THE TAXPAYER RELIEF Act of 1997, signed into law on Aug. 5, made important changes in the rules for capital gains. Now, different tax rates apply, depending on when the asset was sold, how long it was held and its nature.
- The maximum tax rate on capital gains dropped to 20 percent (down from 28 percent) for sales on or after May 7, 1997, of property held more than one year. For those in the 15 percent tax bracket, the rate was reduced to 10 percent. However, for sales of assets after July 28, 1997, assets must be held more than 18 months to qualify for the reduced rate. Assets sold after July 28, 1997, and held more than one year but not more than 18 months are subject to the maximum 28 percent tax rate. Assets held one year or less and sold at any time are still treated as short-term capital gains taxed at the same rate as ordinary income. The reduced capital gains tax rates apply not only to individuals but also to trusts and estates.
- After 2000, in addition to the reduced tax rates above, an even lower rate of 18 percent (8 percent for those in the 15 percent tax bracket) applies to property held for more than five years. The five-year holding period starts after 2000 for those in tax brackets higher than the 15 percent bracket (those in the 15 percent bracket can begin the five-year holding period at any time). There is a special election allowing individuals in higher tax brackets to elect to treat assets acquired before 2001 as having been acquired after 2000. Making this election requires immediate recognition of gain to date. Unless an individual has capital losses that will offset the gains, the potential 2 percent tax rate savings may not be worth the current income tax cost.
Special Rates for Certain Assets
- Collectibles. The reduced capital gains rates do not apply to collectibles (e.g., stamps, antiques, gems, and most coins). Gain from the sale of collectibles held more than one year is taxed at no more than 28 percent.
- Depreciable real property. Gain on depreciable real property sold on or after May 7, 1997, is subject to a special rate on the portion of the gain related to depreciation recapture. Such gain is taxed at a 25 percent tax rate; the balance is eligible for the 20 percent rate. If a building costing $200,000 was fully depreciated over 15 years when it is sold on Dec. 1, 1997, for $1 million, of the $1 million gain (there is no basis in view of the depreciation), $200,000 is taxed at 25 percent and $800,000 is taxed at 20 percent.
- The depreciation recapture rule applies to sales of homes that were used partly for business. So, for example, if an individual has claimed a home office deduction, the portion of the gain from the sale of a residence representing depreciation claimed on the office is taxed at 25 percent.
- Qualified small business stock. Gain on the sale of small business stock held more than five years is still 50 percent excludable. However, the nonexcludable portion is not subject to the 20 percent rate. Instead, it is taxed at the maximum 28 percent rate (which results in an effective tax ate of 14 percent-50 percent of 28 percent). If the stock is not held for more than five years, (but is held for more than 18 months), no exclusion can be taken but the gain is eligible for the 20 percent rate.
- There is an opportunity to defer all gain recognition on the sale of small business stock by rolling over the proceeds into other small business stock. The rollover must take place within 60 days of the date of sale. Only small business stock held more than six months is eligible for this rollover treatment.
- Most homeowners need no longer worry about taxes when selling their homes. The new law simplifies the home sale rules and provides meaningful tax relief for homes sold on or after May 7, 1997. It allows individuals to “trade down” without adverse tax consequences and may simplify record keeping of home improvements for many homeowners.
- The old rule allowing gain to be deferred if a replacement home was bought or built within two years before or after the date of sale and the $125,000 once-in-a-lifetime exclusion for those age 55 and older have been repealed. In their place is an exclusion of $250,000 ($500,000 on a joint return) for the sale of a principal residence by a seller who owned and occupied the home for at least two of the preceding five years. On a joint return, title to the home need not be in joint name as long as both spouses lived in the home for at least two years and neither claimed an exclusion within the past two years. In effect, this exclusion can be used any number of times as long as the two-year requirement is satisfied each time.
- Use of the new exclusion is not affected by whether a homeowner previously claimed the $125,000 exclusion.
- The two-year rule is waived if a move is necessitated by a change in jobs or some unforeseen circumstances. In this case, a prorated exclusion is allowed for the period of the two-year period that has been satisfied. So, for example, if a single individual relocates to a new job after owning and living in a house for one year, the exclusion is $125,000 (one-half of $250,000). The two-year rule is reduced to a one-year requirement if the move is required because the owner becomes physically or mentally incapable of self-care and moves to a licensed nursing home. In this case, as long as the one-year requirement is satisfied, the full exclusion can be claimed.
- Changing marital status. A spouse who received the marital residence in a transfer incident to divorce can add on the former spouse’s ownership period for purposes of the two-year requirement. Similarly, widowed individuals can include the ownership period of the deceased spouse for purposes of the two-year period.
- Individuals who own separate homes and marry do need not to time the sale of their homes to before or after the marriage. As long as they meet the two-year requirement, they can each claim $250,000 exclusion on a joint return (a total of $500,000).
- Transition rule. Those who were in the process of selling their homes when the new law was enacted have a choice between the old or new rules if:
- The sale was completed before Aug. 5, 1997.
- The sale was completed after Aug. 5, 1997, pursuant to a binding contract in effect on that date, or
- A replacement residence was acquired on or before Aug. 5, 1997 (and the deferral rules apply).