December 1997 Hot Topics

Tax Year 1997 in Review; Tax Planning for Capital Gains

Note: Portions of December’s Hot Topics have been taken from other writings appearing on this Website to provide a unified approach and explanation of the new tax law and tax planning techniques available.

General Observations

The Taxpayer’s Relief Act of 1997 ("Act") has profoundly changed the tax landscape. A produce of Democratic and Republican compromises on issues dear to both sides, the Act sacrificed logic, consistency and simplicity for political expediency. Many of the "targeted tax breaks" aimed towards Clinton’s constituency widely missed the mark. In fact, members of the so-called middle class will pay hundreds of dollars to tax professional to prepare their complicated tax returns, and these professional will deliver the bad news: Not only did the preparation of your return cost more, you are not entitled to any of the benefits promised by the politicians!

While richer Americans will finally enjoy a cut in the capital gains rates, the holding period for the lower rates has been increased to 18 months. In addition, investors can no longer sell short against the box or use similar techniques to lock-in gains while waiting out the holding period requirements. There are now several capital gains rates, depending on the property involved and the holding period - a nightmare of tax calculations and netting procedures for gains against losses awaits investors.

There is solid good news on the taxation of the sale of a principal residence. Except for those at the highest end of the spectrum, those who sell their homes for a profit will exclude the profit from tax, provided they owned and lived in the home for at least 2 of the past 5 years prior to sale.

The Act provided modest estate tax relief, phased-in over the next 10 years. One provision aimed at eliminating the tax burden for small family-owned businesses and farms is so complicated it defies explanation. Small business and farm owners will probably find it easier and cheaper to sell their assets at the lower capital gains rates, than muddle through the complexities of these "relief" provisions.

December’s Hot Topics is divided into three parts: (1) Year-End Tax Planning Opportunities; (2) Capital Gains and Sale of Residence Tax Issues; and (3) Retirement and Estate Planning Opportunities.

YEAR-END TAX PLANNING OPPORTUNITIES

Tax year 1997 ends in just 17 days. Looming in 1998 is the most complicated tax code ever. What strategies are still available in 1997? What last-minute actions in ’97 could maximize your tax benefits in 1998?

Year-end tax planning no longer adheres to the simple rule: defer income to next year and accelerate deductions in 1997. Such a strategy could backfire, causing taxpayers to lose benefits in ‘98. Under the Act, many of the tax breaks which kick-in January 1, 1998, will be phased out (reduced ratably over a range of income) when your adjusted gross income ("AGI") reaches certain levels. The accompanying chart illustrates the impact of AGI on various tax incentives.

 UNDERSTANDING THE TAX IMPACT OF YOUR DEDUCTIONS

When calculating your 1997 tax bite, start with total income. From total income, there are certain "above-the-line" deductions (IRA, SEP and Keogh contributions, moving expenses, self-employed health insurance and alimony payments) which may be taken to arrive at AGI. These deductions are permitted whether or not you itemize deductions. Your AGI becomes your focal point for potential tax benefits.

Once AGI is determined, your taxable income is lowered by claiming either standard or itemized deductions ("below-the-line" deductions). Itemized deductions include medical expenses, state and property taxes, home mortgage interest, charitable contributions, casualty and theft losses, job expenses and other miscellaneous deductions.

Itemized deductions reduce your taxable income but not your AGI; consequently, these below-the-line deductions will not help qualify you for those tax breaks pegged to AGI.

To defer or Not to Defer, That is the Question

The Act phases out many so-called "middle-class tax breaks" at relatively modest AGI levels (see chart above). If you will approach the upper limit of AGI in 1998 for a particular tax break, you might increase your 1997 AGI to lower your ‘98 AGI and thus qualify for better tax benefits.

Your decisions must be final by December 31, 1997. Year-end tax planning is a four-step process: (1) identify your 1998 tax break(s) and determine their qualifications and limitations; (2) determine your AGI for this year and estimate your AGI for next year; (3) decide whether it is wiser to increase AGI this year and reduce it next year, or vice-versa; and (4) then accelerate or defer those income and deduction items that affect AGI, according.

