More to benefit from long-term capital gains tax rates
By Luis I. Ingles III, CPA, and Cora M. Barnhart • Bankrate.com

Changes in the tax treatment of capital gains were one of the most welcomed aspects of the Taxpayer Relief Act of 1997. Understanding the new rate reduction in place for long-term capital gains is especially important for taxpayers whose stocks or real estate have benefited from the recent growth in the economy. More individuals than ever will be eligible for the lower tax rates.

This tax tip explains the distinction between the taxation of short-term and long-term capital gains. The tip reviews those provisions in the 1997 act affecting the taxation of capital gains. Two examples are included to clarify how the new legislation has decreased the taxes due on a capital gain. This tip also explains the process for reporting capital gains on your tax form.

Short-term vs. long-term
Capital gains are divided into short- and long-term. Short-term gains are gains on items held for one year or less. These gains are taxed at the same income tax rate of ordinary income, ranging from 15 percent to 39.6 percent. Long-term gains are gains on items held more than a year. They are taxed at rates determined by the taxpayer's income bracket.

The table below illustrates how the Taxpayer Relief Act of 1997 altered long-term capital gains taxes. Before the 1997 act, a taxpayer in the lowest income tax bracket of 15 percent paid that same rate on a long-term gain. If a taxpayer's income bracket were 28 percent or more, the long-term gain was taxed at 28 percent. This set-up only benefited taxpayers in brackets higher than 28 percent. Under the new regulations, all taxpayers pay a lower capital gains tax on long-term capital gains.

Only long-term gains affected
Both the taxation and the definition of long-term capital gains have changed, effective for gains realized after May 6, 1997. Taxpayers now pay a lower rate on all long-term capital gains than on their ordinary income:

• For a taxpayer in the 15 percent tax bracket, the gains are taxed at 10 percent. For taxpayers in the remaining brackets, ranging from 28 percent to 39.6 percent, the gains are taxed at 20 percent.

Are you confused? Working through the following examples will convince you of the impact of the 1997 legislation on your capital gains taxes. You should also consult Chapter 17: Reporting Gains and Losses in IRS Publication 17: Your Federal Income Tax.

Example: Two married taxpayers are filing a joint return. They have ordinary income of $41,200 and $25,000 of long-term capital gains from a sale of stock on Aug. 1, 1998. Adding these amounts indicates their total taxable income is $66,200.

How do they calculate their taxes? Married taxpayers filing jointly are taxed at a 15 percent rate on the first $41,200 of ordinary income and at a 28 percent rate on their next $58,400 of ordinary income. What tax rate should they use to calculate their capital gain taxes?

Before the 1997 act, the capital gain would have been taxed at the same income tax rate that applies to the next $58,400 of the taxpayers' taxable income. The $25,000 in capital gains would have been taxed at a rate of 28 percent. They would have calculated their capital gains taxes as $25,000 x 28%, or $7,000. They would have paid a total of $13,180 in taxes under the old law, computed as follows:

Under the new law, the same married couple filing jointly will enjoy substantial capital gain relief.

This couple will still be taxed at a 15 percent rate on the first $41,200 of ordinary income. The tax rate on their next $58,400 of ordinary income would still be 28 percent. But the tax rate they use to calculate their capital gain taxes now changes because of the new law. Taxpayers in the 28 percent bracket now use a tax rate of 20 percent when calculating their capital gains taxes. This means their capital gains taxes will be $25,000 x 20%, or $5,000. They will now pay a total of $11,180 in taxes, computed as follows:

Thanks to the Taxpayer Relief Act, their tax liability decreases by $2,000.

Reporting capital gains and losses
Now that you have determined your capital gain or loss, you need to report it to the IRS. You will use Schedule D on Form 1040. Enter sales and trades of stocks, bonds, etc., and real estate, if they aren't required to be reported on another form, on line 1 of Part I or line 8 of Part II, as appropriate. You must report all of these transactions, even if you didn't receive Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, or Form 1099-S, Proceeds From Real Estate Transactions. Use Schedule D-1 as a continuation schedule to report additional transactions. You should consult Chapter 17: Reporting Gains and Losses of IRS Publication 17: Your Federal Income Tax.

Conclusion
This tax tip explains the distinction between the taxation of short-term and long-term capital gains. The tip reviews those provisions in the 1997 act affecting the taxation of capital gains. Two examples are included to clarify how the new legislation has decreased the taxes due on a capital gain. This tip also explains the process for reporting capital gains on your tax form. Given the effects the growing economy has had on assets such as stocks and real estate, more taxpayers than ever stand to benefit from this legislation.

--Nov. 1, 1999

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