How Can You Take Advantage of the 0% Capital Gains Rate?

The capital gains rate for certain taxpayers will drop to 0% for tax years 2008 through 2010. How can you take advantage of this 0% capital gains rate?

First, let's review the capital gains rate in general.

Gains from sales of personal investments held for more than 12 months generally are taxed at the capital gains rate which is 5% or 15%. The 5% capital gains rate is available only to those whose ordinary income is taxed at 15% or less. The 15% capital gains rate will remain effective through 12/31/10 (barring any changes to the law prior to that time). The 5% capital gains rate will continue through 12/31/07; then the rate drops to 0% for tax years 2008 through 2010.

The 15% income tax brackets will be higher in 2008 as the IRS makes its annual adjustment for inflation, which will be announced later this year. However, to get an idea of who may qualify for the 15% and under brackets, currently in 2007 a married couple filing jointly must have taxable income (which remember is all of the taxpayer's income less their itemized deductions) of no more than $61,300; and for a taxpayer with a filing status as single, the cutoff is $30,650.

Next, let's review what is a capital gain.

The reduced rates for long-term capital gains generally apply to the "adjusted net capital gains", which include net long-term capital gains (the excess of long-term capital gains over long-term capital losses) less any net short-term capital loss (the excess of short-term capital losses over short-term capital gains). This excludes sales of collectibles (such as art work), qualified small business stock (also known as section 1202 stock), and unrecaptured 1250 gains (which result from the sale of depreciable real property). These gains also include qualified dividend income ("QDI"), dividends from domestic corporations that qualify for the 15% tax rate. For most taxpayers the adjusted net capital gains is merely the sum of net long-term capital gains from real estate, stocks, bonds, and mutual funds, plus any QDI.

Now, let's review how to determine which capital gains rate is used.

In order to find out which capital gains rate (5% or 15%) a taxpayer's gains are subject to, begin with taxable income and then subtract the capital gains received during the tax year. Subtract the difference from the maximum tax bracket amount (e.g., $61,300 or $30,650). The result is the amount of capital gains subject to the 5% rate (or 0% rate in 2008), with the remainder subject to the 15% rate.

Of course, if taxable income without capital gains is greater then the taxpayer's 15% ordinary tax bracket, then all of the capital gains are taxed at the 15% rate. Conversely, if taxable income including capital gains is less than or equal to the taxpayer's 15% ordinary tax bracket, then all of the capital gains are taxed at the 5% (or 0% in 2008) rate.

Let's take a look at a few examples of how the calculations work.

1. Suppose a taxpayer filing under the "married filing jointly" status has total ordinary income of $36,100 included in taxable income plus adjusted net capital gain income (ANCGI) of $25,000 for a total taxable income of $61,100. Since taxable income is less than the cutoff of $61,300 (see above), all of the ANCGI is taxed at the 5% rate for 2007, and would be taxed at 0% if they had this income in 2008, 2009 or 2010.

2. Suppose, instead, that the taxpayer filing under the " married filing jointly " status has total ordinary income of $65,000, and ANCGI of $35,000, for a total taxable income of $100,000. Since the ordinary portion of the taxable income is greater than the cutoff for the lower tax bracket, all of the ANCGI is taxed at the 15% rate.

3. Finally, let's say the taxpayer filing under the "married filing jointly" status has ordinary income of $43,100, and ANCGI of $60,000, for total taxable income of $103,100. Since ordinary income is less than the maximum taxed in the 15% regular tax bracket, part of the capital gains will be taxed at 5% (0% for 2008). The amount taxed in the lower bracket is $18,200 ($61,300 - 43,100). The remaining capital gains of $41,800 [$60,000 - 18,200] are taxed at the 15% rate.

Let's go over the cautions to consider in your planning.

Caution #1: The kiddie tax

When Congress first passed the bill to lower the capital gains rates, there was a huge loophole. Taxpayers could gift appreciated stocks and mutual funds to their teenage children, who are usually in a low tax bracket. Then the teenagers could sell the investments at the 0% rate in 2008 and pay no tax on the gains. Lawmakers took exception to this planning, noting that the intent of the bill was to allow retirees to pay a lower rate on investments they may need to cash out.

In response, Congress broadened the "kiddie tax", which kicks in when a child's investment income (such as interest and capital gains) exceeds a certain level. This investment income is then taxed at the parents' top marginal rate. Currently, that level is at $1,700, so any investment income received by children in excess of $1,700 is taxed at their parents' tax rate. In the past, the kiddie tax applied to children under the age of 14. It has now been raised to include those younger than 19 and up to 24 years old if the child is a full-time student.

Caution #2: AMT

Regardless of the potential benefits possible from the favorable capital gains rates, be aware that the Alternative Minimum Tax (AMT) may eliminate any potential benefit. As a taxpayer "cashes" out investments to take advantage of the favorable rates, the additional income, even if qualifying for lower tax rates, could push the taxpayer's overall income into a higher bracket, which could trigger the AMT and effectively negate the benefits of the lower capital gains rates. Seem complicated? It is. We strongly recommend you review all AMT and capital gains issues with your CPA/Tax Coach.

What are the planning opportunities? Who stands to benefit the most from the reduced capital gains tax rate?

Adults who provide financial support to their aging or retiring low-income parents. Gifting appreciated capital assets such as stocks or bonds instead of cash, can be a good way to provide them with extra income. Taxpayers can gift up to $12,000 a year per person with no gift-tax consequences. If married, a taxpayer and spouse may give up to $24,000.

Retirees with investment accounts. The capital gains breaks do not affect the withdrawals from tax-deferred retirement savings plans (i.e., IRA's). But if the taxpayer is retired (retiring) and owns stocks, bonds, or mutual funds, the 2008 tax year may be the time to sell.