When it comes to capital gains, timing is everything
The dust seems to have settled in the wake of confusion on the taxation of capital gains and dividends, which makes it a good time to review the rules regarding the holding period for long-term capital gains.
One less day of ownership can be the difference between having your gain or dividend income taxed at rates as high as 35 percent instead of the preferential 15 percent top tax rate that applies to long-term capital gains from most capital assets and to qualified dividend income.
The holding period is the minimum period of time you must hold a capital asset for the gain from its sale to be favorably taxed as a long-term capital gain, or for otherwise qualifying dividend income to be eligible for the long-term capital gain tax rates.
Here are some of the more common holding period rules, to help keep you from making a tax mistake that you won’t be able to undo after you have sold the asset.
To yield “long-term” capital gain, an asset must be held for more than one year — in other words, for at least a year and a day. The holding period begins on the day after you buy an asset and ends on the day you sell it. For example, suppose you bought stock on June 20, 2004. Your holding period began on June 21, 2004, the day after you bought it. If you sell at a profit on or after June 21, 2005, your gain will be long-term capital gain. If you sold on June 20, 2005, your gain or loss is short-term, taxed at the same rate as ordinary income.
For publicly traded securities, the holding period begins on the day after the trading date you bought the securities, and ends on the trading date you sold them. For example, assume you bought a stock for $5,000 and on June 20th you sold it for $20,000. Assuming your ordinary income tax rate is 35 percent, the tax on the sale is $5,250. If you had waited only one more day to sell the stock your tax would have been $2,250 at the 15 percent rate — a difference of $3,000.
Qualified dividends that you receive from domestic corporations and “qualified foreign corporations” are taxed at the 15 percent maximum rate applicable to long-term capital gains. To get qualified dividend income, you must hold the stock on which the dividend is paid for more than 60 days during the 121-day period, which begins 60 days before the ex-dividend date (this is the first date following the declaration of a dividend on which a stock buyer won’t receive the next dividend payment).
As with the holding period for long-term capital gains, you include the day you sold the stock when counting the number of days you held it, but not the day you bought the stock.
For dividends paid on preferred stock that are attributable to a period or periods totaling more than 366 days, you must hold the stock for more than 90 days during the 181-day period beginning 90 days before the ex-dividend date.
There are a number of special holding periods that must be met for certain types of gains to be favorably taxed. Here are a few of them:
• If you inherit a capital asset, you automatically are treated as having held it for more than one year. Thus, for example, if you inherit a vacation home and sell it six months later at a gain, your gain, if any, is low-taxed long-term capital gain. (You will get a step-up in basis equal to the property’s value at the death of the person who left it to you, so there may not be much gain in the ensuing six months.)
• Up to half of the gain on the sale of qualified small business stock is tax free (and the balance is taxed at a special 28 percent capital gains rate) if the stock was originally issued after Aug. 10, 1993, by a qualifying corporation and the stock is held for more than five years. (The exclusion is 60 percent if the company operates within certain “empowerment zones.”)
• If you invest in commodity futures, gain on the sale of those futures qualifies as long-term capital gain as long as you held them for at least six months and a day before the sale.
• A capital gain dividend from a mutual fund automatically is treated as long-term capital gain, regardless of how long you held the mutual fund shares generating the dividend.
There are instances where your holding period includes someone else’s. For example, if someone gives you stock, your holding period includes the donor’s holding period. Similarly, if you acquire property from your spouse (or your ex-spouse, in the case of a divorce), your holding period includes your spouse’s (or ex-spouse’s) holding period.
In addition, it doesn’t matter how long you hold such assets as stocks or bonds owned by an IRA or a qualified retirement plan account. That’s because all your withdrawals will be treated as ordinary income. And if the assets are held within a Roth IRA, your withdrawals will be 100 percent tax-free if they are qualified distributions.
If you are in doubt about whether a specific transaction qualifies, it is a good idea to consult your tax advisor before you consummate the sale.
Kirk B. Leoni is a shareholder/director at Nathan Wechsler & Company, responsible for the firm’s audit and accounting policies and procedures.