Cutting Your Capital-Gains Tax Bill to Zero

A tax break that could benefit many investors is scheduled to arrive next January, and it's not too soon to start planning ahead.

At first glance, the provision appears relevant only to lower-income taxpayers: Beginning in 2008, the tax rate on long-term capital gains from sales of stocks, mutual funds and other securities is scheduled to drop to zero -- yes, zero -- for people in the two lowest ordinary income brackets. (For higher-income taxpayers, the top long-term capital-gains rate is scheduled to remain at 15%.)

But financial planners say many people with higher income also may be able to take advantage of the zero tax rate if they can reduce their taxable income through deductions, such as mortgage interest and charitable donations, or by socking away money in tax-advantaged accounts, such as 401(k) plans.

"A lot of middle-income people will qualify for this," says Tony DeChellis, senior manager of product development at Thomson Corp.'s PPC/Quickfinder, a Fort Worth, Texas, publisher of tax information.

Families in an upper tax bracket may benefit, too, by making gifts of stock, mutual-fund shares and other securities that have increased in value over the years to low-income family members, such as their young-adult kids, grandchildren or parents, who may then be able to turn around and sell the securities tax free next year.

But use caution: Such gifts may cause problems for students applying for college financial aid, or to seniors seeking Medicaid eligibility, including for nursing-home care. They could make a senior's Social Security benefits subject to tax, or increase the tax on those benefits. Also, because of the recently expanded reach of the so-called kiddie tax, investment income above $1,700 for a child younger than 18 typically is charged at the parents' higher tax rates. It's always smart to check with a financial adviser before making a large transfer of shares.

Nadine Gordon Lee, president of Prosper Advisors LLC, an Armonk, N.Y., wealth-management firm, says she is already planning to take advantage of the upcoming 0% rate. She and her husband have begun transferring shares of equity-based mutual funds, purchased at a lower cost, to one of their sons, now 16. The plan is that he will begin selling them in 2008, when he turns 18, Ms. Lee says. The Lees also are giving highly appreciated stock to their other son, who is 19, and those shares are being sold this year at the current capital-gains-tax rate of 5% for lower-income brackets.

Giving appreciated stock "works nicely for funding the lifestyle of your college and graduate students who are not eligible for financial aid," Ms. Lee says.

Before making any such gifts, be sure to check with a tax adviser on any possible gift-tax or estate-tax consequences, or other possible hitches, Ms. Lee says. However, a gift of this type may be an efficient way to use the annual gift-tax exclusion, she says. That means you can give away as much as $12,000 this year to anyone else -- and to as many other people as you wish -- without any federal gift-tax consequences. (Gifts that exceed that amount typically must be reported to the Internal Revenue Service. Generally, there's a lifetime gift-tax exclusion of $1 million per donor. Gifts above that limit typically are subject to gift tax, and the top rate now is 45%. Gifts don't count as taxable income to the recipient. They also aren't deductible on the giver's income tax returns.)

Investors should never sell securities solely because of tax considerations. But if you're thinking of selling anyway, understanding the tax considerations can help you and your family keep more of the gains.

The 0% rate for lower-income taxpayers was part of the 2003 tax act passed by Congress that, among other things, set the maximum long-term capital-gains rate at 15%. But these rates are set to expire after 2010 unless Congress extends them. Many members of Congress are concerned that an extension could exacerbate the budget deficit.

How low must someone's income be to qualify for the 0% capital-gains-tax rate? Nobody knows for sure because income brackets are adjusted annually for inflation, and the IRS won't release the numbers for 2008 until late this year. But for 2007, a single person falls into the 15% bracket with taxable income of not more than $31,850. For joint filers, this figure is $63,700.

A few pointers: Favorable capital-gains rates apply only to "long-term" gains, or gains on shares held for more than a year. Short-term gains (on shares held a year or less) typically are taxed at regular federal income-tax rates, which can be as high as 35%. What's more, the low capital-gains-tax rates apply only to shares in taxable accounts. They also don't apply to sales of appreciated art and other collectibles; there, the top capital-gains rate typically is 28%.

If you do decide to sell, make sure to unload the shares that will result in the best tax result. This can get tricky. For example, suppose you own 300 shares of a stock purchased many years ago. You bought 100 shares at $5 a share, another 100 shares at $10, and another 100 shares at $50. Now you decide to sell 100 shares. Unless you specify otherwise, the shares of a stock that you bought first are considered to be the ones sold first. If you prefer to sell more-recent shares, make sure to notify your broker at the time of sale and get a confirmation. With mutual funds, you can use the average cost of the shares purchased. There are two averaging methods. See IRS Publication 564 for details.

If you still have confidence in your investment, but you want to take advantage of the zero rate next year, here's a strategy to consider: Sell some of the investment at a gain in 2008, and then immediately buy back shares of the same investment. That means you can still enjoy that zero rate, maintain your position in the security but have a higher basis when you eventually sell the new shares. (The strategy doesn't run afoul of so-called wash-sale rules, because these only apply when selling an investment at a loss, not for gains.)

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THE IRS OPENS its doors to electronic filing this year -- for most people.

Opening day for e-filing your federal income-tax return for 2006 generally was this past Friday, the IRS said. But you can't e-file until Feb. 3 if you're claiming key tax provisions enacted last month. Both e-filed returns and paper returns claiming these provisions -- deductions for state and local sales taxes, higher education tuition and fees, and educator expenses for classroom supplies -- won't be processed if submitted before Feb. 3.

Tax returns filed on paper will be accepted but won't be processed until after IRS systems are updated Feb. 3, the IRS said.

IRS officials strongly urge taxpayers to file electronically. E-filing is "the fastest, safest and most accurate way" to file, said IRS Commissioner Mark W. Everson. He said people will get their refunds more quickly that way than filing the old-fashioned paper way. E-filing also "greatly reduces the chances for making an error."

Last year the IRS received more than 73 million returns electronically, up 7% from the prior year. A spokesman said almost 54% of all returns were filed electronically.