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For many of you, the reenactment of the 20% capital gain tax rate may appear to be the passage to Zion -- the crossing-over to the promised land. The capital gain tax rate has not been this low since 1986, and for many of you who have seen the effects of a recession over the last 6-8 years in the Bay Area, this is a long hoped for harbinger of greater prosperi-ty.
This article (1) shows that the current capital gain tax situation is not as sweet as it was in 1986, and (2) points out where, for a variety of reasons, you will not be achieving as low a tax rate as you might otherwise think. Thus although it may appear we should have crossed over to Zion, for many of you, it will be close to business as usual. The major reasons for this opinion are as follows:
1. Prior to 1987, the 20% capital gain tax rate was really a 60% exclusion of capital gain income from taxation. Thus your adjusted gross income only included 40% of your capital gain income. The taxation of Social Security and the deductibility of rental property losses (the latter phasing out above $100,000 joint adjusted gross income) would not have been as severely impacted under the old scheme of taxation as under the new. Given these effects, as well as the current lack of California conformi-ty, my own calculations and many commentators indicate that the actual combined Federal and California marginal tax rate for most "20% capital gains" for most middle-class taxpayers in California will be 32-33%.
2. The pre-1987 20% tax rate applied to all capital assets
held longer than one year. Currently the 20% tax rate does not
apply to:
a. Appropriate property not held for at least 18 months. If you
hold property for one year but not 18 months, the maximum Federal
tax rate is 28%.
b. The recapture of depreciation. Previously, only the excess
of your actual deprecia-tion over the amount that you would have
deducted using the straight line method, which was called accelerated
depreciation, was taxed at a higher tax rate. Under the new scheme,
any and all deprecia-tion taken on real property will be taxed
at 25% (assuming that total gain exceeds total depreciation and
assuming the property was held longer than 18 months).Example.
In 1998, Joe Green sold a building for $320,000. He paid $100,000
for the building 20 years ago. Since then, Joe has taken $40,000
of deprecia-tion on the building. Thus his tax cost or basis at
the time of the sale was $60,000. Of the $300,000 of gain, $40,000
would be taxed at a maximum rate of 25% while the remainder of
the gain would be eligible for the 20% tax rate.
c. Collectibles. Under old law, the capital gain tax rate applied to sale of just about anything that you owned for several years. Under the new law, the lower capital gain tax rate does not apply to the sale of collectibles, e.g., stamps, antiques, gems and most coins. So the new law is a specific encouragement to hold financial securi-ties and real property.
3. Another difference between current and pre-1987 tax law
is that under prior law you could treat long-term capital gain
from the sale of investment assets (e.g., stocks and bonds) as
both capital gain income for the 60% exclusion from taxable income
and as investment income for the deduction of investment interest
expense. Since your investment interest expense was and is limited
by the amount of your investment income, this feature of the law
favored investment in growth stocks which paid low dividends but
were expected to produce significant capital gains on sale. Now
you can treat long-term capital gain income as eligible for the
20% tax rate or you can use it to increase your investment interest
expense, but not both.
4. Before 1987, California also allowed a partial exclusion of
capital gain income from taxation. If you owned property longer
than one year but less than 5 years, you could exclude 35% of
your capital gain from taxation, and if you owned property for
more than 5 years, you could exclude 50% from taxation. Under
current California tax law, there is no lower rate or exclusion
from tax for capital gains, and the maximum California tax rate
for 1997 is 9.3%.
As I indicated above, my calculations indicate that in most situations,
you should expect a combined marginal tax rate on "20%"
long-term capital gains of roughly 33%. In doing these calculations,
I did find one situation however, that produced a marginal tax
rate of close to 40%. See schedule above. The taxpayer's name
is Richie Startup -- a young person with salary, a little investment
income, a rental property, and $15,000 in tax preference due to
the exercise of incentive stock options. If she sells Intel, Dell
Computer or Microsoft stock she has held for more than 18 months
so as to produce $120,000 of gain -- with the loss of rental deductions,
and the effect of alternative minimum tax, she has a marginal
tax rate of close to 40%.
In summary, until California changes its tax law, you should figure that your combined Federal and California capital gain rate even on property held longer than 18 months is 33%, and if you have larger amounts of capital gain, tax preferences, or other deductions or losses subject to phase-out at higher income levels, you should expect even higher tax rates and consult a tax professional to calculate your actual marginal tax rate if that number is significant to your planning.
Copyright Eleanor S. Hansen 1997
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