There are a number of tax law changes that were passed 4 years ago, that had an effective date of January 1, 2001 that will of interest to United States citizens and resident aliens residing abroad.
Qualified 5 Year Gain
Beginning in 2001, the 10% capital gain rate is lowered to 8% for “qualified 5 year gain.” A “qualified 5 year gain” is defined as a long-term capital gain from the sale of property that was held for more than 5 years.
Beginning in 2006, the 20% capital gain rate is lowered to 18% for all property that was held for at least 5 years, and purchased after January 1, 2001.As passed, this law would appear to result in higher taxation for individuals who bought property prior to January 1, 2001, and who sell it at a gain after January 1, 2006.
However, a corrective measure in this legislation allows individuals who bought property prior to January 1, 2001, and who intend to hold the property until at least January 1, 2006 to “make an election” in their 2001 tax return to have a “deemed sale” of the property as of January 1, 2001 and to pay tax on the gain. This “deemed sale” would give the stock a new holding period and a new cost basis.
As an example, we will assume that Mr. Jones purchase 100 shares of XXX stock for $5 ($500) on July 1, 1998. On January 1, 2001, XXX stock has a fair market value of $11 ($1,100). If Mr. Jones makes a “deemed sale” election in his 2001 tax return, he will report a long-term capital gain of $600, and pay a capital gains tax of $120.
Mr. Jones will now have a new holding period in the stock that will be January 1, 2001, as well as a new basis ($1,100) for determining future gain or loss. If this stock is sold at a gain after January 1, 2006, Mr. Jones will pay the capital gains rate of 18% versus 20%.
Should you make this election on your 2001 tax return? There are a number of factors to consider before you make this election. Aside from the unknown question as to whether the stock will appreciate during the next 5years, a factor is the time value of money.
Suppose the stock increases to $21 over the next 5 years and is sold by Mr. Jones on January 15, 2006. Mr. Jones will report a long-term capital gain of $1,000 on his 2006 tax return and pay a capital gains tax of $180. In total, Mr. Jones paid a tax of $300 ($120 plus $180) on the gain. If Mr. Jones did not make the election, his tax in 2006 would be $320. Thus, the question is whether it is worth paying $120 in tax in 2001 on a stock that you did not actually sell, to save $20 in tax in 2006?
At first glance, this law appeared to offer the opportunity to make the “deemed sale’ election by “selling” stocks with losses, equal to stocks with gains, to create a “wash effect.” Unfortunately, the new law does not allow a “deemed sales” to generate a loss. Stocks sold at a deemed loss are treated as having a zero effect.
One ready conclusion to this confusing law is that all stocks in your portfolio that are in a loss position as of January 1, 2001 should be considered a candidate for the “deemed sale” election. While you would not obtain a current tax benefit by doing so, neither will you incur a tax cost. And you will obtain a new holding period for the stock (January 1, 2001), and if the stock does turn around and is sold at a gain after January 1, 2006, you will reap the benefit of the lower capital gain rate of 18%.
For stocks in your portfolio which are in a “gain” position as of January 1, 2001, you will need to consider several factors before you make the “deemed sale” election.
Automatic Extension of Time In Which to File A Tax Return
United States citizens and resident aliens residing outside the United States on April 15, 2002 receive an automatic extension of time until June 17, 2002 in which to file their 2001 US Federal individual income tax return. This automatic extension of time for filing the tax return did not extend the time for paying any tax due. Any tax due with your 2001 US Federal individual income tax return should have been paid by April 15, 2002, and your 2002 first quarter estimated tax payment should have been paid by April 15, 2002. Failure to have done so will result in interest and penalty being assessed of about 1% per month.
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