Capital Gains - Deemed Sales

We have received several inquiries since the 15 th of April concerning the new capital gains rules and how they should have been administered on last year's tax returns.  Many of our inquiries are caused by confusion over the rules.  Issues involving what to do if they missed making the deemed sale election on last year's return and what their available courses of action are remaining for them.  There are various facets of this new law that should be considered before anyone makes the election.  Make sure to consult with an expert before you make this election.

I understand that there are new capital gains tax rates for assets I have held for five years or more.  Is this true?

Yes.  Starting with tax years after 12/31/00 certain assets held for five years or longer may qualify for special 8% and 18% tax rates.

Does this mean that everything I am holding for investment purposes qualifies for this special rate, if I dispose of it?

No.  For property sold after December 31, 2000 , capital gains that would otherwise be taxed at a 10% capital gain rate (because an individual is in the 15% ordinary income tax bracket) will be taxed at 8% if the property is owned for more than 5 years.  The  8% rate applies to property held for more than 5 years even if the holding period begins before 2001.  For property acquired and sold after December 31, 2000, the 20% capital gain rate is reduced to 18% if the property is owned for more than 5 years.  To qualify for the 18% rate, the 5-year holding period must begin after 2000.  Because the 5-year holding period must begin after 2000, the 18% rate won't be available for gains realized before 2006. 

Is there a way I can take advantage of the 18% rate for the assets that I have already?

Yes, Congress has given us an option whereby we can take advantage of the new lower 18% capital gains tax rate.  This is called the deemed sale election.

What is this deemed sale election?

The deemed sale election is a tax election you can make allowing you to, in essence, start your holding period as of January 1, 2001.  This would allow you to sell the asset five years after January 1, 2001 and claim the lower tax rate.

What are the current capital gains rates?

Capital gains tax rates vary depending upon which tax bracket you fall into, and which holding period your assets fall into.  For short term (holding periods of less than one year) capital gains, the tax rate is the same as the tax bracket you fall into.  For long term (holding periods of one year or longer) capital gains, the tax rate is 10% if you fall into the 15% tax bracket and 20% if you fall into the 27.5% and higher tax brackets.  For tax years beginning after 12/31/00, we have new capital gains tax rates for qualified five year property (assets held for 5 years or longer) of 8% if you fall into the new 10% or 15% tax bracket and 18% if you fall into the 27.5% and higher tax brackets.

What is qualified five-year property ?

Qualified five-year property is any asset purchased after 12/31/00 and held for five years or longer.  This is where the deemed sale election comes into play.  For assets you owned before December 31, 2000, you can elect to treat them as if sold and repurchased on 1/1/01 (for publicly traded stock, the date would be 1/2/01).  The sale and repurchase price would be the fair market value as of 1/1/01 (or 1/2/01 for publicly traded stock).  This in effect restarts the holding period for your holdings on 1/1 or 1/2/01.

How do I make this election ?  

To make the tax election and make your current holdings eligible for qualified five year holding status, you report the deemed sale(s) on your 2005 tax return as if it was an actual sale.  You pay any capital gains tax, and take the market value of the asset as it's new basis for future gain/loss calculations.  However, if the deemed sale results in a loss, enter zero instead of the loss.  Attach a statement to your return stating that you are making an election under section 311 of the taxpayer relief act of 1997 and listing the asset(s) for which you are making the election.

Can I make this election for some assets, but not all?

Yes.  This election can be made on an asset-by-asset basis.

I really have a lot of stock.  Can you give me an idea of where this could be beneficial or when it is not a good idea?

Sure!  There are several situations where it would be a good idea to take a look at making this election.  There are about five scenarios to consider.  Ready?

Property with little gain or loss.   You might want to make the election with respect to property that as of January 1, 2001 or January 2, 2001 has not appreciated much or that has a small loss (so that no gain or only a small amount of gain would be recognized) but which you expect to hold until after 2005 and anticipate substantial gains.  You should use caution, however, in making the elections for property with a significant loss, since the loss is not allowed in 2001 or any other year if the election is made.

