Whether you own real estate, stocks, bonds or any other major investment--or if you're considering buying--you could be affected by President Bush's proposal to cut capital gains taxes. Does the Bush plan mean you should sell long-held investments now? And how big an incentive would the tax cut give new investors? Here are answers to common questions about the plan:
Q: What is the proposal to cut capital gains taxes?
A: The President wants to cut the maximum tax that investors pay on capital gains--the rise in the value of an investment--from the current 28% to 15.4% for assets held three years.
Q: Which assets would get this tax break?
A: Real estate, stocks and bonds (including mutual funds) and virtually any other capital asset except for items considered to be collectibles, such as art.
Q: How would the capital gains tax be cut?
A: Investors would exclude a portion of their investment gains from taxation each year, depending on how long the assets were owned. Say you pay $1,000 for a stock this year, and you sell it after three years for $2,000. You'd have a $1,000 gain. Under Bush's plan, you would be able to exclude 45% of that ($450) from taxation. So only $550 of the gain would be taxable, whereas today the entire $1,000 gain is taxable.
Q: How does that work out to a 15.4% tax on the gain?
A: Today, all income and gains are taxed at one top rate--28% for most people. Bush assumes that basic tax rate will remain the same. But by excluding 45% of your gain from taxation, you lower the \o7 effective \f7 tax rate. From the previous example, the taxable part of the $1,000 gain was $550. Multiply $550 by 28% and you get $154. So on your original $1,000 gain, Uncle Sam would get just $154, or 15.4%. Under current law, the government gets $280 of that $1,000 gain.
Q: What if I hold the asset for less than three years?
A: There would be less of a tax break: The percentage of your gain that would be excluded from taxation would be just 15% for assets held one year and 30% for assets held two years. So the maximum tax rate on capital gains would drop to 23.8% for 1-year-old assets and 19.6% for 2-year-old assets. You'd have to hold the asset at least three years to get the 45% exclusion, or 15.4% tax rate.
Q: So the goal would be to promote long-term investing?
A: Correct. Many proponents of this measure believe that it would discourage short-term speculation and encourage Americans to put their money into the best long-term investments they could find. In theory, Bush's plan would help more businesses raise capital needed for long-term expansion.
Q: What's the downside to Bush's proposal?
A: Critics say that a capital gains tax break helps only the wealthy. Also, no one is sure how much revenue the government would lose by cutting the tax rate. Though investors could pay less tax over time, the government could actually see higher tax revenues in the first year of the change if it encourages people to sell assets they've held for long time.
Q: Would the Bush plan in fact cover assets I already own, not just new ones I might buy?
A: Yes, the President wants this tax change for any asset sold after Feb. 1. However, experts say investors absolutely should \o7 not\f7 dramatically alter their portfolios based on Bush's proposals.
Q: That's because Congress is likely to rewrite the plan or reject it completely?
A: Exactly. "The best thing to do is wait," says Tom Ochsenschlager, tax partner with the accounting firm of Grant Thornton in Washington. He notes that even if Congress grants a capital gains tax cut, it may be only for new investments made after a certain date in the future, or solely for investments in start-up businesses.
Also, Brian Frazier, accountant at Arthur Andersen & Co. in Los Angeles, notes that Congress could revisit the so-called alternative minimum tax, whereby investors over a certain income level could have any capital gains tax-cut benefit reduced significantly.
Q: But if I were planning to sell some assets anyway, shouldn't I wait to see what happens with the tax-cut proposal?
A: Perhaps. But it's often folly to base your investment decisions solely on the tax climate, most investment advisers say. A lower capital gains tax may give you an incentive to invest in the first place, but once you've decided that an existing investment no longer fits in your portfolio, whether the government takes 28% or 15.4% of your gain shouldn't be the deciding factor.
Also, if you wait to sell an asset, the price could decline, negating any tax benefit.
Q: Could Bush's proposal, if passed, spark a big selloff on Wall Street or in housing?
A: That's tough to call. On one hand, people would certainly have more incentive to sell, since the capital gains tax would fall for the first time since 1986. Frazier believes that homeowners who have held property for a long time might indeed be induced to sell. "I think we'd see a lot more real estate going on the market," he said--at a time when the market already is glutted in many areas.
Stocks might also be hit by an initial bout of profit taking. But the incentive that a lower capital gains tax gives to \o7 buyers \f7 could offset that selling to a large degree. Ultimately, stocks and other assets will rise or fall based largely on their individual prospects--not tax policy.