Tax relief that appeals to investors could soon be a thing of the past.
A series of sunset provisions scheduled to become effective in three years will bring higher tax rates for capital gains, dividends and estates as a result of tax laws passed in 2001 and 2003. That three-year window could slam shut a year or even two years earlier if a new president and Congress decide to make a mark before the sunset provisions kick in.
With that in mind, experts say it isn't too early to begin lining up strategies to help soften the blow. "It doesn't appear likely that anything definitive will happen before next year's elections," says George G. Jones, a tax attorney at CCH Wolters Kluwer in Washington, D.C. "But it seems fairly certain that taxpayers with long-term capital gains clearly won't benefit, at least in the short run. Allocating some gain recognition to pre-2011 recognition and some to post-2010 years is starting to make more sense if not now, then soon."
C onnie Brezik, a CPA at Asset Strategies in Scottsdale, Ariz., says she is carefully scrutinizing client situations involving highly appreciated stock, mutual funds and other assets. "If a client is on the fence about selling in the next few years, the ability to lock in favorable capital gains rates is certainly an important consideration," she says.
The 15% tax rate on most long-term capital gains and qualified dividend income is scheduled to remain effective through December 31, 2010. The 5% rate that applies to gains and dividends of individuals in the two lowest tax brackets remains in place through 2007, and drops to zero in 2008, 2009 and 2010. Beginning in 2011, capital gains rates are slated to return to their pre-2003 levels of 20% and 10%, respectively, while the tax on dividends is scheduled to revert to ordinary income rates. Meanwhile the estate tax, scheduled to disappear in 2010, will be reinstated in 2011 in the form that existed before the 2001 Tax Relief Act.
To put into perspective just how good a deal investors are getting right now, consider that Charlie Chaplin was an up-and-coming director the last time capital gains tax rates were any lower. Since then, they have bobbed around in every direction, reaching a maximum rate of nearly 50% in the late 1970s. Congress reduced the maximum rate to 28% in 1978, and before the Jobs and Growth Tax Relief Reconciliation Act of 2003 kicked in, it was 20%. The levy on qualified dividend income is an even better bargain than it was in previous years. Before 2003, dividends were taxed at ordinary income rates.
Even if the capital gains tax rate only rises to 20%, the additional tax bite over current levels could be significant for real estate or other long-held assets that have appreciated substantially. To complicate matters further, a post-2010 capital gains tax rate of only 20% is by no means assured. In July, Democratic presidential candidate John Edwards, perhaps seeking to counterbalance the flap over his $400 haircuts earlier in the year, with a nod to the common man, proposed raising the capital gains tax to 28% for families with incomes over $250,000, and beefing up tax benefits for lower- and middle-income families. Edwards' presidential chances seem slim, but other members of his party share similar views.
Look for salvos aimed at tax breaks that many perceive as benefiting the wealthy to become louder and more frequent. "Taxes are going to be a major issue in the 2008 campaign, and it's likely we'll hear a lot more talk about raising the tax rate on capital gains," says Michael Townsend, vice president for legislative and regulatory affairs at Charles Schwab & Co. "Generally, I expect that Republican candidates will be more outspoken about keeping the rates as low as possible, and advocating them as a way to stimulate the economy. Democrats may be more favorably inclined toward raising them and argue that they're a tax break for the wealthy."
He speculates that lawmakers will reach a compromise on the estate tax in 2009 or 2010 by providing for a $3 million to $4 million estate tax exemption and a lower tax rate for estates above the exemption amount.
Of course, much depends on who is in the driver's seat a year from now. Hillary Clinton has the best shot at the presidency among Democratic candidates, contends Greg Valliere, vice president and chief political strategist at the Stanford Group. "With the fallout from the war in Iraq and the uncertain economic outlook, the stars are aligning for a Democrat to take the White House," he argues. "If that happens, it is likely that there will be a major tax bill in 2009." At that point, changes could become effective at the beginning of 2010 or even become retroactive for 2009-well before the sunset provisions are scheduled to kick in.
Clinton would probably follow her husband's precedent by taking a moderate stance on economic issues to avoid spooking the financial markets, he believes. "That means capital gains rates might go back up to 20%, but not to ordinary income rates. I don't think she would bring the dividend tax back to ordinary income rates either, but it might settle somewhere in the mid-20s." Valliere thinks lawmakers will eventually peg the estate tax exemption at about $3 million to $4 million, with a maximum estate tax of around 30%. "The idea of abolishing the estate tax that was floated earlier in the decade is not going to happen," he predicts.
Accompanying the election tax talk is a growing sentiment at the Treasury Department that corporate tax rates should be lowered or even eliminated to help the United States become more competitive with other countries that have lower tax rates. "If corporate rates are lowered, the argument to lower taxes to shareholders, who are effectively owners of a public corporation, becomes less compelling," says CCH's Jones.
Still, voices advocating a continuation of favorable tax rates continue to be heard. In late August, a bill was introduced that would make permanent the provisions in the 2003 law that reduced capital gains and estate taxes. HR 3170 joined several other bills aimed at extending the tax cuts past 2010. For several months, Republican candidate and former Massachusetts governor Mitt Romney has been promoting a tax plan under which middle-class families-which he has controversially defined as those with adjusted gross incomes of $200,000 or less-would pay no taxes on income earned from savings, capital gains or dividends.
Regardless of the eventual outcome in Washington, the uncertainty over the future of a lower capital gains tax is prompting some financial advisors to rethink conventional end-of-year tax strategies. "For years, traditional wisdom when it comes to recognizing capital gains was defer, defer, defer," Brezik says. "No one can predict what Congress will do. But I do know that a 15% tax rate is a heck of a good deal."
With that in mind, she has altered her thinking about using Section 1031 of the Internal Revenue Code to defer taxes on appreciated property. "The problem is that you may be rolling an investment into something that you will have to sell at a higher tax rate a few years from now," she says. "Instead of using a 1031 exchange, we're telling people to sell the property, pay taxes at today's low rates and buy new property."
Jones says advisors may wish to review installment sales agreements that defer the recognition of capital gains proportionately to the year each payment is made. Those who entered into deferred payment sales extending beyond 2010 should consider the possibility of a higher tax rate for sales in those years. Home sales also require review, particularly for homeowners who may already be bumping up against the maximum $250,000 or $500,000 capital gain exclusion on the sale of a primary residence. Those making plans to sell have an added incentive of lower capital gains rates if they close before 2011, notes Jones in a recent report. Or they could take a chance by hoping Congress extends the lower capital gains rates or raises the home-sale exclusion amount.