IRS rules might ease some taxpayers' pain

GARY KLOTT, GANNETT NEWS SERVICE

Originally published Sunday, March 24, 2002

It may be small consolation for investors who suffered heavy losses in last year's stock market slide and saw their interest income sliced by Federal Reserve rate-cutting. But many taxpayers will find the federal government taking a bit less of a bite out of investment income on 2001 tax returns.

For higher-bracket investors, last year's half-point cut in each of the tax rates above 15 percent will mean a slightly lower tax on interest, dividends and profits from the sale of stocks and other investments that were held one year or less (all of which are subject to tax at regular rates.)

Lower-bracket investors will find a lower capital gains rate for investments held more than five years.

Young children will also get a small break on their investment income.

But there is no new relief for investors who bailed out of money-losing stocks or mutual funds last year. As before, capital losses can be used to offset any capital gains you have, plus up to $3,000 of other income, such as salary from your job. (Any excess losses can be carried forward for use in a future year.)

Schedule D shortened

Investors will find that Schedule D, where capital gains and losses are reported, has been shortened from 54 lines to 40. But the trimming didn't do much to trim the workload for investors. "It's just less to look at," says Mark Luscombe, principal federal tax analyst at CCH Inc., a major legal publisher.

The IRS trimmed the 14 lines by transferring calculations for some less commonly reported gains -- including collectibles and depreciable real estate -- to worksheets in the Schedule D instructions.

New 5-year capital gains rate

As a general rule, profits from the sale of most types of investments held more than one year are subject to a top capital gains rate of 20 percent, with a 10 percent rate applying for investors who are in a tax bracket no higher than 15 percent.

But starting on 2001 tax returns, lower-bracket investors are eligible for an 8 percent capital gains rate, instead of 10 percent, for most investments held more than five years.

A similar reduction will eventually apply to higher-bracket investors -- but not until 2006. If you're in a tax bracket higher than 15 percent, you'll be eligible for an 18 percent capital gains rate, instead of 20 percent, for investments acquired on or after Jan. 1, 2001, and held more than five years.

Special election

While the 18 percent rate will generally apply only to investments purchased since the start of 2001, there is a way to make investments acquired before 2001 qualify. Investors can elect to pretend the investment was sold and then immediately repurchased at the start of 2001.

By making this "deemed sale" election on your 2001 tax return, you'll have to pay tax now on prior appreciation, but any future gain on the investment would be eligible for the 18 percent capital gains rate starting in 2006.

If you make the election for readily tradable securities, the shares are deemed to have been sold on Jan. 2, 2001, at their closing market price on that date, and reacquired on that date for the same amount. For other assets, the date of the deemed sale and buyback is Jan. 1, 2001.

When to elect

Of course, the question arises: Who in the world would want to pay tax many years sooner than necessary just to become eligible for a paltry 2 percentage-point break on the capital gains rate far in the future?

"It is one of the strangest provisions around," said Bob Trinz, an editor at RIA in New York, a publisher of professional tax references.

But, he says, there are some situations when the election might make sense for an investment that you plan to hold for many years and which you expect will have large future appreciation.

One such situation is if your investment had little or no gain as of Jan. 2, 2001. You'd pay little or no tax for the chance to have your future gains taxed at a rate no higher than 18 percent in 2006.

About the only situation in which it might pay to make the election for an investment that has large paper gains as of Jan. 2, 2001, is if you happen to have enough capital losses to offset the tax on those gains on your 2001 return. Many investors are likely to have some extra losses available given last year's big market sell-off.

Investors have plenty of time to consider the merits. The deadline for making the election is Oct. 15, 2002. If you file your return before Oct. 15, you'll still have until Oct. 15 to make an election by filing an amended return.

The election is made by reporting the deemed sale on Schedule D as if it were an actual sale. You'll also need to attach a statement to your return listing the assets for which you're making the election.

Kiddie tax

The investment income of children under age 14 has long been subject to special tax treatment to prevent higher-bracket parents from transferring a lot of investments to their younger sons and daughters just to save on taxes.

The amount of investment income a child under 14 can earn before it becomes subject to tax at their parent's rate has increased to $1,500 on 2001 returns, from $1,400 in 2000.

Most parents have a couple options for reporting interest and dividend income for a child under 14. You can fill out a separate return for the child. Or you can include the child's income on your own return and attach Form 8814.

In either case, the first $750 of the child's investment income will be tax-free and the next $750 will generally be taxed at the child's 10 percent tax rate. (The 10 percent rate is incorporated in Form 8814. But if you're filing a separate return for the child, you'll need to use the special "Tax Computation Worksheet for Certain Dependents" in the IRS instruction booklets to get the benefit of the new law's reduction in the bottom rate from 15 percent to 10 percent.) Additional income is taxed at the parents' rate, which will likely be a lot higher than the child's rate.

Including the child's income on your own return will save you the bother of filling out a separate return for your child. But the shortcut can often result in a higher tax bill for the family.

That's because including the child's income on your return will increase your "adjusted gross income." And that can cause you to lose some tax benefits. The size of certain tax deductions, such as those for medical and "miscellaneous" itemized expenses, is affected by adjusted gross income. In addition, many tax benefits -- including the child tax credit, IRAs and various college tax breaks -- are phased out for taxpayers with adjusted gross incomes above certain levels.

Tax series

This is the fourth in a seven-part series on taxes. Coming up:

- March 31: Maximizing personal deductions

- April 7: Your job, your business

- April 14: Traps to avoid

Previously

- March 3: Changes for 2001 will make filing more complicated

- March 10: Benefits, wrinkles of new law

- March 17: Tax season tricks

Help with filing

IRS office

The South Sound Internal Revenue Service office is at 402 Legion Way S.E. in downtown Olympia. The office is on the third floor and is open 8 a.m. to 4:30 p.m. weekdays.

Staff at the Olympia office will help you prepare 1040EZ and 1040A forms, and the following 1040 forms: Schedule A/B, Schedule EIC, Schedule H, Schedule R, Form 2441 (child-care credit) and Form 8812 (additional child tax credit).

The office staff will not prepare Schedule C and D forms or partnership or corporate returns.

By phone

- TeleTax: 800-829-4477. Call for recorded tax information for nearly 150 tax topics and for automated refund information.

- Tax help: 800-829-1040. Often your tax questions can be answered by reading tax forms, but more help is available here 24 hours a day, seven days a week.

On the Web

- IRS: www.irs.gov

- National Taxpayers Union: www.ntu.org

- The AARP also has a Web site at www.aarp.org/taxaide

The Olympian Copyright 2002

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