Benefits of the Capital Gains Tax

As you know, dividends have always been taxed as "ordinary income." That meant you paid your regular tax rate, which could be as high as 35% (formerly 38.6%).

That was then. Effective for all of 2003 through the end of 2008, qualified dividends from domestic corporations and qualified foreign corporations will be taxed at the same low rates as long-term capital gains. And those rates have been reduced, too (see below). Bottom line: The maximum rate on qualified dividends is now only 15%. And if you're in the 10% or 15% rate bracket (see the table above), your dividends will be taxed at only 5%. (For 2008, the rate will be 0%, but just for that one year.)

Here's the catch. To be eligible for the reduced rates on qualified dividend income, you must hold the stock on which the dividends are paid for more than 60 days during the 120-day period that begins 60 days before the ex-dividend date (the last date on which shareholders of record are entitled to receive the upcoming dividend). In other words, when you own shares only for a short time around the ex-dividend date, your dividend income will be taxed at your regular rate (up to 35%).

One more thing: The new low rates don't apply to dividends received in tax-deferred retirement accounts (traditional IRAs, 401(k) accounts, SEP and Keogh accounts, and the like). Dividends accumulated in these accounts will still be taxed at your regular rate (up to 35%) when withdrawn as cash distributions.

Sunset Rule: Unless Congress takes further action, dividends received after 2008 will once again be taxed at your regular rate.

Long-Term Capital Gains Now Taxed at 15% or Less
More good news for those who invest in taxable accounts: Long-term capital gains from sales on or after May 6, 2003, will be taxed at no more than 15% (down from 20%). If you're in the 10% or 15% bracket, you'll pay only 5% on long-term gains from sales on or after the magic May 6 date (0% in 2008, but only for that one year). However, it's not all peaches and cream.

· The 25% maximum rate still applies to long-term real-estate gains attributable to depreciation deductions claimed against the property (so-called unrecaptured Section 1250 gains).

· The 28% maximum rate remains in place for long-term gains from collectibles and certain small-business stock. So if you sell your prized stamp collection for a huge profit, the new law won't save you a dime.

· Long-term capital gains from sales before May 6, 2003, remain subject to the old rates (20% maximum rate for most folks, 10% maximum rate for those in the 10% or 15% brackets, 8% maximum rate for five-year gains earned by taxpayers in the 10% or 15% brackets).

· The lower capital-gains rates have no impact on investments held in tax-deferred retirement accounts (traditional IRAs, 401(k) accounts, SEP and Keogh accounts, and so forth). As before, capital gains accumulated in these accounts will be taxed at your regular rate (up to 35%) when withdrawn as cash distributions.

Sunset Rule: Unless Congress takes further action, the "old" capital-gains rates will reappear after 2008.

Taxpayers can reduce their income taxes considerably by generating net capital gains instead of ordinary income. The maximum tax rate for most long-term capital gains is 20 percent, compared with a maximum tax rate of 39.6 percent for ordinary income. In addition, capital assets usually offer the owner the flexibility to control when the income or loss is recognized because the owner typically determines when to sell assets.

Investment strategies that emphasize capital appreciation over current income can significantly enhance after-tax portfolio returns. Long-term investors should keep growth-oriented investments out of tax-deferred accounts to benefit from the capital-gains tax relief.

Capital gains usually are taxable, whether the underlying asset is held as an investment (eg, stocks, bonds, and mutual funds) or for personal purposes (eg, a vacation home or an automobile used for personal purposes.) On the other hand, capital losses are deductible only if the assets were held for investment purposes.

Losses incurred from the sale of investment assets can be deducted to the extent that they equal capital gains. But if the losses exceed the capital gains, the deduction is limited to a maximum of $3,000 of those losses against ordinary income in a given tax year. Any excess will be carried over until it can be offset against future capital gains or deducted as a loss against the taxpayer's ordinary income up to $3,000 a year.

Almost everything a person owns and holds for personal or investment purposes is a capital asset, including stocks and bonds, a residence, household furnishings, automobiles, boats, jewelry, and precious metals. Capital assets do not include inventory; notes and accounts receivable acquired in the course of business for services rendered or from the sale of inventory; or, in certain cases, copyrights or literary, musical, or other artistic compositions. Letters and memorandums prepared by or for a person also are not classified as capital assets. Gains on sales of certain assets used in a business are taxed at capital gains rates; however, one may have to pay ordinary income tax rates on a part of the gain (depreciation recapture) resulting from the sale of such property.

Various capital-gains tax rates apply, depending on the type of property sold, the holding period prior to the sale, and the taxpayer's income level. Gains on property held for 12 months or less are treated as short-term capital gains, subject to the same tax rates as ordinary income. Gains on the sale of property held for more than 12 months are considered long-term capital gains. Long-term capital gains are subject to tax rates of 10 percent (for gains in the 15 percent tax bracket) or 20 percent (for gains in the 28 percent or higher tax bracket).

When capital gains are calculated, all long-term gains are first netted by long-term losses and short-term gains by short-term losses. Net losses in one category then offset net gains in the other.

New Rules

Under the new rules, the long-term capital-gains tax rate is 15% instead of 20% for most investors.
Meanwhile, dividends that meet certain qualifications are taxed at the same 15% rate rather than at ordinary income tax rates that had been as high as 38.6%.

All investors should take a fresh look at their portfolios and their tax planning techniques. The law itself is
straightforward, but the ramifications are going to be more complex. One example: The tax breaks
for capital gains and dividends will expire (or "sunset" in Washington-speak) in 2009.

