Lowers Rates, But Comes with New Complications in Timing

by Jane A. Bruno
author of
The Expat's Guide to U.S. Taxes (Hands on Help for Americans Overseas)
Every American abroad should add this book to their shelf.

       The Taxpayer Relief Act of 1997, signed into law by  President Clinton in August of this year, was widely applauded for providing a long-awaited reduction in the rate of tax on  capital gains. Indeed, investors were delighted that the 28% rate of tax on long-term gain was reduced to 20% (for 15%   taxpayers, the capital gain rate is 10%). What most early reports did not stress was that those of you who invest must now be aware of new complications in how long an asset must be held to benefit from certain capital gains tax rates. The following will give you the basics of these changes. You may find you will need a whole different investment strategy in order to take advantage of the new rates.

New Holding Periods

Long-term gain--Under the old law, long-term capital gains were taxed at a maximum rate of 28%, and you had to hold the asset for more than one year to avoid being taxed at ordinary income tax rates (which could be as high as 39.6%). Under the new law, the highest rate of tax on long-term capital gain is 20%, but you must hold an asset for more than 18 months in order to qualify for the 20% rate (10% for lower-income taxpayers). However, you may be able to take advantage of a transition rule that applies to sales of capital assets on or after May 7, 1997, and before July 29, 1997. If an asset that had been held for more than one year (at the time of sale)  was sold between those two dates, it is eligible to be taxed at the 20%/10% rate. If the asset was sold before May 7, 1997, and had been held for more than one year, the old 28% maximum rate still applies.

Mid-term gain—This is a new category of gain that you may not have heard about. It applies to the situation where an asset is held more than 12 months, but not longer than 18 months. The maximum rate of tax in this case is 28%. It applies to sales of assets occurring after July 28, 1997.

Short-term gain—The rules here are basically the same as before. Gain on the sale of a capital asset held for less than one year is taxed at ordinary income rates.

Five-year gain—To further muddy the waters, still another category of capital gain has been created for purchases after December 31, 2000! If you hold an asset purchased after this date for longer than five years, it will qualify for an 18% capital gains tax rate. Furthermore, if you are a 15%-bracket taxpayer, you can use an 8% rate (instead of 10%) beginning in 2001 so long as the asset has been held more than five years (regardless of when it was acquired).

Impact of Holding Periods on Tax Paid

To realize just how much the timing of a sale can affect your tax liability, let’s look at the following simple example:

Suppose you bought a stock for $10,000 and later sell it for $50,000, resulting in a $40,000 profit. Suppose also that you are in the 39.6% tax bracket. The holding period of the stock will determine how much of the profit you get as follows:

Holding Period –One year or less—Tax rate is 39.6% or $15,840. You keep $24,160.

Holding Period-More than 1 year (but less than 18 mths.)—Tax rate is 28% or $11,200. You keep $28,800.

Holding Period-More than 18 mths.—Tax rate is 20% or $8,000. You keep $32,000.

Holding Period—More than 5 years (bought after 2000)—Tax rate is 18% or $7,200. You keep $32,800.

The chart makes it quite clear that the difference of a few months in selling a stock or other capital asset can cost (or save) you thousands of tax dollars. You would be well advised to keep very careful track of purchase and sales dates so you can take advantage of the huge potential for tax savings.

Jane A. Bruno is an attorney with a Master's in Tax Law from George Washington University. She has extensive experience with tax issues related to living overseas, having lived in several countries in Europe and Africa over the past 12 years. A former IRS employee, she has worked as a tax consultant/preparer in such diverse places as Germany, South Africa and the Commonwealth of Virgina. She recently published:

The Expat's Guide to U.S. Taxes (Hands on Help for Americans Overseas)
by Jane A. Bruno

This self-help book presents in simple and concise form the complicated U.S. tax laws that impact on Americans living overseas. It covers a wide range of topics, starting with the most common tax situations for Americans living overseas and ending with an appendix of tax forms and other important tax information. Numerous examples are used to clarify difficult points and tax saving tips are given where appropriate.