by Bob Rywick
The recently passed Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the 10 percent tax rate on adjusted net capital gain to 5 percent, and the 20 percent tax rate on adjusted net capital gain to 15 percent.
The act also eliminated the special 8 percent and 18 percent rates on most capital assets held for more than five years (though the 18 percent rate had not yet come into effect, since it only applied if the holding period for the asset began after Dec. 31, 2000).
These new lower rates are effective for sales after May 5, 2003, and for installment payments received after May 5, 2003, even if the sale occurred before May 6, 2003. The new rates apply to non-corporate taxpayers, such as individuals, estates and trusts.
The lower rates do not apply to:
● 28 percent rate gain (gain on the sale of collectibles, and the unexcluded gain on the sale of certain Section 1202 small business stock); and,
● 25 percent rate gain on unrecaptured Section 1250 gain (gain attributable to depreciation taken on real property).
This article discusses how the tax on long-term capital gains is computed if a taxpayer has gains and/or losses both before May 6, 2003, and after May 5, 2003. A future article will discuss the inclusion of qualified dividend income in adjusted net capital gain so that it is taxed at a maximum rate of 5 percent or 15 percent, depending on the taxpayer’s bracket.
Computing tax on long-term capital gains when some gains are post-May 5, 2003, gains and some are pre-May 6, 2003, gains. Before being amended by the act, IRC § 1(h)(1)(B) provided that long-term capital gain (other than 28 percent or 25 percent rate gain) would be taxed at a rate of 10 percent to the extent it would be taxed at a rate under 25 percent if it were ordinary income.
Under the act, the rate is reduced to 5 percent. For tax years that include May 6, 2003, the act provides that adjusted net capital gain would be taxed at the lowest rate available. Thus, if all the gain would not be taxed at a rate of 25 percent or less if it were ordinary income, then the adjusted net capital gain taken into account would be taken into account in the following order:
1. First, the net capital gain determined by taking into account only the lesser of gain or loss properly taken into account for the part of the tax year after May 5, 2003 (other than 28 percent or 25 percent rate gain).
2. Second, the part of the net capital gain properly taken into account for the part of the tax year before May 6, 2003, that would be taxed at a rate of 8 percent because it was realized on the sale of property held for more than five years before it was sold.
3. Third, the part of the net capital gain properly taken into account for the part of the tax year before May 6, 2003, that would be taxed at a rate of 10 percent because it was realized on the sale of property not held for more than five years before it was sold.
Example 1: Your clients are married and file joint returns. They expect to have adjusted gross income of $100,000 in 2003. Their personal exemptions and itemized deductions will total $25,000. Thus, their total taxable income will be $75,000 ($100,000 less $25,000). Of their total AGI, $35,000 represents long-term capital gain on the sale of non-dividend-paying stock (not small business stock) that they bought in 1997, and the balance of $65,000 represents wages. They have no dividend income in 2003.
Of the total net capital gain, $5,000 was from the sale on March 15, 2003, of stock bought in 2001; $20,000 was from the sale on April 10, 2003, of stock bought in 1997; and $10,000 was from the sale on May 25, 2003, of stock bought in 1997.
For 2003, $56,800 of your clients’ taxable income of $75,000 would be taxed at a rate under 25 percent (based on tax tables in effect that reflect changes in tax rates and the tax brackets for taxpayers filing joint returns made by the act). This mean that $14,000 of ordinary income will be taxed at a rate of 10 percent, and $26,000 will be taxed at a rate of 15 percent.
Of the net capital gain, $16,800 is available to be taxed at the lowest capital gain rates, since it would be taxed at a rate under 25 percent if it were ordinary income. The net capital gain will be taxed as follows:
● The $10,000 gain on the stock sold on May 25, 2003, will be taxed at a rate of 5 percent. The fact that the stock was held for more than five years has no effect on the rate at which it was taxed since it was sold after May 5, 2003.
● Of the $20,000 of gain on stock sold on April 10, 2003, $6,800 will be taxed at a rate of 8 percent since the stock was held for more than five years. The balance of $13,200 will be taxed at a rate of 20 percent, since the stock was sold before May 6, 2003.
● The $5,000 gain on stock sold on March 15, 2003, will be taxed at a rate of 20 percent.
