The 1997 Tax Act: Capital Gains

Chapter 2
Capital Gains
A Tax News & Views Special Report:
Promises Kept: The 1997 Tax Law

Guide to
Promises Kept

Tax Cuts for Individuals

Principal Tax Increases

Other Key Provisions

Table of Contents

he Act's emphasis on tax cuts for the middle class is balanced by a substantial cut in capital gains taxes, which is not limited to the middle class and which will deliver substantial benefits to many higher-income taxpayers. Although the President had resisted general capital gains relief because he believes it provides a disproportionate benefit to the wealthiest Americans, he accepted the cuts once he was assured that other provisions in the legislation would even out the benefits for the middle class and the poor. The capital gains cuts in the new law include:

An individual capital gains rate cut.
A special lower rate for assets held more than five years.
A $500,000 exclusion of gain on the sale of a personal residence.
Liberalization of the small business capital gains rules.

Major Capital Gains Provisions

Reduction in individual tax rates on net capital gains: The maximum rate of tax on the net capital gains of individuals will fall from 28% to 20%. A 10% capital gains rate applies to gains for taxpayers in the 15% tax bracket. These new rates apply for both the regular tax and the alternative minimum tax (AMT).

Planning Point: Capital Gains and the AMT. The decision to apply the alternative rates for AMT purposes was dictated by Congress' desire to give capital gains relief to individual taxpayers who realize a significant capital gain only once in their lives. Such a taxpayer might be a small business owner selling a successful business at retirement. If the normal 28% AMT rate were to apply to such a gain, the relief in the bill would be meaningless. Nonetheless, careful AMT planning will be required because of the AMT treatment of state and local taxes on capital gains. (See the planning points below.)

For gains recognized after July 28, 1997, the Act extends the holding period required for long-term treatment from 12 to 18 months. Gains on assets held for more than 12 months but fewer than 18 months continue to be taxed at the 28% rate.

The tax rate on long-term capital gains from the sale or exchange of collectibles will remain at the current maximum rate of 28%. Any sales or exchanges of section 1250 propert (that is, depreciable real property) that yield long-term capital gains will be taxed at a maximum rate of 25%.

Effective date. The 10% and 20% tax rates apply to gains on capital assets sold or exchanged (or installment payments received) on or after May 7, 1997. Gains recognized before May 7, 1997, will be taxed under the prior law rules that imposed a top capital gains rate of 28%.

Capital gains have been subject to tax since the modern income tax was imposed in 1913. In 1923, a preferential rate of 12.5% was provided for capital gains, while the rate on ordinary income topped out at 73%. Rates have fluctuated over the years, with the tax on capital gains ranging between 20% and 35%, generally, while the maximum ordinary income tax rates soared as high as 94%. The Tax Reform Act of 1986 briefly eliminated any preferential treatment of capital gains. The 1990 and 1993 tax acts again created a capital gains preference by increasing the tax rates on ordinary income. In 1996, the highest-income taxpayers paid tax rates of 39.6% on ordinary income and 28% on capital gains.

The following chart shows the relationship of ordinary and capital gains tax rates since 1956.

The Act's capital gains provisions create a preference that is similar in size to that which existed in the early 1980s. As a result, many of the tax-planning considerations that were second nature to high-income taxpayers in the 1980s now must be recalled and updated. We discuss these planning points at the end of this section.

Gains on property held by individual taxpayers for more than five years are subject to a reduced rate effective for taxable years beginning after Dec. 31, 2000. The 20% and 10% rates are reduced to 18% and 8%, respectively. The special 18% rate, however, applies only to gains on assets acquired after 2000. To avoid having to sell and repurchase assets to start a new holding period, affected taxpayers may elect to treat marketable securities and certain other assets as if they had been sold and repurchased for the purpose of recognizing gains but not losses on Jan. 1, 2001.

Exclusion of gain on the sale of a principal residence: Taxpayers now may exclude up to $250,000 ($500,000 in the case of a married couple filing a joint return) of gain realized on the sale or exchange of a principal residence. Taxpayers may use this exclusion once every two years. Only taxpayers who have owned and occupied a home as a principal residence for at least two of the five years prior to any sale or exchange may take full advantage of the exclusion. Taxpayers who fail to meet this requirement due to some unforeseen circumstance (such as a change in employment) are only able to exclude a fraction of either the $250,000 or $500,000 amount.

