NEW CAPITAL GAINS TAX RULES GO INTO EFFECT SOON

Now that you've had time to become familiar with the capital gains rules passed by Congress as part of the 1997 Taxpayer Relief Act, it's time to learn some new capital gains rules that could save you money. These rules were passed as part of that 1997 Act, but many taxpayers have forgotten about them because they don't go into effect until January 1, 2001.

As you well know, the 1997 tax act cut the capital gains tax rate on most types of assets held for over 12 months. The rate was cut from 28 percent to 20 percent for taxpayers whose ordinary income puts them in the 28 percent or higher income tax brackets, and from 15 percent to 10 percent for taxpayers in the 15 percent bracket.

Beginning in 2001, gains on assets sold by investors in the 15 percent tax bracket will be taxed at 8 percent instead of 10 percent if they held the assets more than five years. Consequently, some investors in this bracket sitting on unrealized gains from assets they've had for around five years or more may find it advantageous from a tax standpoint to sit on those gains a little longer to take advantage of the lower rate in 2001.

There is one potential complication that you'll want to talk to your tax advisor about. Realizing a large amount of capital gains could push you into the next higher tax bracket. In that case, part of the gains will fall under the 8 percent rate, and part will be subject to the 20 percent rate.

A caution, too, about delaying the sale of assets. First, you may find it more beneficial from a tax standpoint to sell the asset this year. Perhaps you've got some excess investment losses you want to offset with gains. Second, you may feel from an investment perspective that it's time to sell the asset now. It could always drop more in value between now and next year, or between now and the time it reaches the five-year holding period, than you would save in taxes at the lower capital gains rate. Don't let the tax tail wag your investments.

Higher-income investors have a more complicated, less beneficial situation. The top rates will drop from 20 percent to 18 percent on property held over five years-but for the property to qualify it must have been purchased no earlier than 2001. Thus, property you're already holding-even if you've held it for many years-doesn't qualify, with one exception that we'll explain in a moment. Also, you obviously won't benefit from the lower rates until 2006.

Nonetheless, there are some strategies you can implement now or soon to help out this situation. The most obvious strategy is to wait until next year before buying something you've had your eye on-a particular stock, perhaps, or a vacation home-that you intend to hold at least five years.

A second strategy is trickier. Tax rules beginning in 2001 for taxpayers in the 28 percent or higher brackets allow an option called the "deemed sale and repurchase election." In essence, you pretend that you sold and repurchased the same asset on the same day-as early as January 2, 2001, if you like. Since you didn't really sell it, you don't pay transactions and commission costs. However, you will pay capital gains taxes on this phantom sale, at your 20 percent rate, unless you're able to offset the gains with other investment losses.

The phantom sale starts the five-year clock ticking, and any future realized gains after five years will be taxed at the lower 18 percent. That's the catch, of course-that you're confident the asset will gain substantially in value in the next five years. If it loses money, you'll have paid capital gains on what is, in fact, a capital loss. Even if the asset doesn't lose money, you've got to take into account the time value of money on the capital gains taxes you've paid five years in advance. Plus, you've got to come up with the cash to pay the taxes incurred now. That's why property with a low basis that you are confident will appreciate substantially the next five years generally makes the best candidate for this strategy.