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Fewer But More Complex Changes Await Taxpayers In 2001---Capital Gains, Foster Children Rules Will Raise Tax Filing
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Good news for the 2001 tax filing season: taxpayers will have to deal with only a few changes in the tax code. Now the bad news. Even though the changes are designed to help taxpayers, they will leave a large number of individuals scratching their heads in confusion. That's when a tax professional can help.
"Last year, filling out a Schedule D for capital gains and calculating the earned income credit were cited as the most complex issues by our 17 million U.S. tax clients," said Mark A. Ernst, president and chief executive officer of H&R Block. "Changes to both of those areas for the 2001 tax season will not only impact a large portion of taxpayers, but will again generate questions and confusion."
What's New With Capital Gains?
Courtesy of the Taxpayer Relief Act of '97, you will have to adjust to new long-term capital gains rates and holding periods that go into effect Jan. 1, 2001. Assets must be held for five years to qualify for the new capital gains rates of 8 percent (for gains otherwise taxed at 10 percent) or 18 percent (for gains otherwise taxed at 20 percent). Taxpayers can still hold a capital asset - such as a stock or mutual fund - for one year and one day to qualify for the previously existing capital gains rates of 10 percent or 20 percent, depending on their tax bracket.
"Congress developed the new rates and holding period as a way to encourage long-term investing," said Maggie Doedtman, EA, manager of tax training for H&R Block. "Essentially, all stock that you own as of January 1, 2001 can be considered newly bought and you can take advantage of the new, lower capital gains rates by not selling the stock before January 2, 2006."
To the extent that your capital gains would be taxed at 10 percent, you can qualify for the lower 8 percent capital gains rate immediately. However, this applies only to stock that was held for at least five years before it was sold.
Here's a tip when it comes to dealing with the new rates and holding period. If you're planning to hold on to a stock long term, and the Jan. 1 value is less than your basis OR if you have a good idea that the stock is going to have some solid gains, consider a deemed sale. A deemed sale lets you treat the asset as having been sold even though you haven't actually sold the stock.
For example, on Jan. 2, 2001, you elect to take a deemed sale of XYZ stock that you bought in December of 1995. Even though you didn't really sell the stock, you can report the gain from the deemed sale on your 2001 Schedule D. The advantages you get include:
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To the extent that your capital gains would otherwise be taxed at 10 percent, your gains will be taxed at the new 8 percent capital gains rate. Any remaining gain is taxed at the 20 percent capital gain rate. That means if the stock price continues to rise, you will have already paid taxes on some of the gain. You will also establish a new, higher basis in the stock that will help further reduce any future capital gains.
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If there is no gain (the fair market value on Jan. 1 is equal to or lower than your basis), there's no current tax to pay, but you establish your future eligibility to use the 18 percent bracket. Your basis stays the same.
The disadvantage is:
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You will pay tax on gain now rather than in the future, losing potential earnings on the money used to pay the tax. The loss of earnings should be compared to the potential savings from the lower tax rates.
It's probably a good idea to ask your tax professional or financial advisor for some help in deciding about this tax strategy.
New Foster Child Definition in Effect for 2000
Taxpayers who claim a foster child in order to qualify for the child tax credit or earned income credit need to be aware that Congress has changed how it defines a foster child for purposes of the credits.
In previous years, an individual could claim a foster child as a qualifying child for the earned income and child tax credits if the child was a member of his or her household for an entire tax year and the taxpayer treated the child as his or her own. The child did not need to be a relative. Starting with the 2000 tax year, a foster child is considered a qualifying child for the earned income credit and child tax credit only if the child:
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Is the taxpayer's brother, sister, stepbrother, stepsister or a descendent of any of these siblings;
OR
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Was placed in a taxpayer's home by an authorized agency.
Here's an example of how the new definition will impact taxpayers:
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Rick, Laura and Laura's 7-year-old daughter Beth have lived together since 1998.
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Rick and Laura are not married and Beth is not Rick's daughter.
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In both 1999 and 2000, Rick had more income than Laura.
Under the old definition, Beth was a qualifying child for both Rick and Laura. Because Rick had the higher income, only he was eligible to claim the earned income credit in 1999, not Laura. For the 2000 tax year, Beth now is a qualifying child for Laura only. That means Laura is now the only one eligible to claim the earned income credit, not Rick. This has the potential to increase Laura's refund and reduce Rick's refund by several thousand dollars.
"The new definition could create quite a bit of confusion among affected taxpayers," said Joe DiMatteo, a tax training specialist for H&R Block. "While it's good that the new definition will allow more blood relatives to qualify for the earned income credit, it's going to leave some taxpayers who provide the majority of a child's financial support unable to qualify for a credit they received in the past."
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