Recent Capital Gains Tax Changes
High-net-worth individuals who acquire new assets in 2003 and hang on to them for at least five years will benefit from a capital gains tax law that went into effect May 2003.
The zero-percent rate is just the latest in a series of investor-friendly tax changes enacted during the most recent Bush administration. Prior to his taking office, investors whose overall income put them in the top four income-tax brackets faced a long-term capital gains rate of 20 percent, while lower-income investors paid capital gains taxes of 10 percent.
Tax-law changes in May 2003, however, lowered the rates by 5 percent each, with the lower rate eventually being zeroed out in 2008.
The changes have had the most effect on investors in the higher income ranges, 25 percent to 35 percent tax brackets. These individuals now find their capital gains taxed at 15 percent. This lower rate also applies to some dividends that stocks and mutual funds pay account holders. When you hear "lower capital gains rate," it generally means this 15 percent level, because there are few investors with incomes low enough to qualify solely for the 5 percent, now zero percent rate.
Although the new rule is applicable to any long-term investment purchased after May, 2003, individuals relinquish a great deal of flexibility by locking themselves into traditional investments such as stocks and bonds for half a decade or longer. In fact, those who stand to benefit most from the new law are investors in alternative asset classes such as private equity, because it often takes five to fifteen years for these vehicles to realize gains anyway.
But what about investors who bought securities just before 2003and do not plan to unload them for another five years? They can still take advantage of the new law by making what is called a "deemed sale" to reset the holding period start date to 2001.
This strategy requires selling the asset at its current value and buying it back at the same price. The deemed sale is treated as having occurred on May 2, 2003 for securities and May 1, 2003 for all other assets. The good news is that there are no sales expenses or sales contracts to deal with. Of course, any long-term capital gain generated by this sale will normally be taxed at the regular 20% rate. For assets held less than one year, any short-term gains will be taxed at ordinary tax rates. The capital gains and the tax will be reduced by capital losses generated during the year or carried forward from prior years.
Such a strategy can be advantageous for those who plan to hold their investment for more than five years because any new gains realized after that time will be taxed at the 18% rate. For example, a deemed sale might benefit a venture capitalist invested in an early-stage private company that will not sell shares to the public for several years.
Determining the current value of actively traded securities requires looking up closing prices for the day prior to the intended sale. The value of illiquid securities must be estimated. The Internal Revenue Service may dispute an estimate, so those considering a large deduction should have an evaluation conducted by a licensed independent appraiser. The IRS is less likely to dispute an appraiser's figure than that of an individual.
To determine whether a deemed sale is appropriate, individuals must take into account the state and local tax consequences, if any. This can get tricky if several investments were made in the same asset at different prices. Also, investors need to decide whether they would generate greater returns by leaving the money invested for five years than they would save after paying the taxes associated with a deemed sale.
If an investor stands to earn little or no profit from a deemed sale, the strategy might not be advantageous. A deemed sale does not make sense when it involves locking in a loss, because future gains will be calculated from the lower price, ultimately resulting in greater tax burden. Meanwhile, the investor receives no tax benefit currently because the loss deduction is not allowed under the deemed sales rules.
Why not make a real sale, take the loss, and get the tax benefit? One reason not to is that there is a substantial risk the asset's value could climb during that month. Of course, the value of illiquid investments is unlikely to fluctuate as much as that of public securities over the course of a few weeks. Although there is no way to predict the future, most investors should be able to make a reasonable assessment of whether the value of their investment could change significantly in that time frame. The risk depends on the unique circumstances of each investment.
The decision to make a deemed sale is complex, so it is somewhat helpful that the tax law allows room for a change of heart. A deemed sale election does not have to be made until the 2003 tax return is filed, provided it is filed in a timely fashion.
This means that there is no problem if an investor who originally decided to make a deemed sale ultimately chooses to sell the asset, not repurchase it, and pay the tax. It will not hurt investors to at least consider making a deemed sale; there is a whole tax year to consider the decision
It is also important to note that the current capital gains tax law might change. Due to the econmic climate and political make-up of Washington, it is not clear how lawmakers will deal with the lower capital gains rates. They could let them run their course and expire at the end of 2010. But they also could decide to end both rates early or keep just one lower rate but not the other. Regardless, it is important to keep in mind the deadline of such rates is December 31, 2010.
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Charles M. Bloom, Registered Principal offers securities
and advisory services through Centaurus Financial, Inc. - Member FINRA and SIPC - 775 Avenida Pequena, CA, 93111 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - CA Life Insurance License No. 0A52786 - Centaurus Financial, Inc. and Shoreline Wealth & Investment Management are not affiliated companies.
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