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A Capital Idea?

Washington's pledge to trim taxes on asset gains is causing confusion in markets. Here's what investors should know.

May 06, 1997|TOM PETRUNO

Uncle Sam's promise of a cut in the tax on long-term capital gains has helped re-energize the battered Nasdaq market of smaller stocks and the stock market in general, sending many key indexes to new highs Monday.

But the tax cut pledge, an agreement between President Clinton and congressional Republican leaders last week within the long-term balanced-budget plan, also is creating massive confusion among investors in securities markets, real estate and small businesses.

The reason: None of the details of the tax cut have yet been worked out. And as usual with anything that must be decided in Washington, the devil is certain to be in the details.

Moreover, despite the apparent initial euphoria on Wall Street about a capital gains tax reduction from the current 28% top rate, many analysts worry that a cut will actually hurt stocks once it takes effect--by fueling pent-up selling by long-term investors.

Whether that turns out to be true, however, remains to be seen. Some Wall Streeters note that the bulk of stock market assets still are in the hands of big institutions, most of whom don't pay much attention to tax issues.

And in the long run, experts note that a capital gains tax cut is inherently good for stocks, by further enhancing the appeal of asset appreciation versus, say, interest income.

For now, the advice that most tax advisors are giving their individual-investor clients is simply to stand pat: Don't sell stocks or other long-term, appreciated capital assets, or if you do, use a transaction that will allow you to postpone realizing your capital gain until beyond the effective date of the tax cut.

"It's certain death for an advisor to be recommending an asset sale now," said Robert Willens, tax strategist at Lehman Bros. in New York.

Here are some of the issues investors in securities, real estate and small business should consider in light of the tax cut promise:

* The cut is expected to be significant. Currently, Uncle Sam takes as much as 28% of any gain you realize on a long-term investment (i.e., a capital asset held more than one year). That compares with a 39.6% top federal tax rate for ordinary income, such as wages, interest or dividend income.

Although Clinton and Republican leaders did not specify what they want the new capital gains tax rate to be, Senate Majority Leader Trent Lott (R-Miss.) said Monday that he believes Congress' tax-writing committees will get it "into that range of under 20%."

Senate Republicans earlier this year had proposed a top rate of 19.8%. Under that plan, investors would simply exclude 50% of any long-term gains from taxation, and include the other 50% with ordinary income--thereby effectively taxing capital gains at half the top ordinary tax rate of 39.6%.

Democrats, however, could push for a smaller exclusion that might make the effective top gains tax rate 21% or 22%, Willens said.

In any case, a new rate in the 20% range would mean investors would pay about 30% less tax on a capital gain than under current law--a nice sum by any measure.

* The effective date of the cut is the big unknown. Congress could make the tax cut retroactive to any date it chooses. The date obviously is of major importance to investors.

If Congress were to allow the lower tax rate on any long-term asset sold since, say, May 1, investors would be free to sell assets now and know they'll benefit from the tax cut. But so far, no effective date has been publicly discussed.

Rather than make it retroactive, Congress could set a date in the future. But that would risk a torrent of selling of stocks and other assets immediately on that date.

Until a date emerges, many experts believe that investors who care about tax issues will do the logical thing: refrain from selling.

* If sellers hold back, stocks could continue to surge. If buyers are eager to get into stocks to reap future capital gains, while sellers are suddenly scarce, it would be logical for prices overall to continue to rise, or at least not to fall.

But that's a gross generalization, experts note. For one thing, the biggest investors in the market, including pension funds and mutual funds, care little about taxes.

"Mutual fund managers don't even think about taxes," said Jeffrey Petherick, co-manager of the Loomis Sayles Small Cap stock fund in Boston.

Still, for perhaps the smallest stocks--those whose prices are determined more by the actions of individual investors than by institutions--the waiting game for the effective tax cut date may indeed help prop up prices, Petherick said.

More important, however, is the general sentiment toward smaller issues. Because that sentiment had been so negative in recent months, pushing smaller stocks down far more than blue chips, many investors believe there are plenty of bargains among smaller issues.

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