The new rules also changes the dynamics of saving for retirement. For starters, they make tax-sheltered accounts like 401(k)s somewhat less compelling. There has always been a trade-off with such accounts: In exchange for having your investments grow tax deferred, you paid regular income tax rates
on your withdrawals rather than the more favorable capital-gains rate. Now the gap between regular rates and those for dividends and capital gains will be even greater--at least until the next round of tax changes. (The new law will also make variable annuities and nondeductible IRAs even less attractive than they
were before because they offer no pretax deferral and no tax breaks at withdrawal.)

Does that mean you should shift money from your 401(k) to your taxable account? Again, no. The main advantage of retirement accounts--tax deferral--continues to make them a good deal for investors. That's even more true for people who work for companies that offer matching contributions, which are essentially free money. So your strategy here too should remain the same as before: Sock away money in your 401(k) first (taking advantage of the match), next, if you're eligible, set up a Roth IRA (where you put in after-tax dollars and it grows tax-free forever), and only then invest in a taxable account.

Where you may want to change your strategy, though, is in determining which assets to hold in your taxable account and which belong in your tax-deferred accounts. Specifically, you'll want more equities in your taxable account (taking advantage of the lower rates on capital gains and dividends) and more taxable
bonds in your tax-advantaged accounts (sheltering those payouts from tax until withdrawal). Tax-free muni bonds, of course, remain in the taxable account.

Before making any move, you will want to evaluate your entire portfolio. The key is the cost--in ommissions and taxes--of making the changes. But if you have losses in your taxable account, now is a great time to upgrade your portfolio.

Complications and unresolved issues? There are plenty. First, there's the problem of this year: The new tax rules for capital gains went into effect as of May 6, creating two different tax rates for one tax year. When investors match their capital gains and capital losses for the year, will they be required to match
first-half gains with first-half losses and second with second? That's still to be determined. Then there's the required dividend holding period. Roughly, to receive the tax break, you must own the stock for at least 60 days around the "ex-dividend" date (the day on which the stock starts trading without its dividend). The
rule works like the wash-sale rule: Sell too soon and your dividend won't qualify; you'll have to pay ordinary tax rates. To get the full benefits of the dividend-tax break, be prepared to do some careful timing before selling any shares. And don't be confused by the similar tax rates on dividends and capital gains:
You still can't offset dividend income with capital losses. The IRS is rewriting Schedule D, and there are likely to be a lot of errors on this year's returns.

Collectibles and Real Estate

Long-term capital gains from sales of collectibles still are subject to a maximum tax rate of 15 or 28 percent, depending on the tax bracket in which the gains fall. The portion of a gain from real estate that relates to previous depreciation deductions will be taxed at 25 percent.

For example, assume a person purchased a rental property for $100,000 in 1994 and sold it in July 2000 for $125,000 (net of expenses) after having claimed depreciation deductions totaling $18,000. The total gain would be $43,000 ($125,000 - [$100,000 - $18,000]). However, only the amount relating to price appreciation ($25,000) would be taxed at the 20 percent rate. The $18,000 of depreciation recapture would be taxed at 25 percent.

Calculating a Gain or Loss

The gain or loss on a sale or trade of property is calculated by comparing the amount realized with the adjusted basis of the property. The adjusted basis of a property is the original cost or other basis of the property--such as carryover basis if the property was acquired by gift, or a stepped-up basis if the property was acquired by inheritance--properly increased or decreased for items such as purchase commissions, legal fees, capital improvements, and depreciation.

Carryover basis equals the donor basis. Stepped-up basis, on the other hand, typically is the fair market value of property on the date the person from whom the property was inherited died. The amount realized from a sale or trade is the total money received, plus the fair market value of all property or services received. An indebtedness against the property, or against the seller, such as a mortgage, that is paid off as a part of the transaction or assumed by the buyer must be included in the amount realized.

Deducting or Carrying Forward Capital Losses

Capital losses are deductible if they do not exceed certain limitations. If a taxpayer's capital losses exceed the capital gains, up to $3,000 ($1,500 for married persons filing separately) of losses may be deducted provided a person's taxable income is at least equal to the amount of the deduction.

If a taxpayer's capital loss exceeds the yearly limit, the person may carry over the unused part to the next tax year and treat it as if it occurred in that year. A net loss may be carried forward until it is exhausted or the taxpayer person dies. This carryforward option may be used to reduce a person's tax liability when a future capital gain is incurred. Taxpayers who do not have future capital gains may use the carryforward loss to offset taxable income up to $3,000 per year.

Worthless Securities

Stocks, stock rights, and corporate or government bonds with interest coupons or in registered form that became worthless during the tax year are treated like capital assets held by a taxpayer and sold on the last day of the tax year. To determine whether they are long-term or short-term capital assets, a person is considered to have held the securities until the last day of the year in which they became worthless.

The deduction for a worthless security must be taken in the year in which it becomes worthless, even if it is sold for a nominal sum in the following year. If the owner does not learn that a security has become worthless until a later year, an amended return should be filed for the year in which the security became worthless. Because it may be difficult to determine when a stock became worthless, the capital loss should be deducted in the earliest year in which such a claim may be reasonably made. A seven-year statute of limitations applies to the filing of such an amended return.

Taxpayers should keep any documents indicating the date on which a security became worthless, such as bankruptcy documents and financial statements.

Conclusion

Generating capital gains is a key tax-saving opportunity. By assessing their options now, taxpayers can realize significant savings when they file their income tax returns.

Benefits of the Capital Gains Tax