Lowering Your Capital Gains Rate (Really)

This was supposed to be the topic yesterday, because I had promised ‘something on personal finance for a change.’ I got carried away. (But trust me: what the country does on the economic questions raised yesterday will affect your personal finance.) Tonight is the State of the Union. For another view of it, albeit partisan, some of you may want to click here.

But here’s the skinny on lowering your long-term capital gains tax rate from 20% to 18%. I’m going to give you the short form and then point you to a full, very well presented analysis, if you want to know more.

The short form is that the long-term capital gains tax rate falls from 20% to 18% for assets held more than 5 years – but only if those assets were purchased after the year 2000 – and that you can, this year only, do something called a ‘deemed sale’ to make sure that any or all of the assets that wouldn’t otherwise qualify (because you bought them before 2001) do qualify.

With the deemed sale, you pretend to have sold shares on January 2, 2001, and then to have bought back at the same price on the same day.

It seems like a cause to celebrate. (Don’t worry – if you’re one of those obnoxious souls who has already filed his or her 2001 taxes, you can file an amended return any time until October 15 to register a deemed sale.) But actually it’s a cause to yawn and go back to playing with the kids.

Here’s why.

At very best, if all goes right, it’s true: by going through this (easy) exercise you might save a tiny bit when you pay your 2006 taxes in 2007. On a $10,000 gain, assuming Congress doesn’t make yet more changes, your tax would be $1,800 instead of $2,000. You’d get to keep $8,200 of the gain instead of just $8,000.

Not nothing, of course. But there are potential costs.

• If the deemed sale is of something that had gained in value as of January 2, 2001, you have to pay tax – now – on that gain (unless you have enough realized losses in 2001 to offset the gain). Why pay a certain tax now in hope of slightly lowering your tax five years from now? Especially when you consider that you might never get that tax break anyway! (The stock might go down, you might choose to sell in fewer than five years, you might decide to give the stock to charity, Congress might change the capital gains tax in a way that makes this moot, or you might die.)

• If the stock you’re considering “selling” this way showed a loss on January 2, 2001, you do NOT get to take the loss.

• Only on stocks or mutual funds or other assets on which you had no appreciable loss or gain on January 2, 2001 might this make sense. So go ahead – if it’s worth an extra piece of your brain to deal with this.

For those who love puzzling through these things for the fun of it – I’d guess it’s more about the game than the money – click here for Kaye Thomas’s excellent explanation and analysis. (It’s just one piece of his fairmark.com tax advice site.)

And, no, it turns out this won’t work on your home. There were those who thought they could do a deemed sale as of January 2, 2001, taking a $200,000 gain, say – but paying no tax because of the $250,000/$500,000 exclusion of gains on the sale of a primary residence. That would have been great – suddenly the cost basis of the house had jumped $200,000, so if they ever sold it for real, they’d be $200,000 less likely to show a taxable gain. But no, the law doesn’t allow this. (Sorry.)

Tomorrow: Lowering the Capital Gains Rate To Zero