Patient investors, you're finally destined to get your reward. After years of heaping praise on the buy-and-hold folks who fund American capitalism, Congress this year is promising new, lower tax rates for profits on assets that are held five years or longer. True, lawmakers might have overestimated people's patience: They voted in the new rate in 1997 but stalled the actual cuts until 2001. In fact, most investors can't reap the benefits for five more years. But the reward will be worth the wait, right?
Well--maybe. Fact is, claiming the new capital-gains rates--down from 10% to 8% for couples earning less than $45,200, and from 20% to 18% for those earning more--is going to be tricky. To realize any savings on stocks or other assets you already own, you'll have to pay taxes this year in the hope (or gamble) that you will save taxes in 2006.
That violates the cardinal rule of tax planning: Never pay Uncle Sam a dime today that you can put off until tomorrow. So tax pros are getting headaches deciding whether the eventual savings are worth the cost and risk of an immediate tax bill. "There's a long list of outcomes that could turn any decision to pay tax now into a mistake," explains Bernard Kent, a tax partner with PricewaterhouseCoopers.
TEEN ANGLES. The new break is actually two separate rate cuts. Taxpayers in the lowest bracket--up to $45,200 in taxable income for couples, or up to $27,050 for singles--get an immediate benefit. If they sell an asset after Jan. 1 that they've owned for five years or longer, they'll pay 8% tax on the gain. (If they've owned the asset one to five years, the rate is 10%; less than one year, 15%, the same as current rates.)
That suggests an easy strategy for parents or grandparents: If you're planning to build up your teenagers' accounts this year, give them appreciated property that you've held a long time. With a gift, the recipient inherits the giver's holding period and cost basis. So if you give your teen $10,000 in stock that cost you $5,000 five years ago, and she's in the 15% bracket, she can sell the stock and net $9,600 after taxes--instead of the $9,000 you would have left if you sold the stock. A couple can give up to $20,000 a year to a child without incurring any gift tax. But take note: Your child will only get the 8% rate if she's 14 or older. The income of younger children is taxed at their parents' top rate.
Taxpayers above the 15% bracket--meaning most investors--will have to wait longer. Their rate cut, from 20% to 18%, will apply only to assets acquired after 2000 and held five years. But Congress, in its wisdom--and its search for a revenue bump--created an opening to help you get the lower rate on assets you already own. It's called a deemed sale, and it lets you pretend that you sold an asset on Jan. 1, 2001 (Jan. 2 for traded securities), then immediately repurchased it.
Say you bought 100 shares of a $10 stock in 1999. On Jan. 2, the stock closed at $12. If you think you're going to stay with this stock until 2006, you can recognize $200 in gains so far, pay $40 in tax at today's 20% rate, and start the clock on a new holding period. If you wait until 2006 or later to sell, you'll pay just 18% tax on gains above $12.
The good news is that you don't have to do anything to use this tactic until you file your 2001 return--as late as Apr. 15, 2002--and can change your mind until Oct. 15, 2002. "You'll be 16 months into the new holding period before you have to decide whether to act," says Bob Trinz, editor of RIA's Federal Taxes Weekly Alert.
The bad news is that the choice will still be fraught with risks. If you do a deemed sale but sell the position before 2006, you'll lose any earnings from the money you used to make the early tax payment. Worse, if you die owning the stock or give it to charity, you'll lose big, because you've paid taxes on profits that otherwise never would have been taxed.
Don't even think about a deemed sale for a position that's underwater: The rate-cut law bars you from using losses on a deemed sale to offset other gains. You're also barred from using the 18% rate on stock you acquire by exercising options--either employer stock options or traded options--that you owned before Jan. 1. And the tactic doesn't work well for assets bought in 2000, even if you have gains, because profits will be taxed at short-term rates, up to 39.6%.
CREATIVE ACCOUNTANTS. If you want to reclassify an asset, look hard at the gains you already have. The more profit you have made, the more immediate tax you'll pay--and the more future growth you'll need to cover the lost earnings on those tax dollars. Take that $10 stock that has risen to $12. To make a deemed sale pay, it must hit $20.40 by 2006--a 70% gain. How likely is that? Experience since 1946 suggests stocks return 10% a year--or 61% over five years.
As the chart shows, the target price needed to make this strategy break even rises steeply, depending on how much gain you already have. "If you have a small enough profit to date, and are optimistic enough about the stock, this can be an O.K. deal," says Robert Gordon, president of Twenty-First Securities, which devised an online calculator (www.twenty-first.com) to test the lower rate.
Who will take advantage of a deal that's just O.K.? Investors holding stock with zero or tiny long-term gains--and after 2000's markets, there may be lots of these candidates. Owners of small businesses that are about to take off might want to exchange a small tax hit now for bigger savings later, suggests Martin Nissenbaum, head of personal finance and taxes for Ernst & Young.
Creative accountants are investigating other angles. Taxpayers with past operating losses on passive activities--rental real estate, say, or stock in a small company that you didn't actively manage--might benefit, says David Lifson, managing partner of accountants Hays & Co. Usually, you can't claim such losses until you dispose of the investment. But if the Internal Revenue Service regards a deemed sale as disposition, such taxpayers could unlock those losses, use them to offset this year's income--and still keep the asset.
If you think you might want to tap these lower rates, start getting your records in order. For closely held businesses or real estate, you'll need an appraisal of their value as of Jan. 1. Stock investors need records of closing prices on Jan. 2. Mutual-fund shareholders have a bigger challenge: They need to identify which shares they owned before Jan. 2, 2000, and apply the tactic only to those shares to avoid triggering high-tax short-term profits.
Is it worth it? Keep in mind that the Bush Administration and Congress may soon come up with a simpler break: an across-the-board rate cut. If they do, deemed sales may go straight to the list of Ideas Best Forgotten Quickly.