Zero Capital Gains Rate in 2008 Requires Careful Planning

One of the greatest benefits of the tax code is the special tax rates that currently apply to gain recognized from the sale of capital assets held for more than a year (long-term). The special tax rates apply to virtually all capital assets including land, improved real estate, your home, and business assets in excess of the accumulated depreciation previously deducted.

Beginning this year, 2008, these special rates, which apply to net long-term capital gains (LTCG)(1) and qualified dividends drop to zero percent to the extent that your regular tax rate is less than 25% and 15% for all other capital gains. These rates, which apply only to non-corporate taxpayers, also apply for the alternative minimum tax and are available through 2010 barring any future tax law change.

This zero tax rate provides an extraordinary opportunity for a taxpayer to cash in on certain gains and pay no tax. This could be tax paradise for those who carefully plan their transactions this year through 2010.

The conventional strategy in the past was to offset as much of your gains as possible with losses from selling other assets in your portfolio. If you have an overall loss, then it is limited to $3,000 ($1,500 for married taxpayers filing separately), and any excess carries over to the next year. Keep in mind that losses from the sale of business assets are generally separately allowed in full in the year of sale, and not mixed with the losses from the sale of other capital assets. So with this change in the law, a new strategy emerges: it may be more appropriate to take gains to the extent they would be taxed at zero percent.

What this zero tax means to you is that there is no tax on your long-term capital gains to the extent that your regular tax rate is less than 25%. Before you make plans to sell everything in 2008 through 2010, remember that the gain itself adds to your income, impacts income-based limitations, and may possibly push you into a higher regular tax bracket, so it is a balancing act to take advantage of this zero rate. Of course, you can also use losses to offset the gains, and contrary to past conventional strategy, you should only have enough losses to keep the gain within the zero tax rate. If your income is too high to take advantage of the zero tax rate, then continue to employ the conventional strategies discussed above for 2008 through 2010.

The zero tax rate applies to the amount of your taxable income below the 25% tax bracket. For 2008, this “breakpoint” is the “top” of the 15% bracket and is:

• $32,550 for single taxpayers and married taxpayers filing separate returns;

• $65,100 for married taxpayers filing joint returns and surviving spouses; and

• $43,650 for heads of households.

Thus, the amount of your adjusted net capital gain taxed at 0% is:
(1) The break-point amount for your filing status, minus
(2) Your “other” taxable income (taxable income reduced by adjusted net capital gain).

Here’s an example to illustrate the tax savings. Todd is a 40-year-old single taxpayer who earned $25,000 of wages in 2008. He has some stock with a very low basis that he’s held for 15 years that he sells for a $10,000 gain. He has no other income and does not itemize his deductions. His taxable income – AGI of $35,000 less the standard deduction and his exemption allowance – is $26,050. His 2008 tax is $2,006, making his effective tax rate just 7.7%. Since Todd’s taxable income is within the 15% tax bracket, he pays no tax on the $10,000 LTCG. If he’d sold the stock in 2007, his tax on the gain would have been $500. If the law required the gain to be taxed at ordinary rates, the tax on it would be $1,500. Either way, Todd saves a significant amount of tax on his 2008 sale.

The following issues may also come into play when planning your capital gains and losses strategies: (1) Gains from the sale of inherited capital assets are automatically long-term; (2) By election, long-term capital gains can be used to increase the amount of investment income when figuring the investment interest deduction, but then aren’t eligible for the lower capital gain tax rates; (3) Losses from selling personal-use capital assets, such as your home or auto, are not deductible, and (4) You may have short and/or long-term capital losses from a prior year to account for. You should also take into consideration how your state taxes capital gains; most do not have a 0% LTCG rate, and many do not have any special rates for capital gains.

Please give our office a call so that we can help you develop a strategy to suit your unique situation.

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