the new rules...

CAPITAL GAINS TAX CHANGES

Over the last few years there has been much talk about reductions in the tax on capital gains. These cuts have finally been enacted as part of the Taxpayer Relief Act of 1997. New, lower rates for long term capital gains apply to gains realized after May 6, '97. As discussed below, with certain minor exceptions, long term capital gain rates have been reduced from 28% to 20% and, for certain lower income taxpayers, from 15% to 10%. (These rates also apply for purposes of the alternative minimum tax.) However, the new law has also extended the holding period rules so that to qualify for these lower rates you must hold the asset for more than 18 months. A special rule applies to assets sold after May 6, 1997 and before July 29, 1997. If you sold any capital assets during this period, you qualify for the new lower rates as long as you held the asset for more than one year.

With respect to sales after July 28, 1997, there are three different kinds of capital gains with different treatment for each:

#1. As under prior law, net short term capital gains remain taxable at ordinary income tax rates (15% to 39.6%). Short term capital gains continues to mean gain from the sale or exchange of a capital asset held for one year or less.

#2. Mid term capital gains (from the sale of assets held more than a year but not more than 18 months) are taxed at a maximum rate of 28%.

#3. And finally, long term gains (which now means gain on the sale of assets held more than 18 months), which are taxed at a maximum rate of 20% (10% to the extent they would be subject to tax at a 15% rate if taxed as ordinary income).

Still confused? Perhaps looking at some individual situations will help out. Let's begin with those of you who are in the 28% or higher "normal" income tax bracket:

1. You sold an asset prior to May 7. You held this asset for more than one year. Your capital gains tax rate would be a maximum of 28%. You would still fall under the old law for capital gains.

2. You sold an asset after May 6 and before July 29. You held this asset for more than one year. Your capital gains tax rate would be 20% (down from 28%). You would receive the benefit of the new rates during the "phase in" period.

3. You sold an asset after July 29. You held this asset for more than one year, but LESS than 18 months. Your capital gains tax rate would be a maximum of 28%. In effect, you would fall under the "transitional" rules, which would be exactly like the capital gain rules currently in effect (maximum of 28% OR your "normal" tax rate, whichever is less).

4. You sold an asset after July 29. You held this asset for more than 18 months. Your capital gains tax rate would be 20%.

As you can see from the examples above, you need to recognize the "phase in" period.
Many people believe that they can sell an assets NOW (i.e., after July 29) that were held for more than a year but less than 18 months and receive the 20% rate. This is NOT the case.

Now let's take a few seconds to look at the impact to taxpayers in the 15% "normal" income tax bracket:

1. You sold an asset prior to May 7, and you held this asset for more than one year. Your capital gains tax rate would be a maximum of 28%. But since your "normal" tax rate is less than the maximum capital gain tax rate, you would pay your tax at 15%. This is nothing new. You would still fall under the old law for capital gains.

2. You sold an asset after May 6 and before July 29, and you held this asset for more than one year. Your capital gains tax rate would be 10% (down from 15%). You would receive the benefit of the new rates during the "phase in" period.

3. You sold an asset after July 29, and you held this asset for more than one year but less than 18 months. Your capital gains tax rate would be a maximum of 28%. But again, since your "normal" rate is lower than the maximum capital gains tax rate, you would pay tax at the 15% rate. Even though you would fall under the "transitional" rules, you would continue to pay tax at your "normal" rate or the 28% rate... whichever is less. Since your "normal" 15% would be the lesser of the two, that would be your rate.

4. You sold an asset after July 29, and you held this asset for more than 18 months. Your capital gains tax rate would be 10%.

Additionally, two other rates have also been incorporated for "super long-term gains." Profits on assets purchased after year 2000 that are held at least five years will be taxed at an 18% rate for most taxpayers. Further adding to the complexity of the new tax break is a special provision for lower income bracket taxpayers. For taxpayers whose total income puts them in the 15% "normal" tax bracket -- some of whom are retirees with little income but significant portfolios -- the longer term capital gains rate of 8% applies to assets sold in 2001 that have been held for at least five years, no matter when they were purchased. Since year 2000 is still a long way away, I'm not going to burden you with any great detail regarding these super long term gains issues.

So let's look at an example:

Jill, a single person, has taxable income other than capital gains of $80,000 in 1997 (putting her in the 31% tax bracket). She also has $10,000 of long term capital gains from sales after July 28, 1997, $5,000 of mid term capital gains, and $2,000 of short term capital gains. Although Jill is otherwise in the 31% tax bracket, only the $2,000 of short term gain is taxed at that rate. The $5,000 of mid term gain is taxed at 28%, and the $10,000 of long term gain is taxed at 20%.

So what does all of this really mean? For the high bracket taxpayer, he or she will pay up to $39.60 in tax on each $100 dollars of "regular" income such as wages, interest, dividends, etc., but $100 in long-term capital gain income would be taxed at only $20. This is a significant savings. Even lower bracket taxpayers who are forced to pay tax of $15 on $100 of "regular" income will only be required to pay $10 on $100 of long-term capital gain income. These are significant savings. In effect, long-term capital gains rates were slashed by about 30%. Sweet.

And if you are a mutual fund investor, don't feel left out. Mutual funds will be providing you with much more year end information on your annual Form 1099 so that you can benefit from these changes. The form will have to separately report the different kinds of gain so that they can be properly reflected on your return.

Given all of the information reported above, consider this tax planning opportunity: With the 10% rate for low bracket taxpayers, if you have appreciated stock or other capital assets that you are thinking of selling, you may wish to consider transferring those asset to children over age 13. To the extent their other taxable income is below the 28% tax bracket amount ($24,650 for 1997), they can take advantage of the low (10%) rate for net capital gains. (For children 13 or under the "kiddie tax" rules can cause the child's income to be taxed at the parent's (higher) tax rates.)

But be aware: For capital gains attributable to collectibles, the tax rate remains at the old maximum rate of 28%. And part of the capital gain from the sale of depreciable real property may be subject to a 25% tax rate where the depreciation recapture rules apply.

Finally remember that while the tax rates have been changed for capital gains as outlined above, those gains continue to be included in adjusted gross income (AGI). Thus, they will still have an impact on any related tax area dependent on AGI. These include itemized deductions for medical expenses, casualty losses, and miscellaneous itemized deductions as well as the phase out of itemized deductions and personal exemptions, and the inclusion in gross income of Social Security benefits.

These new rules provide many tax saving opportunities. However, the rules can be extremely complex and contain pitfalls that can cause the unwary to pay more tax than is otherwise necessary. If you have any questions on any of the new capital gains rules, be sure to let me know.

Regarding estimated taxes, I can't seem to locate my Frequently Asked Question response on that issue. I'll track it down and get back to you.

TMF Taxes
Roy
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