Thomson Reuters | The Year of Tax-Free Capital Gain Has Arrived

30 Apr 2008

The Year of Tax-Free Capital Gain Has Arrived

Capital Gain Rate Drop CreatesPotential to Save Taxpayers Thousands of Tax Dollars

“The ultimate tax rate reduction for capital gains took effect on January 1, 2008, so don’t miss it,” says Bob D. Scharin, Senior Tax Analyst from the Tax & Accounting business of Thomson Reuters. Legislation enacted back in 2003 provides that certain capital gain (and qualified dividend income that is taxed like long-term capital gain) is subject to a 0% tax rate—converting this money into tax-free income. Now that your 2007 tax return is filed, it is time to begin thinking of how you will implement strategies for this 2008 tax break.

In plain English, the 0% rate meansthat you owe no tax on capital gain to the extent your taxable income does notexceed the level at which the 25% regular income tax bracket kicks in. For2008, this threshold is taxable income of up to:

$65,100 for married taxpayers who file joint returns.
$43,650 for heads of households.
$32,550 for other unmarried taxpayers and marriedtaxpayers who file separate returns.

This seemingly simple tax break has a few confusing wrinkles. Scharin asks and answers questions that clarifycommon misconceptions.

How much tax can this save me? By reducing the capital gain rate from 5% to 0% on the above amounts oftaxable income, the maximum tax savings are as follows:

$3,255 for married taxpayers who file joint returns.
$2,182.50 for heads of households.
$1,627.50 for other unmarried taxpayers and marriedtaxpayers who file separate returns.

These figures are 5% of the income limits presentedabove.

Must my income be below thesethresholds to qualify? No. First off, the tax break applies to taxable income. Depending on your deductions, your grossincome can be considerably more. Also,you may qualify for some tax-free income even if your total taxable incomeexceeds threshold amounts. Your non-capitalgain and dividend income reduces your window of opportunity to takeadvantage of this 0% rate. Thus, you canderive some benefit from the 0% rate if your non qualifying income is less than the above threshold amounts.

For instance, suppose a married couple has $70,000 of taxableincome. It consists of $60,000 of wagesand interest income, plus $10,000 of capital gains. The couple’s taxable income exceeds the$65,100 threshold, but they pay no tax on $5,100 of the capital gains. That is the amount by which the applicabletaxable threshold exceeds their $60,000 of income from sources not subject tothe favorable capital gain rate. Theremaining $4,900 of capital gain would be taxed at a 15% rate.

Planning tip: If you are in this situation,seek out ways to reduce your income that is not eligible for the 0% rate—byincreasing contributions to a Section 401(k) plan at work or by investing incertificates of deposit or Treasury bills that defer into 2009 interest earned in2008. Retirees can minimize theirretirement plan distributions and instead get cash for living expenses byselling appreciated investments.

Do all capital gains anddividends qualify? No. Only the types of capital gain and dividendsthat would otherwise be subject to the 15% top rate applicable to those withhigher incomes are eligible. Gains mustbe long-term capital gains, which means gain from investments held for longerthan one year. Also, gains from the saleof collectibles cannot be sheltered from tax by this break.

Can I shift capital gains tolower-income family members? Yes. You may make gifts ofappreciated assets that the gift recipients then sell. The capital gains will be reported on theirtax returns. The long-term capital gainholding period will be measured by the date the gift-giver acquired theproperty. If you held it for over a year,the gift recipient may sell right away and still qualify for long-term capitalgain treatment. That treatment can meanzero tax.

This strategy does come with two caveats, Scharinwarns.

The tax-free gains can indirectlyraise someone’s tax bill. Before you place an order to sell aprofitable investment, consider the effect that the extra capital gain incomewill have—even if the income itself is tax-free. Although the gain may not be taxed, it willraise your adjusted gross income. This could, in turn, increase the portion ofSocial Security benefits subject to tax.
No kidding about the kiddie tax. If your children are subject tothe kiddie tax and your income is too high for the 0% capital gain rate, theywill not qualify for it either. Underthe kiddie tax, in 2008, unearned (i.e., non wage) income in excess of $1,800 ofthose up to age 18—or 23 if full-time students—is taxed at the top tax rate oftheir parents. If the parents’ income falls into a 25% or higher tax ratebracket, the children cannot qualify for the 0% rate.

In 2007, the kiddie tax applied only up to age 17. That the age limitincreased in the same year as the capital gain rate dropped is nocoincidence. Congress saw the prospectof families shifting income to college students to take advantage of the 0%rate as a loophole too big to avoid being plugged up.

Planning tip. For purposes of the kiddie tax,an individual comes under the full-time student status only if he or she is afull-time student in at least five calendar months of the year. Thus, a childwho takes a year off between attending high school and college would be a fulltime student for the year he or she graduated in May or June, but would not bea full-time student the following year if college did not start until September.

Can I still deduct capitallosses? Yes, butcapital losses must first be used to offset capital gains. Excess losses may be used to offset up to$3,000 of other income (e.g., wages). “People who are eligible for the 0% rate on capital gain derive no taxbenefit from offsetting those gains with capital losses. If possible, they should defer the lossesinto a future year when they either have no capital gains or the gains aresubject to tax,” Scharin explains.

Can the 0% rate hurt myeligibility for stimulus payments? In some circumstances, the answer is “yes,”and some background information is needed to understand how.

Most stimulus payments are being sent out in 2008 based on 2007 income.If you did not qualify for the maximum payment amount (i.e., $600 per taxpayer,$1,200 for joint returns, and $300 for qualifying children) that year, you geta second chance for more money based on your 2008 return.

If you do not receive at least $3,000 of wages, Social Securitybenefits, or other qualifying income, you can still get a minimum payment of$300 ($600 for joint return filers) if your gross income is at least as much asthe applicable basic standard deduction plus the exemption amount (twice theexemption amount for a joint return) and you owe some tax. Consequently, $1 of tax liability can putsome individuals in line for a $300 ($600 for joint return filers) stimuluspayment.

Here’s where the problem arises: A capital gain can boost a low-incometaxpayer’s gross income above this threshold, but the 0% rate would stop theindividual from owing any tax. No taxliability would mean no stimulus payment.

Will the 0% rate be around longerthan just this year? Yes. As thelaw reads now, the 0% rate will be around through 2010. If your family cannot take advantage of itthis year, you may be able to derive tax savings in the future.

AboutThomson Reuters

Thomson Reuters is the world’s leading source of intelligent informationfor businesses and professionals. We combine industry expertise withinnovative technology to deliver critical information to leading decisionmakers in the financial, legal, tax and accounting, scientific, healthcare andmedia markets, powered by the world’s most trusted news organization. Withheadquarters in New York and major operationsin London and Eagan, Minnesota,Thomson Reuters employs more than 50,000 people in 93 countries. ThomsonReuters shares are listed on the New York Stock Exchange (NYSE: TRI); TorontoStock Exchange (TSX: TRI); London Stock Exchange (LSE: TRIL); and Nasdaq(NASDAQ: TRIN). For more information, go to www.thomsonreuters.com.

The Tax &Accounting business of Thomson Reuters (formerly Thomson Tax & Accounting) isthe leading provider of technology and information solutions, as well asintegrated tax compliance software and services to accounting, tax andcorporate finance professionals in accounting firms, corporations, law firmsand government. Tax & Accounting includes the Professional Software &Services, Corporate Software & Services, and Research & Guidancebusiness groups.