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Author: yenomit Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121150  
Subject: Taxes on Capital Gain Date: 12/12/1997 11:42 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.

Nemo
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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: 913 of 121150
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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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: 915 of 121150
Subject: Re: Taxes on Capital Gain Date: 12/14/1997 3:27 PM
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<<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 >>

Here is the information that you might find useful regarding estimated taxes. Pay special attention to the 100%/110% penalty exception. You may qualify for this "loophole", and may be able to pay any balance due on your 1997 return in April of 1998 without penalty.

Enjoy...

Recent questions have underscored the potential problem of the payment of estimated taxes. I assume that many other Fools are sitting on realized stock gains for the year and might also be interested in this question. So lets take an in-depth look into estimated taxes.

Uncle Sam is looking for at least 90% of your current year taxes in the form of withholding or estimated tax payments. Remember that the tax system is that of "pay as you go" (and it seems like the farther you go, the more you pay). If you are a normal W-2 employee, and compute your withholding allowances correctly, you will most likely never have to deal with the issue of estimated taxes. But, if you are a self employed individual, or otherwise generate taxable income without associated withholding, or if your normal W-2 income "spikes" due to the sale of stocks, property, etc., you need to become acquainted with the concept of estimated taxes. Lets open up the floor for questions.

Q: Do I have to pay estimated taxes?

A: Nope

Q: Well, if I don't pay them and should have, what happens?

A: Nothing happens that paying money won't solve (what a great country, eh?). You will be assessed an estimated tax penalty. This penalty can be paid with the tax balance due on the normal tax return filing date (April 15).

Q: How is the penalty computed?

A: The penalty will be computed on IRS Form 2210. In very simple terms, the form compares what should have been paid (on a quarterly basis) to what was actually paid, and computes the deficiency by using an interest rate factor. If you are too lazy to complete the Form 2210, the IRS will be more than happy to complete it for you.

Q: What is the interest rate used to compute the penalty?

A: It varies each quarter, depending upon current Treasury Bill rates, but 1997 will probably see a rate close to 9% on average.

Q: How much exactly is the penalty?

A: That's impossible to say, since the penalty is computed on the quarterly underpayment. But on a $2,000 underpayment which occurred evenly over the course of the year, the 1996 penalty would have amounted to about $125. Now don't grab your calculator and figure that the interest rate is really less than 9%. The key words are "evenly over the course of the year." If the underpayment occurred entirely in January, the penalty would be much higher.

Likewise, if the underpayment occurred entirely in December, the penalty would be much lower. The only way to correctly estimate your potential underpayment penalty is to grab Form 2210, sharpen the pencil, heat up the coffee, and start crunchin' numbers (or run it through your TurboTax program).

Q: OK, then. If I can make more than 9% on my money, would I be better off not paying the estimates, pay the penalty at the end of the year, and pocket the difference?

A: You bet. It happens all the time. But be careful with your computations. Make sure to get a copy of Form 2210 and do the computations yourself. This is a tricky game, and if you guess wrong, the lesson could be painful.

Q: What happens if the underpayment (i.e. stock sale) happens early in the year, but I wait until the end of the year to make the estimated tax payment? Do I avoid the penalty?

A: Legally, no. If you underpay any of the first three installments, you can't avoid the penalty for those installments by overpaying the final installment. Remember that each quarter is treated independently. But the sooner you make the installment, the lower the ultimate penalty will be.

BUT CONSIDER THIS: Withholding from wages (W-2) is treated as paid equally over all installments. If you have a situation such as the one noted above, have your employer take out mucho, mucho federal withholding (or at least enough to cover the previous underpayment) late in the year. This back-loaded withholding can be used to retroactively abate the penalty. For those of you with W-2 income, this technique is very valuable.

Q: If I make a large estimated tax payment for the first quarter and then suffer big losses for the remainder of the year, is it possible to get that estimated tax payment back?

A: No way, Jose. Once you make the payment, it belongs to Uncle Sam until you file your tax return. That could be almost a year. If your business or financial situation is shaky, you might want to consider not making the estimated tax payment simply to keep your cash flow at a reasonable level.

Q: You mention "quarters." Are the quarters for estimated tax purposes the same as normal quarters?

A: The more you deal with the tax code, the more you realize that "normal" is the exception rather than the rule. In this case, the computation quarters and payment dates do differ and are as follows:

1st quarter is from Jan. 1 to March 31, payment due date is April 15th
2nd quarter is from April 1 to May 31, payment due date is June 15th
3rd quarter is from June 1 to August 31, payment due date is September 15th
4th quarter is from Sept. 1 to Dec. 31, payment due date is Jan.15th of the following year.

LOOPHOLE ALERT... LOOPHOLE ALERT... LOOPHOLE ALERT...

