Capital Gains Tax - Basic Concepts

CAPITAL GAINS TAX: BASIC CONCEPTS

You must be cognizant of several taxes and should be familiar with means of avoiding them. Planners often confuse the application of federal, state and local death taxes, Generation Skipping Transfer Tax, income tax, property tax and capital gains tax. CapGains tax is levied by the federal government and by many state governments.

The capital gains tax is actually an income tax applied to capital gains ... or, income tax on the gain.

The 1997 tax law made substantial changes in Federal capital gains taxes. The law was intended to lower the capital gains tax rates. But it did not totally succeed. Forbes Magazine, on August 25, 1997, said that there are now seven capital gains tax rates. Of course, it is not easy for a layman to apply the law to different gains. Taxpayers need now, more than ever, to depend on their CPA or other tax advisor to help them sort out the applicable tax rate.

A key issue in calculating this tax is a value known as "basis." Basis is, with some minor exceptions, broadly defined as "What you paid for the asset."

If you bought a stock for $100 in 1975 and its value increased at 7.2% per year for 20 years, it would have been worth $400 by 1995 ... and you would have, in 1995, an unrealized capital gain. If you sold at the $400 figure, you would have realized a capital gain of $300 ... and that gain would have been subject to the tax. Remember, as long as you didn't sell, you have not realized a capital gain ... and, hence, you have not experienced a taxable event.

If, instead of selling, you gave the stock to your cousin and he, immediately, sold it, the tax would be the same because your basis carried over to him. This is called "carry-over" basis ... and is the operative concept when making gifts.

If, on the other hand, you died and left the stock to your cousin who immediately sold it, the basis is different. In the case of transfers at death, the basis is "stepped up" to the fair market value at time of death. So, if you paid $100 and died and left it to cousin when it was worth $400, his basis is stepped up to the $400 figure. If he sells the next day for that price, he pays no capital gains tax because his basis and his selling price is the same. He has not realized a capital gain.

But be careful that you do not overvalue this "step up" in basis. Some planners very adroitly avoid the 35% capital gains tax only to pay 55% estate tax on the same asset.

One outstanding means of avoiding capital gains tax is to use a Charitable Remainder Trust. This trust avoids the tax and provides income to the donor or donors for life and benefits
"The Foundation" at the death of the last donor.