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Reducing the Tax Bill on Capital Gains

Do you own stocks or other securities? When you sell securities, you must report the resulting capital gain or loss on your personal tax return. Don't capital gains and losses simply cancel each other out? Actually, it's more complicated than that.

In fact, even experienced investors are often perplexed by these tax rules. Furthermore, you should be aware of a significant tax break looming on the horizon.

For simplicity, we will limit this discussion to capital gains and losses arising from sales of securities, assuming you have no other capital asset transactions. (Other special rules apply to sales of collectibles and property that are subject to depreciation recapture.)

Starting point: There are different rules for long-term gains and losses versus short-term gains and losses. A gain or loss is long-term if you have held the security for more than one year before the sale occurs. For example, if you bought stock on August 1, 2006, and sell it at a profit on July 31, 2007, the gain is treated as a short-term gain. However, holding the stock for just two more days--until August 2--qualifies the transaction as a favorable long-term capital gain.

To net your gains and losses, first put your long-term gains and long-term losses in one basket. This gives you either a net long-term gain or a net long-term loss. Next, put your short-term gains and

short-term losses in another basket. This results in either a net short-term gain or a net short-term loss. Finally, combine the net long-term gain or loss with the net short-term gain or loss to arrive at an overall net capital gain or loss.

If your capital gains for 2007 exceed your capital losses, any net long-term gain is taxed at a maximum tax rate of 15%. For a taxpayer in one of the two lowest regular tax brackets--either the 10% or 15% tax bracket--the maximum tax rate on long-term capital gain is only 5%.

Future tax break: The long-term capital gains rate is zero percent for lower-income taxpayers in 2008. This tax break was recently extended through 2010 by the Tax Increase Prevention and Reconciliation Act (TIPRA). However, as of this writing, Congress is debating legislation that would bar the zero percent tax rate for certain dependents.

Conversely, if your capital losses exceed your gains, the net loss can be used to offset up to $3,000 of ordinary income such as salary. Any excess is carried over to future years.

Once you understand the netting rules, analyze your current tax situation and act accordingly. For example:

*If you are currently showing a net loss, you can realize capital gains before the end of the year. The capital gains are effectively tax-free up to the amount of your losses.

*If you are currently showing a net gain, you can realize capital losses before the end of the year. The losses effectively absorb the tax you would have had to pay on the gains. If the situation dictates it, you can realize an excess loss that may be used to offset up to $3,000 of ordinary income.

Consider all the aspects, both tax and nontax, in your investment decisions.

Update: New federal tax legislation raises the threshold for the "kiddie tax" from age 18 to age 19 (or under age 24 for full-time students). The change applies to children whose earned income does not exceed one-half of their support. This provision could adversely affect effective tax rates on capital gains.

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