Your client’s total federal income tax for 2003 will be $9,984, consisting of:
● $1,400 (10 percent of ord-inary taxable income of $14,000);
● $3,900 (15 percent of ord-inary taxable income of $26,000);
● $500 (5 percent of post-May 5, 2003, net capital gain of $10,000);
● $544 (8 percent of pre-May 6, 2003, qualified five-year gain of $6,800);
● $2,640 (20 percent of pre-May 6, 2003, qualified five-year gain of $13,200); and,
● $1,000 (20 percent of other pre-May 6, 2003, net capital gain of $5,000).
Observation: The rules of the act provide that net capital gain that is eligible to be taxed at 5 percent is taken into account before qualified five-year gain eligible to be taxed at 8 percent, and qualified five-year gain is taken into account before gain that is eligible to be taxed at 10 percent. These rules are not always beneficial to taxpayers.
For example, assume (as in Example 1) that some of the pre-May 6, 2003, qualified five-year gain cannot be taxed at 8 percent because most of the gain eligible to be taxed under IRC § 1(h)(1)(B) is allocated to 5 percent gain. The qualified five-year gain that can’t be taxed at 8 percent will be taxed at 20 percent, or at a rate 12 percentage points higher. If gain properly taken into account after May 5, 2003, can’t be taxed at 5 percent, it will be taxed at 15 percent or at a rate only 10 percentage points higher.
Example 2: The same facts apply as in Example 1, but assume that pre-May 6, 2003, qualified five-year gain was taken into account before post-May 5, 2003, gain in determining what gain is eligible to be taxed under the lower rates of IRC § 1(h)(1)(B). If that were so, your clients’ total income tax for 2003 would be $9,784 (instead of $9,984), consisting of the following:
● $1,400 (10 percent of ord-inary taxable income of $14,000);
● $3,900 (15 percent of ordinary taxable income of $26,000);
● $1,344 (8 percent of pre-May 6, 2003, qualified five-year gain of $16,800);
● $640 (20 percent of pre-May 6, 2003, qualified five-year gain of $3,200);
● $1,000 (20 percent of other pre-May 6, 2003, net capital gain of $5,000); and,
● $1,500 (15 percent of post-May 5, 2003, net capital gain of $10,000).
When long-term capital loss carryover from a tax year beginning before 2003 is taken into account. The act provides that the amount of net capital gain taxed at 15 percent is the lesser of:
● The excess of the net capital gain (other than 28 percent rate gain or 25 percent rate gain) determined by taking into account only gain or loss properly taken into account after May 5, 2003, less the amount of that gain taxed at 5 percent; or,
● The total amount of net capital gain that is not taxed at a rate under 15 percent.
The balance of net capital gain not taxed at 15 percent or a lower rate is taxed at 20 percent. This means that any capital loss carryover is applied first to reduce the amount of capital gain that is taxed at 20 percent and, then, is applied to reduce the amount of capital gain taxed at 15 percent.
Example 3: Your client is a single woman in a 35 percent tax bracket. She has net capital gain (other than 28 percent and 25 percent rate gain) of $150,000 in 2003 before taking into account a long-term capital loss carryover of $50,000 from 2002. Of this amount, $80,000 was determined by taking into account only gains or losses properly taken into account after May 5, 2003. This $80,000 will be taxed at 15 percent. Her total net capital gain for the year is $100,000 ($150,000 of net capital gain less $50,000 of long-term capital loss carryover). Thus, $20,000 of her 2003 net capital gain will be taxed at 20 percent ($100,000 of total net capital gain less $80,000 taxed at 15 percent).
When gain is properly taken into account. If property was sold before May 6, 2003, but an installment payment was received after May 5, 2003, long-term capital gain on a payment received after May 5, 2003, will be subject to tax at 15 percent or 5 percent, depending on the noncorporate taxpayer’s tax bracket.
Suppose stock is sold on a National Securities Exchange or on an over-the-counter market where the trade date is before May 6, 2003, but the settlement date is after May 5, 2003. In that case, gain or loss on the sale should be treated as pre-May 6, 2003, gain or loss, since it’s the trade date that determines when gain or loss is taken into account. Such a transaction is not an installment sale.
