MAKE THE NEW CAPITAL GAINS RATES WORK FOR YOU

Did you make money on a stock last year? The new capital gains rates may apply to you. If you still have losers, you can still use them, too — to cut your tax bill.

Maybe you’re lucky and made an absolute killing on a stock. Congratulations and thank Congress because they may have saved you money when they passed the 2003 tax law.

But what about those losers you still have? Not to worry. With the recent stock market rally, those dog investments can actually save you money at tax time.

The game is called capital gains and losses. To win it, you’ve got to know the rules. Please don’t look for logic or some sort of grand framework. These rules are the final result of political negotiations rather than any real cognitive thought.

Capital gains result from selling a capital asset — stock, bond, mutual fund, apartment building, diamond — for more than its “basis.” For most people, basis is what they paid for the asset, including transaction costs.

You pay taxes on the gain or profit. If you sell a stock for a profit in a year or less, you get a short-term gain, which is taxed at your regular tax rate. Thanks to the 2003 tax law, ordinary income rates are lower. (For more, see “Lower tax rates and expanded 10% bracket.”)

You do get taxed less on your gains if you owned a stock for more than year. If you have owned a stock for more than a year, you can sell it and pay taxes up to a maximum of 15% under the 2003 tax law. The rate depends on your taxable income. That 15% rate is down from 20%. The lower capital gains rate (which applies to taxpayers in the 15% bracket or lower) is 5%, down from 10%.

Let's deal with a simple case. If you had a long-term gain of $10,000 on an investment in, say, Intel, you could save $500. That assumes (and this is important) that you sold the stock after May 5, 2003. On or before May 5, the old 20% and 10% rates still apply.

How You Can Make a Loser Pay

If you have an investment that’s still down after the stock market bust, you can use the loss to offset any gains, like that big Intel gain we’ve been discussing, and neutralize or at least reduce the tax effect. To put this opportunity to work, note these three conditions:

So, how to make this work for you?

Let’s say you have a net long-term gain from selling several stocks and a net short-term loss from selling several stocks. You can offset the long-term gain with the short-term loss. If, at the end, you have a net loss from all stock transactions, you can use up to $3,000 in losses to offset ordinary income. The remainder can be used in subsequent years until it’s used up.

Let's say you bought 100 shares of Cisco Systems in January 2000 at $60 and another 100 shares of Kellogg at $20. Cisco is now trading at around $23.80, which means you face a long-term loss of $3,620. Kellogg is at about $36, leaving you a long-term gain of $1,600. You can use $1,000 of the loss in Cisco to offset the gain of Kellogg. Then, you can use up to $3,000 more to offset ordinary income. In this case, you would offset $2,020 in ordinary income.

That is, if you decide to sell your Cisco shares. The decision to sell may include things other than taxes — namely, if you think the stock will go up or fall. My one thought on that decision is this: You can’t go broke taking profits.

Understand the Subtleties of Basis

Capital gains have some subtleties that may affect how you deal with your stocks. Let’s start with two issues on basis.

Your mother GAVE you 100 shares of Cisco. She paid $10 for the shares and gave them to you when the stock was at $60.

This is bad news. If you receive an asset by gift, you take the basis of the person who gives you the asset. Technically, it’s called “substituted” basis. In this case, it’s $10. So, now you face a double insult. The stock has fallen from $60 to $22, but you still face a capital gain if you sell!!

Your mother died and LEFT you 100 shares of Kellogg. She bought those shares at $20. Now, the stock’s worth $36.

Now you get what’s known as a “stepped up” basis. That means that your basis is usually the fair market value of the property as of the date of death of the donor. (And that value is calculated by averaging the high and low price for the stock on the date of death.)

Only the gain over that amount is taxable. That means that all of the appreciation from the original purchase to the date of death escapes taxation.

The bottom line: Your basis in Kellogg is $36 a share. Now you don’t have a capital gains issue.

So, the easiest way to completely avoid any capital gains on any of your appreciated investments is to, well, die. That may be carrying tax planning a little too far.

However, it does open some planning strategies to consider. Here are some of them:

Taking It With You

You’re ill and don’t expect to live long. Don’t start giving away your appreciated property now. If you do, you pass on your basis, too. That leaves the recipients vulnerable to massive gains when they sell.

On the positive side, your holding period would be “tacked” onto theirs. So, if between you and your beneficiary, the property would be held more than a year, all gains would be long-term capital gains — subject to that new maximum 15% tax rate from the 2003 tax law.

Your beneficiary receives the property upon your death. Now, there is NO TAX on the appreciation during your lifetime and, even if your heir sells the assets in two weeks, all potential gain from appreciation after your death would be long term, subject to the 15% maximum tax.

Of course, if you have a short life expectancy, sell any investments that have decreased in value and capture the loss deduction before it fades with your death. If you want to see smiles on the faces of your beneficiaries before you go, then gift the proceeds of loss sales, or transfer assets that haven’t increased in value.

Let’s Deal With One Last Issue:

A few years ago, to encourage taxpayers to save for the long-run, Congress offered a new capital gains rate — 8% or 18% on assets held for five years or more starting in 2001. That provision has been taken over by the new capital gains rates on assets sold after May 5, 2003. So, if you were planning to hold onto a stock or a piece of rental property you bought in 2001 until 2006, don't worry. You'll get the lower capital gains rate.