or as long as the income tax has been around, capital gains and losses have been subject to special rules and taxed differently than other income from capital. But the rules governing the rate of taxation and the time the assets need to be held to qualify for long-term treatment often change.
New lower rates. Effective for tax years beginning in 2001, certain assets held for at least five years, which would have been taxed at a 10% rate, will be taxed at 8%. For assets held more than five years and whose holding period begins after December 31, 2000, the maximum rate will be lowered from 20% to 18%.
Basically, this means taxpayers who purchase an asset in 2001 or later automatically are eligible for the 18% maximum capital gains rate, as long as they hold the asset more than five years.
New election available. Individual taxpayers who already hold eligible assets may qualify for the 18% maximum rate by making a “deemed sale and repurchase” election. (No election is needed to qualify for the 8% rate as the holding period for assets qualifying for that rate began prior to January 1, 2001.)
To be eligible for this election, the asset must be either “readily tradable stock” (as of January 1, 2001) or a capital asset or property used in a trade or business.
The taxpayer elects to treat the asset as having been sold and then immediately repurchased for its fair market value or closing market price (for securities) on January 2 (the next business day). Provided the five-year requirement is met, the taxpayer recognizes the gain from the election and pays tax on it at the 18% rate. (Although a taxpayer cannot deduct losses or add disallowed losses to its basis, an asset that results in a loss will still be eligible for the 18% rate after 2005—the five-year holding period.)
A taxpayer may pick and choose those assets for which he or she will make an election; it is not an “all or nothing” election. However, an election for any asset, once made, is irrevocable.
Timing of election. To make the election, a taxpayer must report the deemed sale and repurchase on his or her return for the tax year in which the deemed transactions occurred. Thus, calendar-year taxpayers may make the election on their 2001 returns (including extensions). In addition, a taxpayer may make an election for a qualifying asset that has not yet been selected by filing an amended return within six months of the due date of the return (by October 15, 2002, for calendar-year individuals).
Value of the savings. Will the present value of the 2% tax savings in the future exceed the value of the taxes paid currently? The taxpayer may have to carefully consider the assets involved, when (or if) they will be sold and their potential selling prices.
Waiting period. Because the election does not have to be made until the taxpayer’s 2001 return is timely filed, he or she has some time to determine whether assets will appreciate in value and to consider whether to make the election.
Estate tax laws. For assets a taxpayer plans to hold until death, the step-up in basis currently available would eliminate any taxes on these assets. In such a case, the value of this election would be wasted.
Liquidity. A taxpayer will be required to pay tax on the deemed sale but will not have received any actual cash proceeds.
Law changes. There is always the possibility that the capital gains tax will be reduced (or repealed). Changes in the estate tax laws could also affect this decision.
For a discussion of this and other current developments, see the Tax Clinic, edited by Edward Sair, in the March 2001 issue of The Tax Adviser.
—Nicholas Fiore, editor
The Tax Adviser