For those of you who were beginning to doze off, I just thought I would get your attention. If this is the first year that your income has spiked or otherwise increased substantially, you still might not have to pay estimated taxes and might be able to pay the entire balance due on April 15th, without penalty by using the so-called "exception #1." This exception allows that no estimated tax penalty will be assessed if your 1997 tax payments are equal to 100% of your 1996 tax liability. But exception #1 is not available to taxpayers with adjusted gross income (AGI) shown on the previous year return exceeding $150,000 ($75,000 for married filing separately). For those of you with AGI greater than $150,000, your penalty free zone amounts to 110% of the prior years tax. Got that? OK, lets look at an example. Pull out your 1996 Form 1040 and follow along:

1. Is line 31 of your 1995 Form 1040 (adjusted gross income) greater than $150,000? If so, your combination of 1996 W-2 withholding and/or estimated tax payments made in a timely fashion MUST be greater than 110% of line 54 of your 1995 Form 1040 (total tax) in order to avoid any underpayment penalties for 1996.

2. Is line 31 of your 1996 Form 1040 (adjusted gross income) less than $150,000? If so, your combination of 1997 W-2 withholding and/or estimated tax payments made in a timely fashion MUST be greater than 100% of line 51of your 1996 Form 1040 (total tax) in order to avoid any underpayment penalties for 1997.

So if your 1997 withholding is at least as much as your 1996 total tax (assuming that your AGI is less than $150,000), you can blow off any increases in 1997 income, and pay any balance due with the tax return on April 15th without penalty.

Q: I've heard that the new Tax Law (TRA 1997) has made some changes to these estimated tax rules. Is that true?

A: It sure is. First of all, since many provisions of TRA '97 were instituted on a "retroactive" basis, the IRS has said that the estimated tax penalty will NOT be imposed for any installment to the extent that the underpayment was created or increased by the '97 tax act if the period covered by the installment is before January 1, 1998 and the due date of the installment payment is before January 16, 1998. But remember that this relief is ONLY for tax issues directly related to the '97 tax act. If you just screwed up your estimated payments, don't expect this change to bail you out.

Q: Any other changes?

A: Yup. The new law increases the threashold for the underpayment penalty from $500 to $1,000 effective in 1998. This means that no estimated tax penalty will be imposed if the total tax liability for the year, reduced by any withholding or credits is less than $1,000. This provision will provide relief to quite a few taxpayers.

Q: How about changes to "high income" individuals...those with AGI over $150,000 as you covered earlier. Any relief there?

A: There sure is. TRA '97 substitutes the words "the applicable percentage" for "110%" for purposes of determining the preceding years tax safe harbor for individuals with AGI greater than $150,000 for the preceeding tax year. But the new rules don't apply if the preceeding tax year begins in 1997. This is a MAJOR PLUS for many of us. By not requiring payments of the applicable percentage where the preceding tax year begins in 1997, the general rule that requires annual payments of only 100% of the preceding year's tax applies. This being the case, you can base your 1998 estimated taxes on 100% of the tax shown on your 1997 tax return, regardless of your AGI for 1997. So at least potentially, high income taxpayers will have one "free" year in which to use the 100% exclusion, and dodge the estimated tax penalty.

But for tax years beginning after 1998, the applicable percentage (safe harbor) is determined as follows:

...for 1999, the applicable percentage is 105%
...for 2000, the applicable percentage is 105%
...for 2001, the applicable percentage is 105%
...for 2002, the applicable percentage is 112%
...and for 2003 and later, the applicable percentage is 110%

So you will have to stay in close contact with your estimated tax liabilities in order to cover yourself with the safe harbor blanket in the tax years to come.

Okay, that's enough for today. We could spend another two or three pages on the "Annualized Income Method" relative to estimated taxes, but let's leave that for another time. For those of you still around that want to know more about the impact of estimated taxes on your individual tax return, you can call IRS at (800) TAX FORM (800-829-3676) and request Publication 505 entitled "Tax Withholding and Estimated Tax." Or you can visit the IRS web site at http://www


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Author: yenomit Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 922 of 121150
Subject: Re: Taxes on Capital Gain Date: 12/15/1997 11:07 PM
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Well, all I can say is
1) Thanks a bunch for the info!
2) Yechhh! This is the "easier to deal
with IRS"? ;)

Dave

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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: 928 of 121150
Subject: Re: Taxes on Capital Gain Date: 12/17/1997 7:04 PM
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>>Well, all I can say is
1) Thanks a bunch for the info!>>

You are very welcome...

<< 2) Yechhh! This is the "easier to deal
with IRS"? ;)>>

Right...whoever named the new tax act "The Taxpayer's Relief Act" should be turned into the Federal Trade Commission for false advertising.

The largest relief that many taxpayers will receive is when we tax preparer types "relieve" them of their cash after we have prepared their tax returns.

TMF Taxes
Roy

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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: 929 of 121150
Subject: Re: Taxes on Capital Gain Date: 12/17/1997 7:04 PM
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>>Well, all I can say is
1) Thanks a bunch for the info!>>

You are very welcome...

<< 2) Yechhh! This is the "easier to deal
with IRS"? ;)>>

Right...whoever named the new tax act "The Taxpayer's Relief Act" should be turned into the Federal Trade Commission for false advertising.

The largest relief that many taxpayers will receive is when we tax preparer types "relieve" them of their cash after we have prepared their tax returns.

TMF Taxes
Roy

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