Zero Percent Net Capital Gains Tax Rate Becomes Effective For 2008

By Patrick J. Lavoie, CPA

For tax years beginning after 2007, the Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the 5% tax rate on adjusted net capital gains to 0% for those taxpayers who are in the 10% or 15% ordinary income tax bracket.  Taking advantage of the lower rates will take some planning that should be considered early in the tax year. 

Which taxpayers can most benefit from this tax rate change?

Taxpayers who fall into the 15% or lower ordinary income tax bracket for 2008 which include married filing joint taxpayers with taxable income up to $65,100 and single taxpayers with taxable income up to $32,550, may be able to take advantage of this rate change if conditions are right.

Parent to child gifting of appreciated securities.  As this tax rate drop was looming, it was widely considered a good strategy by tax planners for parents to gift appreciated stock or securities to their young-adult children aged over 18 who could then sell the stock or securities tax free (up to the 15% bracket limit amounts).  Congress, however, recently closed this perceived loop-hole by expanding the so-called "kiddie tax rules" to include dependent children aged 19 to 23 with one living parent and who do not file a joint tax return for the year.  These expanded kiddie tax rules capture the children's income at the parent's presumably higher rate.  This gifting strategy may still possibly work if the child who receives the gifted stock or securities is a recent graduate, not a dependent (i.e., receiving half of their support from their parents during the tax year), and finds themselves in the 15 or 10% tax brackets (i.e., less than $32,550 if single or $65,100 if married filing a joint return).

Child to parent gifting of appreciated securities.  Likewise, the reverse of the traditional gifting model can also work where adult children are supporting their parents or other family members (siblings, etc.) and gift appreciated securities to them.  The parents, who oftentimes are only receiving social security benefits and/or small amounts of retirement income either through a pension or IRA, will be the low bracket taxpayer and can benefit from the 0% net capital gain tax rate.  In this example, the parents sell the appreciated stock at a gain and pay no tax on those gains up to the tax bracket limit ($32,550 if parents are single, $65,100 if married filing a joint return).

Taxpayer retirees who have taxable accounts and retirement accounts.  Recent retirees who can afford to live off the proceeds from gains realized in taxable accounts while deferring the receipt of retirement income (except to the extent of the required minimum distribution) and who can delay the receipt of social security income should be able to benefit from this 0% rate.

Taxpayers with substantial tax-exempt income.  Taxpayers who invest substantially in tax-exempt securities and can afford to live off this income while deferring or decreasing the receipt of ordinary taxable income from other sources (wages, retirement income, social security, etc.) should be able to benefit from this 0% rate.

U.S. Service members deployed to combat zones.  Combat zone troops may also have a 0% rate. Troops with rankings up to non commissioned officer may receive non taxable income from serving in a combat zone, serving in qualified hazardous duty areas, or recovering in the hospital due to having received wounds in such places.  Married members filing joint returns whose spouses stay in the United States, who remain in the lower tax brackets, and have capital gain property from which they can realize net capital gains (or whose parents can gift appreciated gain property to them during this time) should benefit from the 0% tax rate.

Interplay of tax rates, taxable income, net capital gains and how the benefit of the zero rate is realized.

Taxpayers who fit into any of the situations above should keep the following important facts in mind.  First, to the extent the taxpayer has other ordinary type income (such as wages, interest, retirement income, etc.), this ordinary income amount is taxed first at ordinary income tax rates.  Second, the net capital gain is then taxed at zero percent up to the maximum 15% bracket amount ($65,100 for married joint, $32,550 single).  Finally, any remaining net capital gain is taxed at the 15% capital gain rate.  Thus, a married joint filing taxpayer who has $125,000 of 2008 taxable income which consists of $25,000 of ordinary type income and $100,000 of net capital gain would be taxed on this income as follows:

1.)        $25,000 is taxed at ordinary income tax rates = $2,948.

2.)        $40,100 is taxed at the net capital gain rate of 0% = $0.

3.)        $59,900 is taxed at the net capital gain rate of 15% = $8,985.

4.)        Total tax = $11,933.

As one can see from this example, it is not the entire net capital gain that will be taxable at the zero percent rate, but only the amount by which the taxpayer's maximum 15% bracket limit ($65,100 for married joint, $32,550 single) exceeds the income taxed at ordinary income tax rates.  In the example above, this number is $40,100 ($65,100 less $25,000 of taxable ordinary income).

Further example of interplay of the various tax rates.  Assume John and Mary Jones (aged 75 and 74 respectively) are the parents of Roger Jones, a very successful stock broker, who supports his parents in their advanced age.  The Jones have very limited income resources and they receive taxable retirement income of $45,000 and $1,500 of interest from savings accounts.  Son Roger makes a gift to them of appreciated stock worth $100,000 (no cost basis) on February 2, 2008.  The following chart reflects how the tax is calculated when the Jones recognize no gain, recognize maximum amount of the gain to assure no additional tax under the zero percent tax rate, and recognize the full gain:

In the above example, when the Jones only sell a portion of the $100,000 of capital gain property in 2008 that assures no additional tax (the "Breakeven Gain" column), the tax savings when compared to the 15% tax their son Roger would have paid on the same gain is $5,790 (or $38,600 X 15%).  If the Jones do not need the additional cash ($61,400) to support themselves in 2008, they could optimize the tax savings on the full $100,000 gain by deferring a part of the gain to 2009 and 2010 (assuming their other ordinary income is going to be roughly the same as in 2008 and the stock's fair market value does not decrease).

Social Security income.  We caution taxpayers who are receiving social security income that employing this strategy will have diminishing tax benefits.  The amount of social security income required to be included in the taxpayer's taxable income is a function of their adjusted gross income, which includes the amount of the net capital gain.  Thus, the higher the gain, the higher the percentage (up to 85%) of social security income that is required to be taxed.  This causes a ripple effect that sees the percentage of ordinary income taxed first rise as the taxpayer's adjusted gross income rises (which increases by the total net capital gain realized).  The net effect is that, although not completely eliminated, the percentage of net capital gain taxed at the zero tax rate decreases as social security income is required to be included in taxable income.

Reminder on Sunset provision.  The reduction to 0% of the 5% net capital gains tax rate will not apply to tax years beginning after December 31, 2010.  Instead, these provisions "sunset" and after this date, the Code will be applied and administered in future years as if those provisions had never been enacted.  Thus, the 0% capital gains tax rate applies only to tax years beginning during 2008, 2009, and 2010 unless Congress makes these changes permanent or legislates them away.

If you would like to discuss this subject further, please contact Patrick Lavoie (plavoie@pmn.com) or any member of our tax service team at (617) 426-9440.

Note: This article represents a general overview of or opinion on certain tax issues or developments and should not be relied upon without an independent, professional analysis of how any of these provisions may apply to a specific situation.  We recommend you consult your professional tax advisor before taking any action based on anything in this article.

IRS CIRCULAR 230 NOTICE:  In compliance with U.S. Treasury Circular 230 Regulations and any applicable state laws, we hereby notify you that any tax advice contained in the body of this document, or attachments thereto, was not intended or written to be used, and cannot be used, by the recipient or any other party for the purpose of  (1) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions, or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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