Capital Gains Tax Alternatives

Introduction
Changes Enacted By TRA97
Matching Gains and Losses
A 10% Tax On Your Capital Gains
Tax Free Gains For Charitable Gifts
Gains From Qualified Small Business Stock
Defer Your Gains With An Installment Sale
Defer Your Real Estate Gains With A Tax Free Exchange
Sale of Company Stock To An ESOP
Tax Free Rollover To A S.S.B.I.C
A Special Break For Employer Securities When You Retire
The “Second Best” Retirement Savings Plan
An Income Annuity With Your Heirs
Combinations of Capital Gains Strategies
Tax Free Gains From Fixing Up Residential Property

The “Taxpayers’ Relief Act of 1997” (TRA97) dramatically altered the rules and choices for investors or business owners with capital gains. This issue of “Tax Solutions” is a summary and checklist of the various choices that are now available for those with substantial capital gains.
 

Changes Enacted By TRA97
 

The “good news” is that the top tax rate on some capital gains has been reduced from 28% to 20% by the “Taxpayers’ Relief Act of 1997”. For taxpayers who are otherwise in the 15% tax bracket, the top rate is now 10%. There is no tax at all on the first $500,000 of gain realized from the sale of a principal residence by a married couple filing a joint return. (The exempt gain is $250,000 for single taxpayers.) In addition, the top federal tax rate on gains resulting from taking depreciation deductions on real estate is now 25% instead of 39.6%. And, gains from the sale of certain “small business stock” are still eligible for a 50% tax exclusion - resulting in a maximum rate of 19.8% instead of 20%. However, if you are in the 28% regular tax bracket, your effective rate on these gains would be 14%.

The “bad news” isn’t overly devastating to most investors.  The deferral of tax on capital gains with devices such as “short sales against the box”, put options, notational principal contracts or other forms of hedging that result in a deferral of the tax without economic risk to investors.  In addition, changes in the rules for charitable remainder trusts effectively eliminated the use of such trusts for young family members or for multiple beneficiaries with wide age ranges. In addition, contributions to a charitable remainder trust must now be arranged so that the charity eventually receives a benefit equal to 10% of the present value of the assets contributed to the trust.

The 2003 Tax Law reduced the top tax rate on long term capital gains to 15% and also reduced the top rate on dividend income to 15%. for taxpayers in the 15% or lower bracket for ordinary income, the maximum rate for capital gains and dividend income is only 5%.

The balance of this report provides a summary of other ways investors can minimize or reduce their capital gains tax besides paying the tax.

Matching Gains and Losses
 

An often forgotten method of reducing the tax on your capital gains (whether short term or long term) is to search through your investments to find any that are worth less than what they cost you. Most active investors will have some losers along with their winners. Capital gains can be offset by capital losses without limit. When your losses exceed your gains, the losses are deductible but the deduction is limited to $3,000 per year - with an unlimited carryover of any unused losses.

A 5% Tax On Your Capital Gains
 

For those in the 15% tax bracket with respect to their other income, the maximum rate of tax on their capital gains will be 5%.

It doesn’t make sense to give money away in order to save taxes - but if you are planning to make some gifts anyway, think seriously about making gifts of highly appreciated (low basis) assets to your children or dependent parents.

And ... if you are in a position where you are trying to find ways to avoid future estate taxes, this tactic will be a nearly perfect fit with your estate tax objectives.

Do you intend to help your grandchildren with their college costs? Why not make gifts of appreciated assets instead of with after tax cash?

Tax Free Gains For Charitable Gifts
 

The tax law doesn’t allow you to make money by giving it to a charity but if you have made pledges to your church, alma mater or other charitable organization, you can satisfy your pledge with gifts of appreciated assets instead of with cash. When you do that, no one has to pay any capital gains taxes and you still get to deduct the full market value of the assets - if they qualify as long term gain assets. If they are short term gains, you only get to deduct your cost (tax basis) but you don’t have to pay taxes on the gain. Compared to selling your appreciated assets, paying the tax and then donating cash to the charity, donating appreciated assets is better for you and the charity still gets the full amount you have pledged.

Gains From Qualified Small Business Stock
 

The 1993 tax law pushed through by President Clinton introduced a 50% tax deduction for gains from the sale of “qualified” small business stock held for more than five years. If you own this kind of stock and bought it sometime after 1992, you could be eligible for this tax break sometime in 1998 or later. Stock bought on the first of January, 1993 would be eligible for the five year holding period as of January 1, 1998.

Gains on this kind of stock are eligible for a 50% reduction in the capital gain. Thus, if you are in the top tax bracket of 38.6%, your effective rate on these gains would be 19.3%. But if you are in the 15% tax bracket, your effective rate would be 7.5%.

