By
Marguerite R. Hutton, PhD, CPA
Associate Professor of Accounting
Faculty Advisor, Theta Phi Chapter
Western Washington University
Massive changes to the U. S. tax laws were enacted in August 1997. Almost 300 new sections were added to the Internal Revenue Code, and amendments were made to more than 800 existing Code sections. Some of these changes have retroactive effective dates, others are effective as of August 1997, January 1998, or even as late as 2003.
This article focuses on two tax law changes that have a strong effect on the 1997 tax year - capital gains and sale of residence. The intent is to provide a broad overview of those new provisions. Since there are many areas of the new tax law changes not covered in this article, links to other discussions and summaries of the Taxpayer Relief Act of 1997 are also provided.
Capital Gains and Losses of Individuals
Prior treatment of capital gains
Before May 7, 1997, the only special treatment available for long term capital gains was a maximum tax rate of 28 percent. This meant that the only individuals who received a "tax break" on long term capital gains were those persons who were in a higher tax bracket than 28 percent. Congress, in the Taxpayer Relief Act of 1997, extended beneficial tax treatment for long term capital gains to all individual taxpayers.
New treatment of capital gains
For sales and exchanges of capital assets, tax rates as low as 20 percent (10 percent for individuals in the 15% bracket) now apply to capital gains of individual taxpayers. However, in order to get the lowest rates, the holding period of a capital asset may be required to be longer than the previous long term holding period (more than one year). In addition, capital gains resulting from the sale of "collectibles" (e.g., coins, gems, antiques) held more than a year are now subject to a maximum rate of 28 percent. The new lower capital gains tax rates are not available for collectibles.
The following table shows the interaction of holding periods and dates of sale of capital assets.
| Date capital asset was sold |
Capital asset held 12 months or less |
Capital asset held more than 12 months butnot more than 18 months |
Capital asset held more than 18 months |
| Sold before 5/7/97 |
STCG
or (STCL) |
LTCG (LTCL)
taxed at a maximum
tax rate of 28% |
LTCG (LTCL)
taxed at a maximum
tax rate of 28% |
| Sold after 5/6/97 and before 7/29/97 |
STCG
or (STCL) |
LTCG (LTCL)
taxed at 20%
(10% if in 15% bracket) |
LTCG (LTCL)
taxed at 20%
(10% if in 15% bracket) |
| Sold after 7/28/97 |
STCG
or (STCL) |
MTG (LTCL)
taxed at a maximum
tax rate of 28% |
LTCG (LTCL)
taxed at 20%
(10% if in 15% bracket) |
New "netting process" for capital gains and losses
In addition, to the new tax rates, a new process for "netting", or offsetting capital gains and losses against each other, was created. This process is as follows:
Step 1: Group capital gains and losses by tax rates if other than short term, or by short-term.
- 28%()
- 20%() [10%]
- Short term()
Step 2: Determine a net gain or loss for each category in Step 1.
Step 3: Use any net loss determined in the 20% category and the short term category to offset net gains in the 28% category, then net gains in the 20% category, then net gains in the short-term category.
Step 4: Determine whether there is an aggregate capital gain or capital loss in the 28% and 20% categories.
Step 5: If there is an aggregate gain:
Net gains in the 28% () category are taxed at 28%, unless the taxpayer is in a lower bracket. (If the taxpayer is in a lower tax bracket, the capital gains in the 28% category are taxed at that lower rate.)
Net gains in the 20% () category are taxed at 20% (or taxed at 10% to the extent that the taxpayer is in the 15% bracket.)
Net short term capital gains () are taxed at ordinary income rates.
Step 6: If there is an aggregate loss, compute the capital loss deduction for the year:
CL deduction = SMALLER of:
(a) overall capital loss, or
$3,000
Capital losses in excess of the $3,000 per year maximum deduction are carried forward to future tax years (indefinite carryforward).
Sale of Principal Residence
Prior treatment of sale of principal residence
For principal residences sold prior to May 7, 1997, gain realized on the sale of a taxpayer's principal residence was not recognized (not subject to taxation) to the extent that the taxpayer acquired a new principal residence that cost more than "adjusted" sales price of the old residence. The new residence was also required to be acquired and occupied during a specified "replacement period." The basis in the new principal residence was adjusted downward to reflect the amount of gain that was not taxed, resulting in a "deferred" gain that would eventually be taxed because the basis in the replacement residence was lower than the amount actually paid.
