The Federal Income Tax laws are constantly changing. They change as a result of new legislation and they change as a result of the expiration of old legislation.
Cinderella and the “Federal Godmother”:
Some of the laws resulting from The “Economic Growth and Tax Relief Reconciliation Act of 2001” and the “Jobs and Growth Tax Relief Reconciliation Act of 2003” (sometimes referred to as the “Bush Era Tax Cuts”) are set to expire at the stroke of midnight on December 31, 2012. That is, the laws themselves (as selectively extended over the years) were enacted with a built-in expiration date. It is as though Congress, the Senate and the President together acted as the “Federal Godmother” in an adaptation of the story of “Cinderella”. However, instead of Cinderella’s coach turning back into a pumpkin, the Federal Income Tax laws revert to what they originally were.
At any point, the Federal Godmother can waive its magic wand to make new Federal Income Tax laws. The new laws could act to reinstate some old laws or make laws that have never previously existed. However, to do so, the Federal Godmother will have to resolve its internal struggle and compromise.
General Capital Gain / Loss Rules:
People often talk about capital gains rates and that the rates are too high or too low. However, what are capital assets in the first place and when do they become Long-Term?
A capital asset is defined in IRC Section 1221. Well, actually, Section 1221 defines what a capital asset is by saying that all assets are capital assets unless they fit within one of the exceptions. It then lists a bunch of exceptions.
Whether an asset is a capital asset is based, in large part, upon the underlying nature of the asset and the purpose for which a particular taxpayer is holding it.
A widget in one taxpayer’s hands might be a capital asset while the same exact widget is not a capital asset in the hands of some other taxpayer. Even more confusing, a widget in the hands of a taxpayer might sometimes be a capital asset and sometimes not. Is it magic?
I will not bore you with the complete list of what is or is not a capital asset, you can find that in IRC Section 1221. However, here are some common examples:
- Inventory is not a capital asset. Inventory is an asset held primarily for the sale to customers in the ordinary course of business. Whether something is inventory is based upon a facts and circumstances test including such things as how often the taxpayer sells that type of thing, the intent of the taxpayer when they purchased that thing, etc.
- If David owns a bicycle factory or a bicycle store, then the bicycles that he holds out for sale to customers are inventory in David’s hands, not capital assets. However, the bicycle that David keeps for his own personal use is not his inventory.
- If Jordan is a residential real estate developer, residential real estate developed by Jordan, and held for sale to customers, is inventory in Jordan’s hands. However, Jordan’s principal residence is not his inventory (even if Jordan built it).
- If Lauren is a CPA who, over a period of 5 years, buys 2 houses for resale then such activities might not rise to level of causing the houses to being considered her inventory. However, if Lauren purchased 10 houses for resale then the houses might be considered to be her inventory.
- Depreciable business properties and real estate used in a trade or business are not capital assets.
- Copyrights, literary rights, music rights, artistic compositions, or similar property are not capital assets in the hands of the people that created those assets.
- Here are a few examples:
- If Maurine creates a painting in the image of her famous dog, Ralph, this painting of Ralph is not a capital asset in Maurine’s hands.
- If Maurine buys a painting of Ralph created by Roy Lichtenstein, this painting of Ralph is not a capital asset in Roy Lichtenstein’s hands, but is a capital asset in Maurine’s hands…..unless Maurine is in the business of buying and selling paintings of Ralph in which case it would be Maurine’s inventory.
- Capital assets are considered to be “Long-Term” when a taxpayer has a holding period of longer than 1-year.
- For purchases, the holding period normally begins on the date of purchase.
- If a taxpayer receives an asset as a result of a lifetime gift, the taxpayer’s holding period tacks on to whatever holding period applied to the person who gave the taxpayer the gift.
- When a taxpayer inherits an asset the taxpayer is automatically deemed to have held the asset for longer than 1-year.
General Capital Gain / Loss Rules for 2012, 2013 and Beyond:
There are 4 possible Long-Term Capital Gains rate for sales of Capital assets in 2012. It is 0%, 15%, 25% and 28%. Say what? If that is true then why is it that all you hear about in the news (and on the campaign trail) is the 15% rate?
The 25% and 28% Capital Gain Rates are for special types of Capital Assets. For most Capital Assets, the Capital Gain Rate is 0% for those taxpayers at or under the 10% Ordinary Income tax bracket and 15% for taxpayers in Ordinary Income tax brackets greater than 10%.
Unless the Federal Godmother steps in, the 0% and 15% rates will expire at the stroke of midnight on December 31, 2012 and will be replaced with a long-term Capital gains rate of 20%.
