When good tax breaks go bad
By Kay Bell • Bankrate.com

Tax savings are alluring Sirens. But beware the jagged rocks of the ever-changing tax code.

Not so long ago, some investors thought they had made out like bandits when they took advantage of tax laws that rewarded patient shareholders. Some even employed a special tax maneuver to guarantee themselves tax savings down the road.

These weren't people falling for a scam. They were serious investors, some relying on advice of reputable financial advisers, utilizing a special tax opportunity that existed -- at the time.

Instead, what looked then like a smart tax strategy has ended up costing them. Their experience illustrates what can happen when tax policy meets practical application.

One taxpayer's boon is another's boondoggle
Most investors are delighted about recent reductions in the long-term capital gains rates. Now if they sell assets held for more than a year, tax on the proceeds will be 5 percent less than it was a year ago: 5 percent instead of 10 percent for people in the 10 and 15 percent tax brackets; 15 percent vs. 20 percent for those in the top four brackets.

But the law reducing the long-term capital gains rates also invalidated another asset category.

In 2001 and 2002, lower tax rates were offered as reward for investments held five or more years. Taxpayers in the two lower-income brackets could sell these assets and pay only 8 percent capital gains taxes instead of 10 percent.

The Internal Revenue Service's preliminary 2001 income tax return information shows almost 2 million filers who made less than $15,000 reported capital gains that year totaling more than $8 billion. While the IRS does not slice its data pie thin enough to show how many benefited, at that time, from the five-year rate, some undoubtedly did.

If they still had those properties, they could sell them today (without having to meet the five-year limit) and pay even less tax.

Good idea at the time
"But the people who really feel cheated are the deemed sale folks," says Mark Luscombe, lawyer, accountant and principal tax analyst at CCH Inc., a provider of tax law information and software.

The deemed sale folks are taxpayers in the top four income tax brackets who reset the holding period for some assets so they could eventually sell them at an 18 percent tax rate instead of the then 20-percent rate. The five-year time frame for these investors didn't begin until Jan. 1, 2001. Capital gains property owned before then, regardless of how many years ago it was purchased, wasn't eligible for the lower rate.

In addition to buying new assets in 2001 and keeping them for five years, these investors were given a one-time opportunity to conduct a deemed sale of existing holdings. The taxpayer simply reported to the IRS that he sold the older asset on Jan. 1, 2001, (or Jan. 2, 2001, for securities) and immediately repurchased it at the same price. No actual transaction occurred (so no sales fees or expenses were due), but the IRS accepted the paper sale -- and collected the current tax on the proceeds.

If the deemed-sale shareholder still had to pay taxes at the 20-percent rate (or higher if it was a short-term gain), what was the benefit of the transaction? Basically, says Bob Trinz, tax specialist and editor of tax publisher RIA's Federal Taxes Weekly Alert, he started the five-year clock running.

This move was appealing to the investor who already planned to hold the property for several years. He was willing to pay a slightly higher tax early so that when he did sell the asset, which he hoped would appreciate even more in the intervening five-or-more years, he would owe the IRS less.

At the time, it seemed like a savvy tax move. Lawmakers had been talking for years about reducing capital gains, but nothing had come of it. Here was a chance to shave at least a few percentage points off the rate by converting an asset you always planned to hang onto for a while.

"Some people made the election late and begged the IRS to take them in," says Trinz. "They're probably ruing the choice now."

Even today's new, lower capital gains rates pose a challenge to investors. The 5 percent and 15 percent long-term taxes are set to expire at the end of 2008.

"The sunset provision," notes Trinz, "does illustrate the peril of planning these days with any horizon."

Any hope for recovery?
So are investors who reworked their portfolios a few years ago simply out of tax luck?

Congress routinely makes what are called technical corrections to tax bills. These are clarifications of unintended consequences that appear after changes go into effect. It's conceivable that a technical correction could be made for investors who lost out under the superseded five-year gain provision.

Luscombe says there's been some talk that once these people who paid taxes in anticipation of getting the 18 percent rate are identified, they would be able to refile under the new rates. But so far, he says, it's just talk.

And that presumes, adds Luscombe, that there won't be any additional changes. As the history of tax code modification shows, that's not a very safe presumption.

Instead, taxpayers might want to consider some advice once given to Trinz.

"The rule that I try to follow," Trinz says, "is one passed on by an old tax lawyer: Never accelerate your tax liability."