Tax relief may be on the way for many people on their biggest investment: their home.
But the outlook is much cloudier for stock and bond investors. Even if they finally succeed in their long quest for capital-gains tax relief, it may be significantly less than they had hoped. And they may be trading that relief for a significant new cost.
President Clinton’s budget, unveiled Feb. 6, includes a provision that essentially would eliminate capital gains taxes for 99 percent of Americans who sell their homes. The proposal would allow married couples filing jointly to sell their principal residence and keep a profit of as much as $500,000, tax-free. For singles, the limit would be $250,000. This exclusion generally could be used every two years.
Tax lawyers and congressional staffers agree that if any significant tax measures are enacted this year, this proposal, or something similar to it, almost surely will be included. “My guess is that you will get a capital-gains tax cut of some sort, certainly for home sales,” says Phillip L. Mann, a lawyer at Miller & Chevalier in Washington and chairman-elect of the American Bar Association tax section.
But betting on broad-based cuts in capital-gains rates could be hazardous to your wealth. While Congress appears enthusiastic, the big question is: Will Clinton agree?
Republican leaders vow to press forward on two fronts: cutting the capital-gains rate itself (the top rate now is 28 percent) for most investments and indexing gains for inflation. They also want to make the changes retroactive to the start of this year. But tax advisers speculate that Clinton won’t agree to make such sharp cuts–and that he may try to limit lower rates to profits on investments made after some future date, rather than on past investments.
Moreover, the president’s budget includes a little-noticed proposal that critics say would mean sharply higher capital-gains taxes, more paperwork and greater complexity for many investors. Here are details of the president’s proposals, who might be helped and hurt, and what actions lawyers and accountants are advising clients to consider during the confusing interim.
Clinton’s plan to eliminate capital-gains taxes for most homeowners enjoys bipartisan support. Not only would it simplify taxes and recordkeeping rules for many people, it also would cost the Treasury very little in lost revenue. That is because most people who sell their home at a profit take advantage of existing tax-law provisions enabling them to defer, reduce or even eliminate capital-gains taxes.
The new plan would be especially good news for people who sell a home that has risen sharply in value over the years and move into a less expensive home. Advocates of the plan point to people who need to move into cheaper quarters because of a job loss, retirement or divorce.
But the president’s proposal also could mean higher taxes for some wealthy people who own homes that have risen in value by more than $500,000. The Clinton plan would replace a current-law provision allowing owners to defer capital-gains taxes by buying a new home of equal or greater value within a specified time period. It also would replace a separate provision allowing a once-in-a-lifetime exclusion of as much as $125,000 in profits for homeowners age 55 or older.
The new exclusion would be effective for sales of homes occurring on or after Jan. 1 this year. For sales between Jan. 1 this year and the date of enactment, taxpayers could choose whether to apply the new exclusion or prior law.
Congressional Republican leaders want lower capital-gains tax rates on stocks, bonds and many other investments. They also want to “index” certain gains for inflation so you won’t owe taxes on profits that result purely from inflation. But you would have to hold such an investment at least three years. Critics reply that indexing might make sense intellectually but would be hopelessly complex for most taxpayers.
Buried in the president’s budget is a controversial proposal that would raise billions of dollars in revenue by requiring investors to use only one method of accounting for gains or losses. Here is an example of how it would work from Robert Willens, a managing director at Lehman Brothers Inc. in New York:
Suppose you bought 100 shares of a stock each year for three years in a row. You paid $58 a share for the first 100-share block, $61 a share for block two and $91 a share for block three. Now, you sell 100 shares at $120 a share. Which 100 shares did you sell? Under current law, you could pick the block that would result in the lowest tax bill. Using the last block, at $91 a share, you would have a $2,900 profit. Your tax, assuming the top 28 percent rate, would be only $812.
But if Clinton’s new proposal becomes law, you would be required to calculate the average cost of all of the shares of that stock you ever purchased, Willens says. That could be an enormous headache if you haven’t done a thorough job of recordkeeping, or if you are confused by how to adjust for stock dividends and splits, or if you received some shares long ago through gifts or bequests.
In this hypothetical case, the average cost of all of those shares works out to $70 a share. Thus, your gain would be $5,000. And the tax, at today’s top 28 percent rate would be $1,400, or 72 percent more than under today’s law, Willens says. Of course, if you sold all 300 shares, the tax would be the same as it is under current provisions.
What to do now? Because the outlook is so unclear, the answer for most investors is nothing. But there are at least two points worth considering:
– If you want to lock in your stock-market gains now and defer the transaction until later in the year when the legislative outlook is clearer, consider “selling short against the box,” advises Willens of Lehman Brothers. In a typical transaction, you call your broker, arrange to borrow shares of a stock you already own and sell those shares, rather than your own. That enables you to lock in any gains you already have while deferring taxes until you complete the transaction in the future by returning the borrowed shares. But don’t dally, because Clinton wants to kill this technique, warns Mark Luscombe, a lawyer and certified public accountant at CCH Inc., a tax information publishing company in Riverwoods, Ill.
– Homeowners who might want to sell but aren’t under any immediate pressure to do so probably should consider waiting awhile longer until a better picture of the bill’s outlook emerges, says Stephen Driesler of the National Association of Realtors. But if you have an eager buyer on the hook and delay might kill the deal or force you to lower your price significantly, it might be wiser to ignore tax issues and charge ahead with the sale. As Luscombe says, never let taxes be the sole factor in an investment.