Property that will appreciate substantially and will be sold after 2005.   You should consider making the deemed-sale election for stock and other qualifying assets that you expect to appreciate substantially in the future and that you expect to sell after 2005.  However, the deemed sale election only reduces the capital gain rate by two percentage points (from 20% to 18 %). So, for the election to be advantageous, the present value of the 2% rate savings after 2005 must be compared to the additional tax due with the 2001 return because of the election.  This brings you to the problem with this calculation.  It is difficult, at best, to predict what the actual gain on the sale will be and whether or not the present capital gain rate structure will be in effect when the asset is sold. Congress can be fickle.

Net Operating Loss Carryovers.  Making the election might be a good move if you have net operating loss carryovers to 2001 (that will otherwise expire) to offset the gain resulting from the election.

Capital Loss Carryovers.   If you have loss carryovers, you may wish to make the deemed-sale election if there are capital losses sufficient to eliminate the gain triggered by the election.  This could be beneficial where you hold depreciable real estate that has appreciated in value.  Making the election for depreciable real estate could result in additional depreciation at no current tax cost.  Also, if you have both capital loss carryovers and passive activity loss carryovers, capital  losses and passive activity losses may both be allowed in 2001 to the extent of any gain resulting from making the deemed-sale election for a qualifying passive activity asset.

Nonrefundable Credits.  It could be beneficial to make the election for qualifying appreciated assets where there are unused nonrefundable credits for 2001.  In this situation, the tax created by the deemed sale would be offset by credits that will otherwise be lost.

Spreading 2002 Gain over 2 Years.   Making the election may enable you to spread the gain on property with respect to which the election is made over 2 tax years (even if you don't get the lower 18% rate because you do not wait 5 years to sell).  For example, assume you own stock that was worth $10,000 more than your cost on January 2, 2001 and you have an actual gain on the sale of the stock on October 1, 2002 of $25,000.  If you do not make the election, the entire $25,000 gain will be reported in your 2002 return.  However, if the deemed-sale election is made for 2001 (IRS says the election can be made as late as October 15, 2002) then $10,000 of the gain is included in your 2001 return and $15,000 is included in your 2002 return.  Whether or not moving the gain from 2002 into 2001 will save you money can only be determined by performing calculations to determine the tax savings, if any.  Also if $10,000 of the gain is included in the 2001 return and additional tax is incurred, you will have paid tax a year early on the $10,000.

I want to emphasize the importance of getting expert help for this determination.  The consequences of mistakenly taking this election can be far-reaching and detrimental to your personal financial position.  Please, ask for help.

Where would the election be detrimental to me?

In general, you should not make the election if the election creates substantial additional tax for 2005 and the tax savings upon the sale of the asset does not justify this early payment of tax.  The practical problem here is predicting with reasonable accuracy the amount of future appreciation.  When the property will be sold, and what the capital gains rate will be in the year of sale is in question.  Also, the deemed sale election could backfire if you pay a 20% capital gains rate for 2005 on the gain triggered by the election and your capital gain rate for the year of the sale is 8% or there is no capital gain tax in the year of sale because you have capital losses to offset the gains in future years.  Under these facts, the election will actually cost you money.  Be careful.   Please call us if you need additional information.  We will gladly assist you with the election decision.  In most cases, an informed decision concerning the deemed sale election cannot be made without detailed calculations.  We will gladly help you with the calculations and with your choices. 

Did I need to have this election made by April 15 th ?

No, the election can be made by the due date of the tax return (including extensions) or by filing an amended return within 6 months of the due date of your return (excluding extensions).  This election is irrevocable.  

Be wise and consult an expert in the tax field before you elect to deem an asset as sold and recognize gains.

©2006 by Dierking Lockie & Associates PC
Elegant Web Design LLC of Sioux City Iowa