A Puzzle for Investors

Posted: Monday, January 26, 2004

WASHINGTON (AP) Investors with capital gains or dividend income from stocks, real estate and other assets can expect new benefits from lower tax rates, but they're also bound to spend more time poring over paperwork to calculate those savings.

The benefits flow from new tax rates enacted in May, which reduced the rates on capital gains from 20 percent and 10 percent to 15 percent and 5 percent. The changes took effect May 6.

Dividends, previously taxed at the investor's ordinary income tax rate, can also qualify for the 15 percent and 5 percent capital gains rates as of Jan. 1, 2003. The change can mean as much as a 20 percentage point reduction in the dividend tax rate for wealthier taxpayers.

''That's a huge difference,'' said Jackie Perlman, senior tax research analyst at H&R Block.

The new tax rates add complications to this year's calculations for two main reasons. First, the capital gains tax rate changed midyear, so multiple rates apply depending when the asset was sold. Second, not all dividends qualify for the reduced rate, and the total amount of those that qualify for the lowered rate may have to be reported on the schedule for capital gains and losses.

Advisers recommend that taxpayers who are about to wade into a pile of paperwork take a few minutes to get organized. ''The first thing I would do is sort out all of your 1099s,'' Perlman said. Separate the 1099-DIV forms for dividends and distributions from the 1099-B forms for stock sales. Write the date you purchased the stock or other asset on the form.

These few steps will put all the information you need at your fingertips when turning your taxes over to a preparer or when filling out the IRS Schedule D, Capital Gains and Losses.

''It will save you a lot of time and grief,'' Perlman said. ''It'll save the tax professional time and grief, and it could even save you money.''

To help taxpayers navigate the new rates for capital gains and dividends, the IRS revised its forms that report earnings in each category.

The new forms detailing information reported by financial institutions and brokers, destined for taxpayers in January, break out the amount of capital gains reported before and after the May 6 date the tax rates changed.

Capital gains qualify for the new 15 percent maximum rate if the asset was held for more than a year and sold on or after May 6, 2003. Capital gains would be taxed at a maximum of 20 percent if the asset was held more than one year and sold before May 6, 2003. Capital gains on assets held one year or less are taxed at ordinary income tax rates.

New tax forms also show the total dividends received during the year and document the amount declared qualified for purposes of the new tax structure. Dividends are ''qualified dividends'' if paid by U.S. corporations and certain foreign corporations.

Because the tax rates for dividends were made retroactive to Jan. 1, 2003, taxpayers avoid the confusion of a midyear rate change. But those who purchased dividend-paying stocks during the year will have to double check that they held the stock for the appropriate amount of time to qualify for the lower rate.

To be eligible for the lower rate, the shareholder must hold the stock for more than 60 days during the 120-day period that began 60 days before the ex-dividend date, the first day a stockholder would not qualify for that dividend payment. Since the holding period starts the day after the purchase date, a stock bought on the day before the ex-dividend date cannot meet the more-than-60 day requirement for the first dividend payment to qualify for the lower tax rate. Generally, a buyer can obtain the ex-dividend date from a brokerage or a company's investor relations services.

There's one wrinkle for margin account holders whose brokerages temporarily lend their stock to others, a practice common among brokers. Any dividends paid out during the time the stock is on loan go to the borrowers, who then reimburse the stock owners. The payments received by the stock owners technically aren't dividends. They're known as a ''payments in lieu of dividends,'' and they're not eligible for the lower rate.

This year, recognizing that some brokers may need more time to adapt to the new law, the IRS is letting taxpayers who receive Forms 1099-DIV erroneously reporting such payments as dividend income to treat them as dividends, unless the taxpayer knows that they are not actual dividends.

All of these complications overlap when it comes to mutual funds, which may report a mix of capital gain distributions, dividends and interest payments.

Taxpayers whose only gains or losses are the capital gain distributions from their mutual funds may avoid Schedule D entirely by using a special worksheet in the Form 1040 or 1040A instruction books. The IRS has revised this worksheet to include the lower tax rates on qualified dividends.

In all of these cases, taxpayers can expect to rely heavily on information provided by their brokers and financial institutions, or in IRS Publication 550, still being updated. Taxpayers should keep good records themselves.

On the Web:

Internal Revenue Service - http://www.irs.gov

Publication 564 Mutual Fund Distributions - http://www.irs.gov/pub/irs-pdf/p564.pdf

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