The qualifying rules are very extensive and complicated, but in general, the tax break will apply to the stock of small corporations engaged in manufacturing or in some form of distribution.

Part of the gain on this kind of stock is subject to the diabolical alternative minimum tax. So before you rush to sell the stock, check with tax advisor who can run the numbers for you based on your tax situation.

Defer Your Gains With An Installment Sale
 

The installment sale isn’t really an alternative to paying the capital gains tax. It’s an opportunity to defer the tax and spread out the income, while also receiving some income on the deferred taxes. It’s somewhat like an interest free loan from the government that you can use to make money at a preferred rate for an extended time.

Securities that are listed on an auction market (NYSE, AMSE, NASDAQ) are not eligible for the installment sale treatment. Non listed stocks and virtually any other kind of asset can be sold with deferred payments and a deferral of the tax. Whatever the tax rules are at the time the payments are received will apply to those payments. Thus, if you had sold some property on an installment plan years ago, the gain on each payment would now be eligible for the 20% capital gains rate.

The payments you receive will be a combination of interest income, capital gains income and a return of your cost basis in the property you sell.

Defer Your Real Estate Gains With A Tax Free Exchange
 

If you have appreciated real estate that you want to convert into some other kind of real estate, don’t sell it and pay the tax and then buy something else.  Investigate the opportunity to use a tax deferred exchange first. It’s not always the best choice, but it’s always worth considering before you pay the tax.

For example, suppose you have some raw farm land you received as a gift or inheritance. The suburbs are getting close and developers or speculators are willing to pay top dollar for the property. If you sell it, you plan to just invest the money in some income producing stocks.  What if you could invest in some income producing real estate where the returns are attractive even after you pay a management fee? If that’s something you might be interested in doing, it can be done with a tax free swap of your farmland for the income producing realty. The variety of exchange properties can range from raw land to factory buildings, office buildings, golf courses, an amusement park and just about any other property that is primarily land and improvements.

The key to a tax deferred exchange is to get the help of a specialist. You can usually find them in the phone book of any major city under real estate consultants or brokers. Call a few and ask if they can refer you to someone who is a specialist in Section 1041 exchanges.

Sale of Company Stock To An ESOP
 

This strategy is also a deferral method for those who are ready to sell out of a closely held corporation.  To use this device, you need to be the controlling stockholder (or the owner of at least 30% of the stock) and to be able to influence any other stockholders.

The “bottom line” is that you can sell your shares of the corporation to a special type of employee benefit plan called an “Employee Stock Ownership Plan.” It’s a tax qualified retirement savings plan for employees that is permitted to invest in company stock. In most cases, the ESOP can raise the funds to buy your stock through loans from banks or insurance companies.

The ESOP then pays you cash for your stock. If you re-invest that cash in stock or bonds of any other U.S.  corporations, your capital gains tax is deferred until you sell those securities. In effect, you have diversified your ownership of a business into a variety of publicly listed stocks and bonds - tax deferred.

How does the ESOP pay back the loan? Your company makes ongoing tax deductible contributions to the ESOP.  Since every buyer of a business expects to recoup his investment from the earnings of the business, this is a very efficient way to sell out. The primary downside is that the cost of this arrangement can be pretty high.

Tax Free Rollover To A S.S.B.I.C.
 

Did you know that you can rollover the gain from any publicly traded securities on a tax deferred basis?  It’s true - but there’s a catch. You can only get the tax deferred rollover by investing the proceeds of your securities in a “Specialized Small Business Investment Company”. That’s an investment company that is organized specifically to invest in small businesses that are regarded as “disadvantaged” by the government. However, as with most government programs, there are always opportunities to take advantage of these tax deals if you do your homework and have the right contacts.  There are plenty of “minority owned” or “disadvantaged” small businesses that are well run. The trick is to find the SSBIC that is run by savvy managers.

A Special Break For Employer Securities When You Retire
 

This is another tax break for a special situation. It’s useful if you are receiving a retirement plan payout and if that payout includes securities (stock) of your employer.

If you elect to make a rollover of your pension to an IRA, when the securities are sold, any gain will be tax “free” until the funds are distributed to you as part of your taxable retirement benefits from the IRA.

If you elect to use the five or ten year averaging tax, the cost of the employer securities to the plan trustee is included in your five or ten year averaging calculation and any gain in excess of that amount will be treated as a capital gain when you sell the stock. For this purpose, the “cost” of the stock is what the company pension plan trustee/administrator paid for it.

You can use the ten year averaging method if (1) you were born before 1936, and (2) you were at least age 59.5 when you received your plan distribution, and (3) you were a plan participant for at least five years, and (4) you received the entire distribution in one tax year, and (5) you have not made a rollover to an IRA of any part of the benefits from that plan.
 