All income must be received and deductions claimed need to be completed by midnight, December 31^st. If you want to file a joint return for 1997, you must be married by midnight of ’97.

MANIPULATING YOUR AGI

Income

Income includes wages, salaries and compensation, interest, alimony, business, farm or investment income, capital gains, unemployment compensation, social security benefits and IRA, pension or annuity distributions. Income can be reduced by deferring salary or bonuses to the following year. Self-employed individuals can reduce income by deferring receipt of outstanding receivables until next year. Retired persons may be able to defer receipt of distributions to the following year.

Investors may reduce their income by selling assets at a loss. Suppose you own a stock that has lost value, but you want to keep it. Can you sell it, recognize the loss, then repurchase it? Yes, if you wait at least 31 days before repurchasing it. This is called a "wash transaction" and the rules state that you cannot acquire "substantially identical securities" within a 61 day period which begins 30 days before the sale and ends 30 days after it.

For wage earners, employee expenses that are later reimbursed under an employer’s accountable plan are not considered gross income; self-employed persons achieve the same result by making business year-end expenditures. If you can, have your employer adopt an accountable plan for employee business expenses.

Remember, if you receive or have legitimate access to a check in 1997, but physically are unable to deposit it, you still have "constructively" received the income in 1997. Therefore, delaying this or other deposits to 1998 will not postpone 1997 recognition of this income.

Lowering AGI in 1998 - Example 1: A married couple with a college-bound child is considering the sale of stock which will produce a $10,000 gain. If their AGI is $80,000 and they expect the same AGI in 1998, then completing the sale this year increases ’97 AGI by $10,000 to $90,000. Their AGI in ’98 remains $80,000; thus, they are eligible for the full Hope Scholarship or Lifetime Learning Credits (available in ’98) because those benefits begin phasing out at $80,000 AGI. Instead of a stock sale, the couple could receive a year-end bonus or other compensation-related payments in 1997.

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Reducing Your AGI

Once your total income has been minimized or maximized, as the case may be, you are entitled to: IRA deductions, spousal IRA deductions (these must be made prior to the deadline for filing your tax return, including extensions), moving expenses, self-employed health insurance, Keogh retirement plans (the plan must be in effect prior to the end of the year) and payments of alimony. The balance after these adjustments is your AGI.

For example, a wage-earner or retiree may increase AGI by accelerating income by receiving bonuses or retirement distributions, or selling property which will generate a profit (as opposed to a loss) this year, and by deferring alimony payments, moving expenses and sales of loss property until next year.

A self-employed taxpayer may reduce business income by deferring accounts receivable billings until next year and by increasing business purchases this year. Pay employee bonuses next year.

Note, you can deduct expenses of equipment in the aggregate amounts up to $18,000 this year, but the equipment must be in service by the end of this year. Self-employed individuals may reduce AGI by making maximum contributions to Keogh plans and deductible health insurance plans.

REDUCING YOUR TAXABLE INCOME WITH ITEMIZED DEDUCTIONS

Even if AGI is increased by income items that would have otherwise been reported next year (thereby increasing your potential tax this year), you can reduce your taxable income by increasing your below-the-line deductions. Remember, taxpayers in the alternative minimum tax ("AMT") may not want to accelerate deductions this year if those deductions will not reduce the AMT.

Example 2: In Example 1 above, the taxpayers could off-set their $10,000 increase in taxable income by increasing their ’97 itemized deductions. Prior to the end of ’97, the couple could give to charity, prepay their January mortgage, pay state or local taxes, pay for routine medical expenses (eye exams, physicals, dental examinations) or pay the second real estate tax installment.

Note: Itemized deductions are subject to a phase-out for AGI exceeding $121,200 (married filing separately - $60,600). Also, the medical and miscellaneous deductions must exceed 7.5% and 2% of AGI, respectively.

