Tax Reform '97: Relief for Investors, Families Through Life's Stages

The following is the first part of a two-part article, reprinted from A.G. Edwards' Tax Saver, a special guide to the new tax law.

The Taxpayer Relief Act of 1997 provides investors valuable tax breaks and introduces new ways to save for the future. But getting the greatest benefit from these opportunities will require careful planning for investment decisions today and in the future. This article offers ideas to help you get started.

Tax Reform '97: Relief for Investors, Families Through Life's Stages

Investors and families are winners under the new Taxpayer Relief Act of 1997, which President Clinton signed into law Aug. 5, 1997. The much-anticipated legislation, which some call a "landmark" compromise between the Clinton administration and congressional Democrats and Republicans, proposes to eliminate the nation's deficit for the first time in at least three decades and provide long-overdue relief to taxpayers. The centerpiece of the reform package--a net $94 billion tax cut over the next five years--delivers the first substantial tax breaks American taxpayers have seen in 16 years.

Although the tax bills endured months of debate and trade-offs from Congress and the White House, the resulting legislation reflects a fundamental goal embraced by lawmakers from all sides: to provide tax relief to families, investors and others through many of life's stages. The new law provides significant tax cuts for investors and offers new incentives for saving for college, retirement and other future needs. It eases the tax burden for taxpayers with children as well as for individuals paying for college. And it can help families pass on to future generations more of the wealth they've built throughout their lifetime.

Of course, the legislation also includes measures to raise revenue, including a tobacco tax increase from 24 cents in the year 2000 to 39 cents after 2001. It also imposes new $12 arrival and departure fees for international airline travel.

As with all newly enacted legislation, details will be slow to surface and interpretations may vary. You'll want to check with your tax advisor or investment professional during the next few months to discern the implications of this complex legislation.

Nonetheless, given the wide scope of the reform package, like many investors, you may be wondering, "How does the new law affect me?" Here's a look at some of the key provisions of the new tax law as we know them now and their implications for investors.

Capital Gains Tax Cuts

For many taxpayers, the new law reduces the top tax rate for capital gains (i.e., profits from the sale of securities or other assets) from 28 percent to 20 percent. It also extends the holding period to qualify for long-term capital gains from one year to 18 months and creates a new mid-term capital gains tax rate of 28 percent for assets held more than one year, but not more than 18 months. The lower 20 percent capital gains tax rate provides investors in the 31 percent, 36 percent and 39.6 percent marginal tax brackets even greater capital gains tax savings than before, and it provides investors in the 28 percent marginal tax bracket a tax break that they have not enjoyed for many years. The new law also gives taxpayers in the 15 percent marginal tax bracket a special capital gains tax rate of 10 percent for assets held for 18 months or longer.


  • Capital gains tax rate cut to 20 percent or lower, depending on holding period and tax bracket.

  • Short-against-the-box strategy retained, but limited in duration.
  • Tax credits for children and for higher-education expenses introduced.
  • Tax-advantaged education savings accounts created.
  • Features and accessibility of regular IRAs expanded.
  • New Roth IRA Plus created.
  • Fifteen percent excise tax repealed for both annual and death distributions.
  • Equivalent exemption for estates increased from $600,000 to $1 million over 10 years.
  • Annual gift exclusion limit indexed for inflation in $1,100 increments.
  • Limited estate tax relief for qualifying family farms and small businesses.

The new rates are generally effective for sales after May 6, 1997, and apply to net long-term capital gains reported by individuals, estates and trusts, although some transition rules apply. The taxation of short-term capital gains (i.e. profits from sale of assets held for one year or less) will not change. Short-term capital gains will continue to be taxed at ordinary income tax rates.

The table on page 62 provides details on these provisions. In general, five different rates may apply, depending on the taxpayer's marginal tax bracket, how long the investment was held and when it was sold.

Effective in 2001, an 18 percent capital gains tax rate will apply to investments purchased after 2000 and held for more than five years. To receive the benefit of the lower rate for assets purchased before 2001, an investor may elect to treat such securities as if they were sold on Jan. 12, 2001, and purchased the following day. This "mark-to-market" gain is taxed at the applicable capital gains tax rate, but all future appreciation will be taxed when the assets are sold at the 18 percent capital gains tax rate (or 8 percent for taxpayers in the 15 percent marginal tax bracket), provided the assets are held for at least five more years.

A New Wrinkle to "Short-Against-the-Box" Strategy. As a short-term tax-deferral and hedging strategy, selling "short-against-the-box" survived the tax law changes--but with limitations. When selling short-against-the-box, you borrow shares of a security you want to sell while keeping the shares you already own. (You are then both "long" and "short" in the position.) By doing so, you can lock in capital gains but defer recognizing the gains for tax purposes until you "close" the short position in the future. Previously, you could remain in this short-against-the-box position indefinitely.