If you believe that that the Federal Godmother will not reinstate the 2012 rates and the capital gain rate applicable to you will go up by 5% then, all other things being equal, taxpayers should consider selling their long Capital assets in 2012 (i.e. harvesting gains) rather than waiting until 2013.
However, there are a number of important factors to consider before you elect to harvest Capital Gains:
- Don’t let the tax tail wag the dog. If you believe that your asset should be held by you for the long-term then you might not want to sell it for tax purposes. While some assets can immediately be repurchased others cannot. Even for those that can be repurchased, if your gain will be subject to a 15% tax rate, you might not want to pay 15% now anyway.
- Be careful harvesting capital gains in the year of your death. If your beneficiaries are eligible to receive “Stepped-Up Basis” for assets that they inherit from you then your beneficiaries may be better off, overall, if you hold the assets until your death. This is true in 2012, 2013, and beyond (at least until the Federal Godmother changes those laws).
- Don’t forget about Capital Loss carryovers. If you have significant Capital Loss carryovers leading into 2012 you will have to have net 2012 Capital gains that exceed your Capital Loss carryovers before you have any Capital gains subject to tax.
- If the goal is to take advantage of lower Long-Term Capital Gain Rates, then there is no benefit to harvesting gains (for the sake of harvesting gains) if the gains do not exceed the Capital Loss Carryovers.
- There is a reduced benefit to using up Loss Carryovers when the Long-Term Capital Gain Rates are at historic lows.
- There is a greater benefit from using up Loss Carryovers to offset Short-Term Capital Gains than using them up to offset Long-Term Capital Gains.
- To the extent that your Capital Losses exceed your Capital Gains, up to $3,000 of your Capital Losses can be used to offset Ordinary Income.
Ordinary Income Rates are higher than Long-Term Capital Gains Rates.
In some situations, a taxpayer might want to consider using up their Capital Losses against Ordinary Income even if it means spreading it out at $3,000 a year.
Capital losses die with the taxpayer. Let’s say that Jay dies on December 25, 2012. Jay can use Capital Losses to the extent of his capital gains on his final Form 1040, that being 2012. If Jay has unused Capital Losses at his death, they are lost forever. If Jay knows that he will die in 2012 and has Capital Loss Carryovers, then he might consider harvesting Capital
Gains to use up his Capital Loss Carryovers. However, does this really help (remember “Stepped-Up Basis”)? Things get trickier if Jay is married to June and their filing status is Married Filing Jointly; which Capital
Losses are Jays and which are June’s? There are other considerations if Jay and June live in a community property state.
- Social Security Benefits. Social Security benefits are not subject to Federal Income Tax until a taxpayer’s other income hits certain levels. As a taxpayers’ other income increases (including as a result of Capital Gains) a larger portion of their Social Security Benefits becomes subject to tax, and at Ordinary Income Tax Rates.
- AGI/Modified AGI Test Items. Certain deductions (e.g. Medical, tax preparation fees, unreimbursed employee expenses, etc.) are only deductible to the extent that they exceed a percentage of the taxpayer’s Adjustable Gross Income (AGI). As a taxpayers’ AGI increases (including as a result of Capital Gains) fewer of these AGI sensitive deductions become deductible.
It would be easy to be confused by the Capital Gain rules. This is complicated by politicians who intentionally misstate certain Federal Income Tax Laws for their own political gain.
The best way to know whether, and to what extent you should harvest Capital Gains is to prepare alternative models using tax software. If the taxpayer really wants to approach this thoughtfully, the taxpayer will have to make some assumptions about tax rates, time value of money, when they will die, possible future appreciation of assets. Looking at just one factor (e.g. that rates might end up being 5% higher in 2013) may cause a taxpayer to make a decision that they would not have made had they looked at more of the considerations.
Copyright ©, Keith B. Baker – 2012
This article is designed to be a public resource of general information. It does not constitute “legal advice” nor does it create a “client-attorney” relationship. While the information is intended to be accurate, this cannot be guaranteed. Tax laws are complex and constantly changing as a result of new laws, regulations, court interpretations and IRS pronouncements. Often, there are also various possible interpretations. Further, the applicable rules can be affected by the facts and circumstances of a particular situation. Because of this, some of the information may no longer be correct or may not apply to all situations. We are not responsible for any consequences or losses resulting from your reliance on such information. You are urged to consult an experienced lawyer concerning your particular factual situation and any specific legal questions you may have.
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