by Bob Rywick
A single day can make a big difference in the rate at which the capital gains and dividends of a non-corporate taxpayer such as an individual, an estate or a trust will be taxed.
Thus, if a capital asset is sold one day too soon, the maximum rate at which gain on the sale will be taxed could be as high as 35 percent (the maximum rate at which ordinary income of non-corporate taxpayers is taxed), instead of 15 percent. Similarly, if a dividend-paying stock is sold one day too soon, dividends received while the stock was held can also be taxed at a rate as high as 35 percent instead of 15 percent. For taxpayers in the lowest two brackets, capital gain and dividends can be taxed at a 10 percent or 15 percent rate instead of 5 percent if the asset is sold too soon.
To help prevent you and your clients from making a mistake that would have substantial tax consequences, this article discusses the most common holding period rules. Remember, however, that the tax payable on capital gain or dividend income is not the only factor to take into account in deciding when to sell a capital asset.
For example, if you expect a stock’s value to decline substantially before the long-term holding period is met, your gain after taxes may still be higher if you sell the stock immediately, even if you have to pay taxes on the gain at ordinary income rates.
Capital gain holding period
To have long-term capital gain on the sale of an asset, that asset must have been held for more than one year at the time of its sale. This means it must have been held for at least a year and a day. The holding period begins on the day after the asset is bought, and ends on the day it is sold.
Example 1: Your client, who is in the 33 percent tax bracket, bought 1,000 shares of Garanjo stock on Sept. 1, 2003. If she sells the stock on Sept. 1, 2004, she will not have held the stock for more than a year at the time of the sale, since the holding period is treated as beginning on Sept. 2, 2003, the day after the purchase. In other words, she will be treated as having held the stock for the one-year period beginning on Sept. 2, 2003, and ending on Sept. 1, 2004. Thus, any gain on the sale will be short-term capital gain.
On the other hand, if she sells the stock on or after Sept. 2, 2004, she will have held the stock for more than a year and the gain on the sale will be long-term capital gain taxable at a maximum rate of 15 percent.
Remember that for publicly traded securities, the holding period begins on the day after the trading date (and not the settlement date) on which the securities are bought, and ends on the trading date that they are sold.
Caution: The non-corporate owner of a capital asset that has depreciated in value may prefer to recognize a short-term capital loss on the sale, especially if he has both short-term capital gains and long-term capital gains on the sale of other assets in the same tax year. If a long-term capital loss is recognized on the sale, then that loss must first be applied to offset long-term capital gains taxed at a lower rate, instead of the short-term capital gains taxed at a higher rate. To be able to first offset the loss on the sale of the asset against his short-term capital gain, the owner should make sure to sell the asset before it has been held for the long-term holding period.
Remember that if you inherit a capital asset, you are treated as holding it for more than one year regardless of the time that you actually held it before its sale. Thus, all capital gain or loss on the sale of an inherited capital asset will be long-term capital gain or loss.
Qualified dividend treatment holding period
Qualified dividends received from domestic corporations and qualified foreign corporations are taxed at the 15 percent and 5 percent rates applicable to long-term capital gains.
To get qualified dividend treatment, the stock on which the dividend is paid must be held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (the first date following the declaration of a dividend on which a stock buyer won’t receive the next dividend payment).
In determining the number of days a stock is held, the holding period starts with the day after the stock is bought and ends with the day that the stock is sold.
Example 2: Your client, who is in the 35 percent tax bracket, buys 100,000 shares of Cordalis stock on May 1, 2004. Cordalis had declared a dividend of $0.25 a share on April 15, 2004, payable to shareholders on June 1, 2004, and the ex-dividend date was May 3, 2004. Since he bought the stock before the ex-dividend date, your client will receive a dividend of $25,000 ($0.25 a share on 100,000 shares) on June 1, 2004.
To have this dividend taxed to him as a qualified dividend at a rate of 15 percent, instead of as ordinary income at a rate of 35 percent, your client must hold the stock for 60 days during the 121-day period beginning March 4, 2004, and ending July 2, 2004. Since your client’s holding period didn’t begin until May 2, 2004 (the date after he bought the Cordalis stock), to get qualified dividend treatment, he must sell the stock on or after June 30, 2004.
Observation: In Example 2, the 121-day period consists of 28 days in March, 30 days in April, 31 days in May, 30 days in June, and 2 days in July. The 60-day holding period would consist of 30 days in May and 30 days in June if the stock is sold on June 30, 2004.
For dividends paid on preferred stock that are attributable to a period or periods totaling more than 366 days, the stock must be held for more than 90 days during the 181-day period beginning 90 days before the ex-dividend date.
Mixed holding periods
There are situations where a taxpayer’s holding period includes someone else’s. For example, a donee’s holding period in gifted property includes the donor’s holding period. Similarly, the holding period of a taxpayer in property acquired from a spouse (or from an ex-spouse in the case of a divorce), includes the spouse’s (or ex-spouse’s) holding period.
Example 3: The same facts apply as in Example 1, except that your client gives her Garanjo stock to her daughter on July 1, 2004. The daughter’s holding period in the stock includes her mother’s holding period. Accordingly, if she sells the stock at a gain on Sept. 2, 2004, she will have long-term capital gain on the sale.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
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