The new law requires that you close the short position by Jan. 30 of the calendar year, following the year in which you entered the transaction. You can close the short position either by delivering the shares of the security you already own or buying additional shares in the open market. The new legislation further requires that you remain "at risk" on that particular security for a 60-day period following the date you close the short position. After this 60-day period, you can enter into another short-against-the-box sale on the same security if that strategy meets your investment objectives.

Assume, for example, you enter into a short-against-the-box position for ABC security on Oct. 1, 1997. You are now required to close the position no later than Jan. 30, 1998. After you close the position on Jan. 30, 1998, you may not enter into another short-against-the-box transaction for ABC security for the next 60 days. Thus you could again enter into a short-against-the-box position for ABC security on April 1, 1998. That short position could remain open until Jan. 30, 1999, when the position must then be closed.

Short-against-the-box positions currently open may be grandfathered, although the details are sketchy at this time. Talk with your tax advisor about your particular situation.

Exclusion for Profits From Home Sales. The new tax law provides home sellers valuable additional capital gains tax relief. For home sales after May 6, 1997, married couples filing joint returns can exclude for tax up to $500,000 in profits from the sale of their principal residence (single taxpayers can exclude up to $250,000). For the vast majority of homeowners, this exclusion will mean tax-free profits on home sales, as they will no longer be required to purchase another home of at least equal value to avoid taxes.

Moreover, as long as the taxpayers have occupied a home as their primary residence for at least two years, they could use this exclusion each time they sell their home. This provision replaces the once-in-a-lifetime exclusion previously available only to home sellers aged 55 or older as well as the capital gains rollover provision previously available to those purchasing a replacement home.

Therefore, under the new law, taxpayers will no longer be able to defer capital gains taxes on profits from the sale of a principal residence that exceed the new exclusion limits, even if they are buying a home of equal or greater value.

Investment Strategy. As an investor, you could enjoy substantial savings from the new capital gains tax rates, regardless of your tax bracket. And if you're like many investors with gains in your portfolio from the long-term bull market, the rate cut is welcome news.

Realize, however, that tax consequences, although a consideration, should not be the sole basis for your investment decisions. First, look at the investment's underlying fundamentals and your investment goals. If your holdings are still in line with your needs, selling based solely on the new capital gains tax rates probably does not make sense.

If, on the other hand, your stock reaches your target price and you decide it's best to reposition those assets, the lower capital gains tax rate you'll pay is certainly a bonus. Remember, however, you will still lose up to one-fifth of your profits to taxes, despite the rate cut.

In addition, to take full advantage of the lower capital gains tax rates, you might consider adding to your portfolio more growth investments that pay little or no dividends (that is, if you don't need current income from your investments). Remember, dividends and short-term gains are taxed at higher ordinary income rates. Or, if your investments warrant, extend your investment holding period on existing investments to longer than 18 months to capture the new 20 percent (or lower) long-term capital gains tax rate.

If you plan to sell short-against-the-box as a way to defer recognizing capital gains from one year to the next, you still can. As long as you deliver the shares you already own to close your position by the following Jan. 30, you will have deferred your gain.

New Tax Credit for Children

In 1998, individuals whose adjusted gross income (AGI) does not exceed $75,000 and married couples whose AGI does not exceed $110,000 will be eligible for a tax credit of $400 for each dependent child younger than age 17. The tax credit will be reduced by $50 for each $1,000 by which the taxpayer's modified AGI exceeds the $75,000 (for individuals) and $110,000 (for married couples) thresholds. This tax credit increases to $500 per child beginning in 1999.

Investment Strategy. The new child tax credit gives many families the opportunity to hold onto money they would otherwise pay the IRS in taxes each year. Remember, tax credits, unlike tax deductions, offset your tax liability dollar for dollar. That is, you deduct your tax credits after you calculate your tax bill, whereas deductions serve to reduce your taxable income. If you're in the 28 percent tax bracket, for example, it takes a $5,357 deduction to reduce your tax bill by $1,500.

If you qualify for this new tax credit, the credit represents extra money available for investment or other uses. For instance, you might earmark this amount for college expenses. (See the second part of this article next month for a discussion about new tax-favored education investment accounts.) Or if you have not already contributed the maximum $2,000 per year, you could make an additional contribution to your regular individual retirement account (IRA) or another retirement savings vehicle. Regardless, your best strategy is to put this "found money" to work toward your future goals.

A.G. Edwards is a St. Louis-based investment firm. For more information on A.G. Edwards, contact Justin Gioia at 1 North Jefferson, St. Louis, MO 63103; phone (314) 955-3235; Web:

Editor's Note: This information is based on reliable sources; however, the accuracy of the information is not guaranteed. Specific tax questions should be directed to your tax advisor.

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