In addition, for sales of principal residences prior to May 7, 1997, taxpayers who were age 55 or older on the date of sale could elect to exclude (once during their lifetime) up to $125,000 of realized gain on the sale of their principal residence. An exclusion, unlike a deferral, requires no adjustment to the basis of replacement property.
New treatment of sale of principal residence
The new tax law repealed both of the above provisions, and provides an exclusion of up to $250,000 ($500,000 for certain married taxpayers filing jointly; discussed later) for the sale of a principal residence, regardless of the age of the taxpayer. To qualify for the full $250,000 exclusion, the taxpayer must, during the 5 year period ending on the date of sale, have owned and used the residence as his or her principal residence for periods of time totaling 2 years.
If, because of either a change in place of employment or health, the taxpayer did not own and use the residence as his or her main home for at least 2 years during the last 5 year period, the maximum amount of the exclusion is reduced. The maximum exclusion (e.g., $250,000) is multiplied by the smaller of:
- the number of days the residence was owned or used as a principal residence, whichever is less, or
- number of days between the date the most recent prior principal residence was sold and the date the new residence was sold, divided by 730 days (2 years), to determine the reduced maximum exclusion.
Example: A taxpayer's employment location changed as a result of a transfer by her employer. She had owned her home for 700 days, but only used it as her principal residence for 650 days. She had not sold a prior principal residence during the 2 year period ending on the date of sale of this residence. (Sales prior to May 7, 1997 are not included in determining whether more than one principal residence has been sold in a two year period.) The maximum exclusion is $222,500 ($250,000 maximum exclusion x 650 days / 730 days).
A married couple filing a joint return qualifies for an exclusion of up to $500,000 (instead of $250,000) if:
- either spouse owned the property for periods totaling 2 years during the 5 year period ending on the date of sale of the residence, and
- both spouses used the property as their principal residence for periods totaling 2 years during the 5 year period ending on the date of sale of the residence, and
- neither spouse has excluded gain on the sale of a principal residence during the 2 years ending on the date of sale of the residence.
If any of the above requirements are not met, the maximum exclusion is reduced in the same manner described above for each spouse. Therefore, if only one spouse did not meet the requirements above, that spouse's maximum exclusion is reduced, while the other spouse is still entitled to his or her $250,000 exclusion.
Finally, a special transitional rule applies for principal residence sales during the period from August 6, 1997 through August 5, 1999, if the taxpayer owned the property on August 5, 1997. This special rule allows a taxpayer who did not meet the ownership or usage requirements (2 years during the last 5 years) to qualify for a reduced maximum exclusion even if there was no change in employment location and no health problems.
Other Resources
As stated above, these provisions are only a very small piece of the Taxpayer Relief Act of 1997, and the coverage in this article is limited to the effect of capital gains and sale of principal residence on the 1997 tax year. However, many other resources are available on the Internet that apply to the multitude of other provisions and changes for future years.
A list of links to Internet sites dealing with 1997 Federal tax legislation, including the Taxpayer Relief Act of 1997, may be found at the Tax and Accounting Web Site, maintained by Professor Dennis Schmidt of the University of Northern Iowa. The location is: http://www.taxsites.com/federal.html
In addition, the 1997 tax forms for the provisions discussed above have been released by the Internal Revenue Service. The Schedule D (Capital Gains and Losses) for Individuals (Form 1040), Form 2119 (Sale of Your Home), and the instructions for both forms may be downloaded from either the IRS Tax Forms Page:
http://www.irs.ustreas.gov/prod/forms_pubs/forms.html
or, since the IRS site is often slow, from an alternate site, such as:
http://www.pktax.com/97forms/97forms.htm
Finally, excellent resources for finding tax materials, in general, are:
http://www.taxsites.com (Tax and Accounting Web Site, maintained by Prof. Dennis Schmidt of the University of Northern Iowa), and:
http://zeta.is.tcu.edu/~yancey/ (maintained by Prof. Will Yancey of Texas Christian University).
