Bafflingly Simple

By Daniel Kadlec

Preparing your taxes is never easy. But if you're stressing over last summer's tax "relief" act, figuring it will lead to some panicky late nights before April 15, take some advice: relax. Most of the new stuff doesn't apply to your 1997 return. Next year will be the killer.

Don't fire the accountant just yet, though. There are two big changes that do affect your '97 return, and together they are the mother lode for those who have sold a home or hitched their finances to the bull market in stocks and stock mutual funds. Home sales will be treated vastly differently going forward. But if you sold last year, you may be able to apply either the old or the new law--a one-time-only chance to have the best of both worlds. The capital-gains tax rate on stocks has been cut, potentially saving you a bundle. But sorting out the handful of different short-, medium- and long-term rates is dizzying.

What's clearest is that Congress has created a record-keeping nightmare. "We believe the forms are now so complex that for some people the savings will be offset by the need to hire professional guidance," says Roberto Viceconte, a tax attorney at M.R. Weiser & Co. in New York City. He notes that there is already a movement in Congress to simplify the changes. But for '97 your tax return will have to allow for a baffling set of rates.

Let's start with the tax rate you will pay on capital gains from the sale of stocks or bonds or other assets. The old rate was 28% on any asset held at least 12 months. The new rate is 20% on any asset held at least 18 months, or 28% if held 12 to 18 months. Then and now, gains on assets held less than 12 months are taxed as ordinary income, at rates up to 39.6%.

Sounds fairly simple. But in the transition year of 1997 you could easily have triggered three or four different rates, depending on when you sold, what you sold and how long you owned it. And just to keep things fun, the lowest tax rate on gains from the sale of collectibles remains set at 28%. It seems that Congress doesn't want to encourage things like rare paintings, antique tables and wine collections showing up in your 401(k) account.

Here are the important dates: the old rate applies to assets sold before May 7; the new rate applies to assets sold after July 28. In between, for some reason, you get a freebie of sorts: the 20% rate on assets held just 12 months, not the new long-term threshold of 18 months. You can see why good record keeping is important.

As you might expect, there are some hidden gems in all this confusion. When offsetting capital gains with capital losses, you must match rates where possible. So if you sold a long-held stock at a loss before May 7, where the 28% rule applies, you're obliged to use it to offset any gains where the 28% rule applies. But, notes Jere Doyle, an estate-planning manager at Mellon Private Asset Management, if you have losses in excess of any gains at a given tax-rate level, you can use those losses to offset gains at another tax-rate level.

That gives you the chance to mismatch a long-term loss with a short-term gain and generate greater tax savings. Say you're in the top 39.6% tax bracket and have no short-term losses but a short-term gain of $1,000. You also have no long-term gains but a long-term loss of $1,000. That long-term loss offsets your short-term gain, rubbing out a $396 tax bill. If you had used the long-term loss against a long-term gain, where 20% is the tax rate, you would have rubbed out only $200 of tax liability.

It's too late now to fiddle with your '97 portfolio. But by examining your records closely, you may find room to mismatch gains and losses in your favor. Remember, though, that you can use any capital loss (as long as there are no countervailing capital gains) to offset up to $3,000 of ordinary income in a given year. That's generally the best way to use a loss.

Another capital-gains trick has to do with the prior sale of assets when the buyer is still paying in installments. The new law allows you to apply the new capital-gains tax rate to any payments received on or after May 7, 1997, even if the sale occurred years ago. More interesting is a quirky provision that has to do with depreciated assets. Say you bought a rental property for $100,000 and over several years depreciated it down to $80,000, and then sold it for $110,000. Under the old law, you must pay 28% on a $30,000 gain.

But the new law taxes the recovered depreciation, in this case $20,000, at a rate of 25%. The rest of the gain is taxed at 20%. Where this really gets tricky is with installment sales. Tom Ochsenschlager, a tax partner with Grant Thornton in Washington, says taxpayers may choose one of two ways to apply the new rule. They may pay 25% on all gains received until the depreciation has been recovered, and then pay 20% on everything after that. Or they may pay a blended rate on all gains for as long as they receive payments.

Beware: this is a lifetime choice. The route you choose the first time will be with you on all gains from installment sales going forward. Ochsenschlager says the blended rate makes the most sense because it results in a lower immediate tax liability. Why pay 25% when you can get a blended rate somewhere between 25% and 20%? But let's say you sold that rental property years ago and by now have recovered the full $20,000 of depreciation. You no longer have any gains due to you that will be taxable at 25%. If you decline the blended rate and go for the "first-in first-out" approach, you'll pay only at the 20% rate on remaining payments to you.

Moving away from capital gains, the big new item is the way you get treated when you sell a house. Under the old rules, you paid no tax on a gain from the sale of your residence so long as you rolled the entire gain into another, more expensive house. You got a one-time exclusion of $125,000 if you were 55 or older. That exclusion typically was used late in life by empty-nesters.

The new law does away with the one-time exclusion and does not allow you to roll gains over. But it gives you a $500,000 exclusion if you are married ($250,000 if single) every time you sell a primary house--so long as you have lived in it for two of the past five years. Again, '97 is a transition year with important cutoff dates. The old rule applies to sales before May 7, the new rule after Aug. 5. If you sold, or went to contract or even bought a new house without having sold the old one in between those dates, you get your choice.

That's no small consideration--especially in high-cost regions like California and the Northeast, where longtime homeowners may have gains of $1 million or more. "We have a number of people in that category," Mellon's Doyle points out. If they sold or went to contract on a new house before Aug. 5, they can still roll that $1 million-plus gain into a new residence and avoid a hefty capital-gains tax. But if their gain is under $500,000, they should take the new exclusion and not pile up a big gain in their new home.

One thing to consider, says Doyle, is amending a previous tax return. You have three years to do that. If you sold a house a couple of years ago and were over 55 at the time--and did not take the $125,000 exclusion--you can amend that return and take the exclusion.

It's not a new provision, but victims of natural disasters (El Nino victims, listen up!) are eligible for special tax relief. They can deduct losses incurred in '98 on their '97 return. To do so, they must be in a federally declared disaster area. The move fast-forwards your refund by a year. But there are income limits. If you expect to report dramatically lower income in '98, you may be able to deduct more of your loss then than you can on the '97 return.

It's worth noting that the self-employed may deduct 40% of family health-care premiums--up from 30%. And here, according to KPMG Peat Marwick, are a few other items to consider:

--You may take a tax credit for adoption expenses. The credit is capped at $5,000 per child but goes to $6,000 for children with special needs.

--If you gave stock to a charity, you can deduct the market value at the time of the gift--not your cost. That provision had expired but was extended through June 1998. It will probably be extended again.

--The 10% penalty on early IRA withdrawals no longer applies if the funds are used to pay for certain medical expenses.

--The costs of insurance and long-term care are now treated as medical expenses, deductible in certain cases.

It's all a lot to ponder in the few days that you have left to file. But that's what late nights in April are for, isn't it?