Will the Zero Percent Capital Gains Tax Rate Help You?

Tree Farmer Magazine: January/February 2008 - Volume 27 No. 1

Note: Example 4 as published was incorrect in Tree Farmer Magazine. The correct calculations are used below.

Example 4 currently reads:

Example 4 should read:

Assume the same facts as in Example 3, but the Jones have $12,000 of qualified dividends in addition to the $24,000 capital gain. The total amount taxed at a maximum rate of 15% is now $36,000. The first $23,000 ($65,100-$42,100) is still taxed at the 0% rate and the balance of $13,000 is taxed at 15%, making the tax $1,950 on the timber capital gains and qualified dividends. Note that no distinction is made as to whether it's the qualified dividends or the timber gain to which the 0% capital gains rate applies.

A zero percent tax rate of will replace the 5 percent rate for capital gains realized after December 31, 2007. The zero percent rate applies to gains through the end of 2010, assuming Congress doesn't change the law between now and then. Let's see if you will benefit from this change. This explanation will get convoluted, but I'm certain you'd expect nothing less from the efforts of Congress to "simplify" the tax code.

The tax rates on both ordinary income and capital gains are indexed with the rates increasing with both kinds of income. The capital gains rate is tied to the ordinary income rate which is tied to the level of your ordinary income. So the starting point is the amount of your ordinary income, which includes salary, wages, business income, non-qualified dividends, and taxable interest, among others. I'll demonstrate this point using the numbers for a married couple filing a joint tax return for the 2008 tax year, Example 1.

Example 1. The salaries of Mr. and Mrs. Jones total $85,000 in 2008. Their additional income from interest and investments total $15,000. They take the standard deduction of $10,900, and two personal exemptions of $3,500 each. This makes their taxable income $82,100 and their tax liability is $13,213. But, we need to look at their marginal tax rate. Here's the break down for their tax liability. The first $16,500 of taxable income is taxed at 10% - $1,650. The next $49,050 is taxed at 15% - $7,357.50. The remaining $17,000 of taxable income is taxed at 25% - $4,250. Adding the tax for the three brackets: $1,650 + $7,358 + $4,250 gives the $13,258 tax due. The average tax rate on their gross income of $100,000 is 13.2%, but their marginal tax rate is 25%. The 25% rate applied to the last $17,000 of taxable income. The next higher tax rate of 28% starts when taxable income reaches $131,450.

Understanding the ordinary income tax brackets and rates allows us to deal with the capital gains tax rates. Keeping in mind that the two lowest tax brackets for ordinary income are 10% and 15%, the 0% capital gains rate applies when your taxable income with capital gains excluded puts you in the 10% or 15% tax brackets. For 2008 this means that if your taxable income without capital gains is more than $65,100 no part of your capital gains would be subject to the 0% capital gains. In this case the capital gains tax rate is a straight 15%, making the average and marginal capital gains rates the same, as demonstrated in Example 2.

Example 2. Assume that the Jones in Example 1 also have a net long-term capital gain of $24,000 from a timber sale. Since their marginal ordinary income tax rate is 25%, above the 15% bracket, the applicable capital gains rate is 15%, making the tax on the timber $3,600.

The 0% rate applies if taxable income excluding capital gains is less than $65,100 as demonstrated in Example 3.

Example 3. Assume that the Jones taxable income with the $24,000 of capital gain excluded is only $42,100. This puts them in the 15% ordinary income tax bracket. An additional $23,000 of income is needed to move them to the next highest bracket. Thus, the first $23,000 of capital gains is taxed at the 0% rate and the balance of $1,000 is taxed at the maximum capital gains rate of 15%. This makes the capital gains tax $150 on the $24,000, for an average tax rate of 0.625%.

Qualified dividends also affects your marginal capital gains tax rate,. You know the amount of your qualified dividends because they are listed separately on the Form 1099's sent by payers. The impact is demonstrated by adding qualified dividends to the facts in Example 3, demonstrated in Example 4.

Example 4. Assume the same facts as in Example 3, but the Jones have $12,000 of qualified dividends in addition to the $24,000 capital gain. The total amount taxed at a maximum rate of 15% is now $36,000. The first $23,000 ($65,100-$42,100) is still taxed at the 0% rate and the balance of $13,000 is taxed at 15%, making the tax $1,950 on the capital gains and qualified dividends. Note that no distinction is made as to whether it's the qualified dividends or the timber gain to which the 0% capital gains rate applies.

Here's how you can estimate if you will benefit from the 0% rate based on your filing status.

A. Estimate your taxable income without capital gains and qualified dividends.
B. Determine the upper limit of the 15% ordinary income tax bracket for your filing status in 2008:

Married filing jointly - $65,100
Unmarried - $32,550
Married filing separately - $32,550
Head of Household – $43,650

C. Estimate the total amount of your capital gains and qualified dividends
D. If the amount A exceeds the amount B, C is taxed at 15% rate. OR,
E. If the amount A is less than the amount B, subtract A from B and call this amount E. E is taxed at the 0% rate. Then subtract E from C and this amount is taxed at 15%.

Remember to Use Form T

On behalf of the IRS I'm reminding you to use Form T – Forest Activities Schedule with the caveat that using it and attaching it to your filed tax return are separate decisions. You should always complete Form T for any transaction to which it applies and keep the form and associated supporting documents in your files. You only have to file Form T with your tax return, however, if your timber activity constitutes a business. For this purpose, making more than one or two timber sales every three or four years constitutes a business.

Assuming your activities constitute a business as determined by the number and frequency of timber sales, you need to complete and attach Form T to your return only if you: (1) Claim a deduction for depletion of cut timber, or the allowable basis of timber disposed of on the stump under section 631(b); (2) Elect under section 631(a) to treat the cutting of timber as a sale or exchange; or (3) Make an outright sale of timber under section 631(b), i.e. timber held for use in a trade or business, or primarily for sale to customers in the ordinary course of a trade or business.

When you originally acquire timberland you use Form T, Part I – Acquisitions to show how you allocated the total original basis to each asset, including each merchantable timber account, and each premerchantable timber account. Once these timber accounts are established you use a separate Form T, Part II – Timber Depletion for each merchantable timber account. For your reforestation projects you need to track each qualified timber property (QTP) separately on Form T, Part IV – Reforestation and Timber Stand Activities. If you use the reforestation deduction and amortization provisions most likely you will not carry a positive balance in these QTP accounts, but if you do then as under previous law this balance is transferred to a merchantable timber account when the trees on the QTP reach the merchantable size class.