Filers May Find New Rates a Bit Taxing

Santa Monica tax accountant Phil Holthouse doesn’t need to poll his clients about the complexity of the new capital gains and dividend tax laws -- he has seen it in his own tax documents.

Last year’s tax law cut rates on both capital gains and dividends. But it also added a new layer of complexity. Some capital gains -- profits from the sale of assets -- are taxed at 15%, others at 20%. Some dividends from stocks and bonds are taxed at 15%, others at ordinary income tax rates.

Investment firms, which are supposed to tell their clients what type of gains they have received, are so baffled by it all that they are regularly revising tax statements they send to clients, confounding taxpayers.

Holthouse said his personal brokers and banks had sent him a stack of corrected 1099 tax statements -- “corrected” because they didn’t figure the tax right the first time. His clients are in the same boat, and that has created a backlog of corrections to be processed on tax returns.

“With the volume of the transactions and the complexity of the rules, it’s not surprising that there are some errors when these things go out the door,” Holthouse said. “We have had some accounts where we’ve received three different 1099s -- the original and two corrections.”

The toughest part about all of this for taxpayers is that the individual -- not the broker or banker reporting the information -- is responsible for getting it right and paying the proper amount of tax.

Here are a few answers to questions investors may face when filing 2003 returns:

Question: Why are there two rates on capital gains?

Answer: Because a tax law passed last year cut rates on capital gains to a maximum of 15%. (The rate is 5% for people in lower tax brackets.) The change took effect last May 6, so only transactions on that date and after qualify for the new rate.

To qualify for the 15% rate, the shares also had to have been owned for more than one year.

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Q: What about shares sold before May 6?

A: They’re taxed at the old capital gains rate of 20%.

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Q: What rate applies to shares that were purchased and sold in less than a year?

A: Ordinary income tax rates, which ranged from 10% to 35% in 2003, depending on income level.

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Q: I realized both gains and losses in asset sales last year, with some of the transactions taking place before and some after May 6. How do I figure my tax rate?

A: Lucky duck. You get the dubious joy of being able to use the entire multiple-column, 53-line Schedule D of IRS Form 1040, which is the sheet that helps filers figure the taxable gain or loss on securities sales.

The new Schedule D requires you to divide your gains and losses into two piles -- transactions that happened before the tax law change, and total transactions for the year.

Subtract losses from gains in each pile. Losses in the pre-May 6 pile can be subtracted from any remaining gains in the total column. If you have a net gain, Lines 19 through 53 on this form -- plus a separate worksheet -- are aimed at figuring the right amount of tax on the whole amount.

Be careful and patient, or hire a tax accountant.

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Q: I sold my baseball card collection at a profit this summer. Do I get the 15% rate on capital gains?

A: Sorry, but no. There’s a separate rate for a gain on the sale of collectibles. You pay 28% in federal income tax.

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Q: What about the sale of rental properties? Would the 15% rate apply?

A: Yes and no. The 15% rate applies to the pure profit, but if you depreciated the building, the write-down must be recaptured at the sale. That amount is subject to a 25% rate.

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Q: I have a pile of losses from previous years. Do they offset gains accumulated at the 20% rate or at the 15% rate?

A: First, they offset 20% gains, but once those gains are used up, they would offset 15% gains. If there are still losses to spare, as much as $3,000 in capital losses also can be used to offset ordinary income. Any remaining losses would be carried forward, yet again, to the following tax year.

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Q: What happened with tax rates on dividends?

A: A new flat rate of 15% was established for certain dividends that were paid on or after Jan. 1, 2003. In the past, dividends were taxed at ordinary income tax rates of 10% to 35%.

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Q: What sorts of dividends qualify for the new rate?

A: Generally, a dividend on a common stock or a mutual fund that invests in common stocks. However, some preferred stock dividends also qualify for the lower rate.

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Q: How do I know whether my dividends qualify for the lower rate?

A: The financial institution that pays the dividend (or reports it to you) is supposed to delineate whether it was a qualified or a nonqualified dividend on your 1099.

But don’t be in a big rush to file, because brokers clearly are having some trouble getting the categories right, and there may be more revisions before the season is through.

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Q: Why don’t all dividends qualify?

A: The new rate was aimed at eliminating double taxation on dividends. Many dividend payments are taxed twice -- once because the corporation pays tax on its income, some of which is passed on to shareholders in the form of dividends; and a second time when investors pay tax on their investment returns.

But some payments that companies call “dividends” -- for example, much of the income paid out by real estate investment trusts and money market mutual funds -- are really interest payments that are deductible to the corporation. Because these dividends have not been taxed twice, they do not get the favorable tax treatment.

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Q: Does that mean all of my REIT income is taxed at ordinary income tax rates?

A: No. About a third of REIT dividend payments are actually a pass-through of long-term capital gains, taxed at a 15% rate, or qualifying dividends, said Jay Hyde, spokesman for the National Assn. of Real Estate Investment Trusts. The REIT will note on 1099 forms how much income is “qualified dividends” taxed at the new 15% rate and how much is not.

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Q: What about preferred stock dividends?

A: Generally speaking, “trust preferred” is really a payment of interest, not a dividend, and does not qualify for the lower rate. But some older preferred shares do pay qualifying dividends.

If you have questions about whether the income you are receiving has been reported in the right category, call your broker or the company that issued the 1099.

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Kathy M. Kristof, author of “Investing 101” and “Taming the Tuition Tiger,” welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail [email protected]. For past columns, visit latimes.com/kristof.