The Act also excludes sales of personal residences with a gross sales price of $500,000 or less ($250,000 or less in the case of a seller who is not married) from the real estate transaction reporting requirement (Form 1099S).

Effective date. The exclusion applies to gains on sales or exchanges occurring on or after May 7, 1997. Taxpayers may elect to apply prior law to sales or exchanges occurring: (1) before the date of enactment; (2) after the date of enactment pursuant to a binding contract in effect on the enactment date; or (3) when the replacement residence was acquired on or before the date of enactment (or pursuant to a binding contract in effect on the date of enactment) and the rollover provision would apply.

Capital Gains Planning Points

Here are some of the issues you and your tax advisor will need to consider with the new capital gains rules.

Maximize the value of capital losses: Depending on your circumstances, a dollar long-term capital loss may save 40 cents of tax, 20 cents of tax, or nothing at all in the current year. That is, it may offset ordinary income (up to the $3,000 limitation), it may offset a long-term gain that otherwise would be taxed at 20%, or it may exceed both your long-term gains and the $3,000 limitation and be carried forward.

Avoid penalties on your estimated payments: You must make income tax payments throughout the year as income is earned. For taxpayers with large capital gains, this means making quarterly estimated tax payments.

To avoid estimated tax penalties, you must pay:

90% of the current year's tax liability.
100% of the prior year's tax liability, if the prior year's adjusted gross income was not more than $150,000 ($75,000 for married taxpayers filing separately); otherwise, 110% (105% between 1999 and 2001, 112% in 2002) of the prior year's tax liability.
90% of the tax liability based on quarterly annualization of current year-to-date income.

Avoid the potentially costly combination of capital gains and state and local taxes: In the event of large capital gains, careful multiple-year planning will help determine when to pay state income taxes, particularly in high-income-tax states. Consequently, taxpayers with large capital gains may find themselves in AMT just by virtue of the state tax on their capital gains.

Weigh ordinary income taxation on retirement plan distributions against capital gain rates on other investments: In some cases, it may be more advantageous for individuals near retirement to invest in equities outside of their retirement accounts so they can obtain the favorable 20% capital gains rate (10% for individuals in the 15% marginal tax bracket). Retirement plan distributions generally are taxed at ordinary income tax rates, which already are higher than the capital gains rates.

Invest in small business? The new tax law allows taxpayers who invest in qualified small business stock and hold the shares for more than six months to elect to roll over tax-free any gain if the proceeds are invested in other qualified small business stock within 60 days. The current maximum capital gains rate of 14% is retained for investors who hold the stock for more than 5 years and do not elect the new rollover treatment.

Avoid dividend treatment when a corporation purchases stock from family members: In certain circumstances, the family member may be treated as receiving a dividend and have to pay tax at ordinary income rates on the entire amount of the redemption proceeds. If certain conditions are met, the family member may instead report only capital gains equal to the difference between the proceeds and basis and pay tax at a maximum rate of 20%.

Convert ordinary income to capital gains with a section 83(b) election: Section 83 imposes ordinary income tax on property received as compensation for services (such as restricted stock, but not stock options), as soon as the property becomes vested or transferable. If you receive eligible property, you can elect under subsection 83(b) within 30 days to recognize immediately as income the value of the property received (that is, the fair market value less any amount paid toward the property) and convert all future appreciation to capital gains income. Careful planning is required to ensure compliance with the strict section 83(b) rules.

Understand stock options: Taxpayers must retain incentive stock options (ISOs) for at least the required holding period (two years from date of grant and one year from date of exercise); after that, the future appreciation over the exercise price will be subject to long-term capital gains treatment rather than ordinary income taxation. This tax is payable only when the stock is sold. Nonqualified stock options (NQSOs) are more flexible, but trigger ordinary income tax on the appreciation "captured" upon exercise of the options, and capital gains tax on appreciation realized on the subsequent sale of the stock.

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Tax News & Views is produced by the Financial Counseling Specialists and the Legislative & Regulatory Services Group at Deloitte & Touche LLP.