Specific Itemized Deductions

Charitable Contributions: Empty your house of old clothes, furniture and other "garage sale" items, estimate their fair market value (make an inventory and take pictures as part of your records), then donate them to Goodwill or your favorite charity to claim a charitable deduction. Items over $250.00, require a receipt.

Contribute appreciated property to public charities and receive a deduction for the full fair market value on the date of the donation. The Tax Act restored the provision allowing a full charitable deduction for gifts of publicly traded stock (held more than 18 months) to a private foundation for the full fair market value of the stock.

Taxes and Mortgage Interest: Pay your fourth quarter state income tax estimate and prepay your January mortgage payment this year. Pay your second property tax installment due in 1998, by the end of 1997.

Medical Expenses: Schedule medical and dental work prior to the end of this year and pay all medical expenses prior to the end of ‘97. These expenses are deductible to the extent they exceed 7.5% of AGI.

Itemized Miscellaneous Deductions: Itemized miscellaneous deductions must exceed 2% of AGI. Employee expenses not part of an employer’s accountable plan are considered itemized miscellaneous deductions. These include uniforms, travel expenses, automobile expenses, meals and entertainment expenses (these have strict requirements), certain education expenses for maintaining skills, union and professional dues and expenditures for equipment (up to $18,000) placed in service in 1997, supplies and publications. Note: special rules might apply to computers, automobiles and other mixed-use equipment.

Paying Deductible Expenses

Payments by check and credit card made in 1998 count as 1997 deductions, even though the credit card charges are paid in 1998. If you are considering several large expenditures, obtain a less-expensive (than credit cards) home-equity line of credit (or use one you already have) to pay the expenses in 1997. Generally, interest on the first $100,000 borrowed against a home-equity line is deductible.

Year-End Tax Planning - Conclusion

Whether to reduce your income in 1997 or 1998 depends on the income restrictions for those tax breaks you desire and your AGI estimate in 1998. You lower your income in 1998 by deferring AGI adjustments or accelerating income into 1997. Itemized deductions reduce your taxable income but not your AGI.

TAX PLANNING FOR CAPITAL GAINS

Capital Gains - A System Machivelli Would Love

Republicans restored a capital gains cut, but at great cost. The capital gains tax rate is reduced from 28% to 20% for assets sold after May 6, 1997, and held longer than 18 months. Unlike the Clinton targeted tax breaks for education, these reductions apply to all taxpayers and are not restricted by AGI. These rules, however, do not apply to collectibles such as artwork, trading cards, stamp collections and memorabilia; therefore, sales of these items will be taxed at the current maximum rates of 28% and 15% for those in the 15% tax bracket. The capital gains cut is significant for those owning stock and highly appreciated real property.

For sales between May 6 and July 28, the holding period is 12 months. For those in the 15% tax bracket, currently couples with AGI of $41,200, the tax is reduced from 15% to 10%. In general, rates drop from 20% to 18% (and from 10% to 8%) for assets held for at least 5 years and sold after December 31, 2005 (special rules apply to publicly traded stock held on January 1, 2001). Gain caused by real estate depreciation will be taxed at 25%.

Under the Act, stocks fared better than real estate. Those who have depreciated their real property will be subject to a 25% capital gains tax on that depreciation. This could negatively impact those owning apartment houses and those who plan to take a home-office deduction for their residences.

New Capital Gains Netting Rules

Technical corrections legislation is pending (H.R. 2645). This legislation will set the "netting" order of priorities for gains and losses from each of the new tax rate groups. Gains and losses are netting on a tax return to arrive at an overall capital gain or loss for the tax year. A taxpayer’s long-term (over 12 month holding period) gains and losses are separated into the following 3 tax groups: (1) 28%; (2) 25% and (3) 20% (10% group for those in the 15% bracket. Within each group, capital gains and losses are netted, thereby producing either a gain or loss for the group.

