A tough tax decision for investors

Taxpayers in the 27-percent-or-higher tax brackets who have stock or business-related assets bought before 2001 have an important tax decision to make.

It involves a tax provision in the Taxpayer Relief Act of 1997 and went into effect last year called the deemed sale and repurchase election. Here is how it works.

Any asset bought after Jan. 1, 2001, which ordinarily would be subject to the 20 percent long-term capital gains rate, will be taxed at only an 18 percent capital gains rate if you hold the asset at least five years. (This doesn't apply to personal residences.) In short, you can't sell it before 2006 if you want to take advantage of the lower rate.

To help higher tax bracket investors who want to take advantage of this break for assets bought before 2001, Congress put in a one-time "deemed sale and repurchase election." Essentially, this allows you to pretend that you sold and repurchased the identical asset based on its fair market value as of Jan. 1, 2001, for a capital asset or property used in a business or on Jan. 2, 2001, for readily tradeable stock.

Starting with this fresh basis, any gains between those dates and when you sell the asset (no earlier than 2006) will be taxed at 18 percent instead of 20 percent.

The catch to this election is that you must pay tax now on any gain the asset made between the original purchase date and the phantom sell-and-buy date in January 2001. The election is also irrevocable.

You have until your filing deadline for your 2001 tax return, plus extensions, to decide whether to take the election. In fact, you can choose not take it, change your mind and file an amended return within six months (by October 15, 2002, for calendar-year individuals).

The question is: Should you take the election?

The decision is complicated because several factors must be weighed, and it's possible to end up paying more tax by taking the election than not taking it. You'll probably want to run the numbers with your tax adviser to assess the best strategy, but here are some general factors to consider, according to tax experts.

First, you probably should consider this election only for assets bought before Jan. 1, 2000. Assets bought during 2000 would qualify for the deemed sale election, but the problem is that because the pretend sale and repurchase is made on Jan. 1 or Jan. 2, 2001, the "sale" would be considered short term and subject to your ordinary tax rates, not the long-term 20 percent capital gains rate.

The election also works best for assets that have appreciated little or not at all since you bought them (which could thus include your short-term assets). That minimizes or eliminates the tax due now. Electing this strategy for a highly appreciated asset would entail paying a big tax bill with cash you'd have to get from somewhere else, unless you can offset it with significant losses from other assets. Furthermore, you run the risk of paying tax on an asset that could end up losing value between now and 2006.

You cannot claim a loss under this election, so unless the loss is small, it might be wiser to sell the asset and write it off against your winners. Of course, there's obviously little value in this election if you're holding an asset that you are not optimistic will gain significantly in value to make the election and the resulting 2 percent tax savings worthwhile.

Choosing the election also would not make sense if you plan to hold the asset until your death, because your heirs would receive the asset with a step-up in basis. However, this factor depends on what happens to future estate tax laws. The new Tax Relief Act eliminates the step-up in basis in 2010, but reinstates it in 2011.

This raises another factor: There's perennial talk about lowering or eliminating capital gains taxes, either of which would make taking this election a bad choice.

Zall is a retired federal employee who since 1987 has written the Bureaucratus column for Federal Computer Week. He can be reached at [email protected]


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