For the 2001 tax year, investors can take advantage of a tax break called the "deemed sale election." This election will reduce the capital gain tax rate on later sales. With this provision, investors can enjoy an 18% capital gain tax on sales that would otherwise be taxed at 20%. Depending upon the situation, an investor may benefit substantially from a deemed sale of capital assets.

Deemed Sales

Generally, capital assets held for more than twelve months are taxed at the long-term capital gain rate of 20% ( 10% for the lower tax brackets). However, for assets acquired on or after January 1, 2001, and held for more than five years, the tax rate is only 18%. The deemed sale election can be used to make those assets that were acquired prior to 2001 eligible for the 18% capital gain rate. By using this strategy, investors can treat assets held on January 1, 2001 as having been sold and then reacquired on the same date. Stocks are treated as if they were sold and reacquired on January 2, 2001, and other capital assets, such as realty and business property, are treated as if they were sold and reacquired on January 1, 2001. Taxes must be paid on gains from the deemed sale. Also, losses cannot be deducted in any tax year. The basis in the reacquired asset is its closing market price or fair market value (whichever is applicable) on the date of the deemed sale, whether that sale was for a gain or an unallowed loss.

To make the election, the investor must report the deemed sale(s) on Schedule D, Form 1040, for the 2001 tax year. If the deemed sale results in a loss, the taxpayer must enter zero instead of the amount of the loss. The election can be made on a share-by-share or asset-by-asset basis. A statement must be attached to the return stating that the investor is making an election under section 311 of the Taxpayer Relief Act of 1997 and specifying the assets for which the election is being made. The Form 1040 must be filed no later than its due date. If the return was filed without making the election for any asset, the election can still be made under certain circumstances. Once made, an election for any asset is irrevocable.

Whether to Elect

The investor must weigh the costs involved when deciding whether or not to elect for a deemed sale. The cost of paying the gain tax up front (or not being allowed to deduct the loss) should be compared to the benefit from the 18% tax rate on later appreciation. It is a good idea to use a deemed sale if the asset has seen little appreciation on the date of the deemed sale or if the asset is expected to soar in value. However, even if the investor faces a large gain in the deemed sale, election may still be advantageous. If the investor has suffered large capital losses in 2001, these losses can be used to offset the large gain for the deemed sale. Otherwise, the investor can only deduct $3,000 for these losses, and the excess losses must be carried forward to reduce gains in future years. Similarly, if an investor has carryover losses from 2000, those losses can be used to offset a large gain in a deemed sale for 2001. In short, the profitability of a deemed sale election depends upon the individual situation.