Taxpayers Prep for Capital Gains Changes

NEW YORK — Now here's something with a nice ring to it: Zero percent tax on capital gains. Folks are already planning how to profit when the tax is eliminated for some taxpayers next year, and wealthy people with kids are in the vanguard.

The capital gains tax rate drops from its current 5 percent to zero for those in the lowest income-tax brackets from 2008 to 2010. Congress enacted the change in the Jobs and Growth Tax Relief and Reconciliation Act of 2003.

It's not quite the bonanza it sounds, though, because changes in the "kiddie tax" cut sharply reduce the ranks of those who will qualify to get the zero percent rate. Any strategy must take into account the new, expanded kiddie tax.

Among those best positioned to profit are taxpayers with young adult children out of college but not yet pulling down a big salary. A pretty substantial tax benefit may be in the offing for those who give appreciated stock to these adult children to sell free of capital gains tax. A parent may transfer $12,000 to a child (a couple may give $24,000) without paying gift tax. No capital gains tax is owed if the child's income rate is below the top of the 15 percent bracket.

Indeed, capital gains strategies have long involved shifting investments to a child to get the lower gains rate. Changes this year and last in the kiddie tax have meant that fewer children qualify, and that those who do are older.

"The new kiddie tax rules were put in place to keep parents from using their kids as a capital gains tax shelter," said Len Burman, director of the Tax Policy Center, a joint project of the Urban Institute and the Brookings Institution.

The kiddie tax is a set of rules that taxes a child's investment income over a certain threshold — $1,700 in 2007 — at the parents' income tax rate. Its reach widens starting in 2008 to include those under 18, dependent children who turn 18 and dependent full-time students ages 19 through 23. For years, only children under 14 were subject to the kiddie tax.

It isn't a shoo-in that shifting investments to an older child is the best way to go. Each case must be considered individually because everyone's circumstances are different.

"We try to look for situations with our clients where it might apply, where we know they have kids over 18," said James Covell, senior vice president, financial consultant for RBC Dain Rauscher, a unit of Royal Bank of Canada. "Then, it's a question of ascertaining whether these kids are full-time students or not, and earning a lot of money or not."

Take the case of David Shechtman, a tax attorney who has been thinking about how to get the most out of the new capital gains rate by giving stocks to his daughters, Lisa, 25, and Abby, 23.

Lisa is a graduate student at the University of Hawaii in Honolulu. As a full-time student, she will have hardly any income for 2007. In 2008, though, she will have a full-time teaching position and her income should be above the cutoff for the 15 percent income tax bracket — which will be $32,550 in 2008 for single filers.

Lisa turned 25 this year, so she is exempt from the current kiddie tax and the version that goes into place in 2008. So, Shechtman figures it makes the most sense to give Lisa appreciated stock in 2007 when her income is below the 15 percent bracket when she can get the 5 percent capital gain rate.

Abby may be a different story. Shechtman, chairman of the tax section at Drinker Biddle & Reath LLP in Philadelphia, is already thinking he may be able to take advantage of the zero percent rate by giving her stock in 2009.

Abby has worked the past two years as a paralegal in Manhattan and plans to attend law school full time starting next fall. She is exempt from the kiddie tax this year and next, but her income will be too high in both years to save any taxes on a sale of appreciated stock.

In 2009, though, depending on how much she earns as a summer law clerk, she probably will be eligible for the zero percent rate.

"A gift that year might be a great strategy," Shechtman said, "assuming the zero percent rate for low earners remains the law and we still have highly appreciated stock for Abby equivalent to what I plan to do for Lisa in 2007."

A final caveat for anyone contemplating giving a lot of stock to a child: Think about whether the child is responsible and what might become of the money after he or she sells the investments.

Taxpayers frustrated with the ins and outs of all this can blame Congress. Its zigzag approach to capital gains and the kiddie tax has created many wrinkles.

"As for the change in course, sometimes Congress figures out that it has gone too far," said Burman. "I think the zero percent rate is kind of goofy. The purpose, I think, was to get a zero percent rate in the code. There are those in Congress who think that rate should apply to all capital gains."

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