The “Second Best” Retirement Savings Plan

If you are planning to reinvest your capital gains in other stocks and bonds or in some tax deferred annuities, take a good look at the special benefits from using a charitable annuity income trust. Basically, it’s like exchanging your appreciated assets for a life income annuity that will pay you an income as long as you live. When you die, the payments stop - the same as with an annuity issue by a life insurance company.

But - you can’t swap appreciated assets for a life income annuity issued by an insurance company without paying taxes on the gain, right now. With an annuity from a charity, you defer the capital gain until you receive the payments.  It’s a little bit like an installment sale in that you do pay the capital gains tax, but it’s spread out over time.  Meanwhile, the tax dollars are invested to make more $$.

You can arrange to include your spouse as a joint income beneficiary so that the payments continue as long as either of you are alive. After you and your spouse are both deceased, a charity of your choice gets what is left.

If you wish, you can even be the trustee of the trust and can manage the investments. But you do have a fiduciary duty to the remainder beneficiary not to squander the funds.

At a minimum, a charity must receive at least 10% of the present value of the projected remainder interest. In simpler language, it means that 10% of what you put into the trust - and any income on that portion - must go to a charity. The rest can come back to you and your spouse.  You can receive a fixed amount each year or a variable amount based on a percentage of the assets in the trust.  The minimum percentage payout is 5% and the maximum is 50%.

A side benefit of this arrangement is that you also get a tax deduction for a portion of the amount put into the trust. For a couple aged 50, that would be about 20% to 30% of the total amount put into the trust. The tax savings from that tax deduction is often sufficient to buy enough life insurance for your children to make up for the apparent loss of an inheritance. And of course, you don’t need to put all of your assets into this kind of trust.

An Income Annuity With Your Heirs
 

Most people buy retirement income annuities from a life insurance company. Some people exchange appreciated assets with a charity for a life income annuity. But you can also enter into an annuity contract with any one that is not in the business of issuing annuities.

The “catch” is that the private annuity is an unsecured contract. You must rely on the obligor to make the payments as promised. Unlike an installment note, you can’t even recover the property if the buyer fails to pay you.  As with an insurance or charitable annuity, when you die, the payments stop.

So why would anyone do that?

Because they may want the property to go to a child or even a grandchild and are willing to take a chance on whether they get paid. The private annuity is more of an estate planning device than a method of avoiding capital gains taxes, but it can serve both purposes. As with a charitable annuity or installment sale, there is no capital gains tax when you exchange appreciated property for a life income private annuity. The tax on the gain is paid as the payments are received over your lifetime. As with other annuities, you can arrange to have the payments made to you and your spouse as long as either of you are alive.

Combinations of Capital Gains Strategies
 

I’ve been a tax consultant for more than thirty years and I’ve discovered that very few people are eager to use any one of these methods to defer or avoid the capital gains tax. There is usually some kind of personal objection - often based on a misunderstanding of how the arrangement really works.

However, I’ve also shown many clients how these various devices that are permitted by the tax law can be used in various combinations to accomplish goals and to solve problems that no one of these devices can do alone.

And a lot of big problems can be made into smaller and more manageable problems by using multiple strategies rather than trying to solve the whole problem with just one of these devices.

No matter what you do, the alternative is to simply pay the capital gains tax and reinvest the balance in some other kind of investment. So the litmus test for each of these alternative strategies is whether the after tax benefits are more than what you could get from just selling and paying the tax.

Tax Free Gains From Fixing Up Residential Property
 

This tactic won’t do anything to reduce the tax on any gains you already have, but when it’s time to re-invest your after tax gains, consider investing for tax free gains instead of for taxable gains.

Up to $500,000 tax free every two years from the sale of a principal residence. You have to live in the residence for at least two of the last five years. The exempt gain is actually limited to $250,000 per person, but if you have the resources and the time to take advantage of this new break, it could be far more profitable than leaving your money in the stock market. As a practical matter, home prices aren’t increasing at a high rate, so you will have to buy low and sell high to benefit from this break.  Obviously, you will need to invest some effort and talent at fixing up run down properties in order to realize any benefit from this opportunity. But where else can you use your time, talent and capital to make tax free gains?

You can also deduct interest on a loan to finance your residence - for loans of up to $1 million. (Half of that if you file separate returns.) With residential interest rates as low as they’ve been since the early sixties, this has to be a good time to invest in a fixer-upper.  Your interest is deductible and the gains on the home are tax free.

There is a small catch. Your fixing up costs are part of the cost of the residence. Since your gain is tax free, it’s as if the fixing up costs aren’t deductible.