Short-term Gains or Losses:

As under prior law, short term (less than 12 month holding period) gains and losses (including loss carryforwards) are netted. If a net short-term capital loss results, then this loss reduces long-term capital gains in the following order: (1) the 28% group; (2) the 25% group and finally (3) the 20% group.

Losses from the 28% and 20% Groups

A net loss from the 28% group (including long-term capital loss carryovers) is used to reduce gain from the 25% group, then the 20% group. Losses from the 20% group first offset gains from the 28% group and the 25% group. Since the 25% group involves gains from depreciation previous taken on real estate activities, there cannot be a net loss, hence, this group does not net against any other groups. If, after application of these netting rules there is a net gain, the gain is taxed at the group’s marginal tax rate (28%, 25% or 20%).

Example 1: If a taxpayer has a short-term gain of $200 and a short-term loss of $400, he has a net short-term loss of $200. Assume the taxpayer had a $25 gain in the 20% group; a $100 gain in the 25% group and a $300 gain in the 20% group. The short-term capital loss would be first applied to the $25 net gains in the 28% group ($200 - $25 = $175 unused loss). The balance of the short-term loss would be applied to the 25% group ($175 - $100 = $75 unused balance) and, finally, the 20% group ($300 - $75 = $225 net gain in the 20% group). The taxpayer would pay a 20% tax on the $225 of gain.

Example 2: In Example 1, If a taxpayer had no short-term capital loss, but had a $300 capital loss in the 28% group, that loss would be applied first to reduce the net gains in the 25% group ($300 - $100 = $200 unused loss) and the amount, if any, remaining would be applied to reduce the net gains of the 20% group ($300 - $200 = $100 net gain in the 20% group).

Example 3: If the taxpayer had a $500 capital loss in the 20% group, a $100 net gain in the 28% group and a $600 net gain in the 25% group, $100 of the loss would reduce the $100 net gain in the 28% group $500 loss - $100 gain = $400 unused loss) and the $400 balance would reduce the $600 gain in the 25% group to $200 ($600 - $400 = $200).

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Depreciation Quagmire

Now some of the complexity becomes apparent. How does one recapture depreciation when there was no requirement to keep track of the depreciation from prior transactions? If a taxpayer acquired a property through a series of Sec. 1031 exchanges, he might not have the records necessary to compute the depreciation recapture. The adjusted basis in the present property is the value used to compute the gain on sale. This value, however, may have no relation to prior depreciation taken with respect to the properties that were subject to the Sec. 1031 exchange provisions.

Example:  For instance, if a taxpayer buys a property for 100x, improves it by 50x and then depreciates it by 80x, the adjusted basis would be 70x (100 + 50 = 150 - 80 = 70). If the taxpayer then exchanged the property for another property worth 200x, he’d carryover his 70x basis. If he then depreciated the property 20x and sold it for 250X, would the depreciation recapture be the current 20x or 100x (prior plus the current depreciation)?

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Taxation of Transactions That Eliminate Risk of Loss

With the new 18-month holding requirement for capital gains treatment, many taxpayers would be tempted to lock-in gains and wait the 18-month period by selling "short against the box" (selling short the identical securities) to eliminate a risk of loss during the holding period. The new law requires gain recognition (but not loss recognition) upon the constructive sale of any "appreciated financial position" in stock, a partnership interest or debt other than on certain straight debt instruments. In general, a taxpayer engages in a constructive sale when he enters into a short sale, an offsetting notional principal contract (a complicated hedging transaction of limited interest to most taxpayers), or a futures or forward contract, with respect to the same or substantially identical property. The sale occurs when the taxpayer acquires the related long position. Some limited exceptions apply to transactions that are closed in the 90-day period ending with the 30^th day after the close of the taxable year. The effective date is transactions occurring after June 8, 1997.

Installment Sales

According to the legislative history, installment sales in which principal payments are received after the effective date will qualify for the new capital gains rates, even though the property was sold prior to the effective date.

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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**