Recent Capital Gains Tax Changes

High-net-worth individuals who acquire new assets in 2001 and hang on to them for at least five years will benefit from a capital gains tax law that went into effect January 2001.

For those in the 28% tax bracket or higher, the new law creates a maximum capital gains rate of 18% for assets held longer than five years. That represents a 10% savings from the capital gains rate of 20% that was levied on these assets prior to January 1, 2001. The 20% rate now applies only to assets held between one and five years.

Although the new rule is applicable to any long-term investment purchased after January 1, 2001, 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 2001 and 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 January 2, 2001 for securities and January 1, 2002 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 2001 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.

For more information:
If you'd like more information about how diversified investment advisors can help you achieve your financial objectives through personalized wealth or retirement and risk management strategies, please contact us. We welcome the opportunity to discuss your unique needs and how we may best meet them.

This page (formatted for versions 4.0 and higher of Netscape or MSIE) is updated regularly so check in from time-to-time to see new articles and updates. You can click on any underlined words on each page to see a specific wealth management topic in the left margin of each page.

Charles M. Bloom, Registered Principal offers securities and advisory services through Centaurus Financial, Inc. - 214 Calle Palo Colorado, CA, 93105 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - Member FINRA and SIPC.

The information contained in this web site is neither an offer nor solicitation of any security or service.