D. Amendments to Title III of the 1997 Act Relating to Capital Gains

1. Individual capital gains rate reductions (Sec. 6005(d) of the Bill, Sec. 311 of the 1997 Act, and Sec. 1(h) of the Code)

Present Law

The 1997 Act provided lower capital gains rates for individuals. Generally, the 1997 Act reduced the maximum rate on the adjusted net capital gain of an individual from 28 percent to 20 percent and provided a 10-percent rate for the adjusted net capital gain otherwise taxed at a 15 percent rate. The "adjusted net capital gain" means the net capital gain determined without regard to certain gain for which the 1997 Act provided a higher maximum rate of tax. The 1997 Act generally retained a 28-percent maximum rate for the long-term capital gain from collectibles, certain long-term capital gain included in income from the sale of small business stock, and the net capital gain determined by including all capital gains and losses properly taken into account after July 28, 1997, from property held more than one year but not more than 18 months and all capital gains and losses properly taken into account for the portion of the taxable year before May 7, 1997. in addition, the 1997 Act provided a maximum rate of 25 percent for the long-term capital gain attributable to real estate depreciation ("unrecaptured section 1250 gain"). Beginning in 2001 and 2006, lower rates of 8 and 18 percent will apply to certain property held more than five years.

The amounts taxed at the 28- and 25- percent rates may not exceed the individual's net capital gain and also are reduced by amounts otherwise taxed at a 15-percent rate.

Under the provisions of the 1997 Act, net short-term capital losses and long-term capital loss carryovers reduce the amount of adjusted net capital gain before reducing amounts taxed at the maximum 25- and 28-percent rates.

The 1997 Act failed to coordinate the new multiple holding periods with certain provisions of the Code.

Explanation of Provision

Under the bill, the "adjusted net capital gain" of an individual is the net capital gain reduced (but not below zero) by the sum of the 28-percent rate gain and the unrecaptured section 1250 gain.

"28-percent rate gain" means the amount of net gain attributable to collectibles gains and losses, an amount of gain equal to the gain excluded from gross income on the sale of certain small business stock under section 1202, long-term capital gains and losses properly taken into account after July 28, 1997, from property held more than one year but not more than 18 months, the net short-term capital loss for the taxable year and the long-term capital loss carryover to the taxable year. Long-term capital gains and losses properly taken into account before May 7, 1997, also are included in computing 28-percent rate gain.

"Unrecaptured section 1250 gain" means the amount of long-term capital gain (not otherwise treated as ordinary income) which would be treated as ordinary income if section 1250 recapture applied to all depreciation (rather than only to depreciation in excess of straight-line depreciation) from property held more than 18 months (one year for amounts properly taken into account after May 6, 1997, and before July 29, 1997). The unrecaptured section 1250 depreciation is reduced (but not below zero) by the excess (if any) of amount of losses taken into account in computing 28-percent gain over the amount of gains taken into account in computing 28-percent rate gain.

The bill contains several conforming amendments to coordinate the multiple holding periods with other provisions of the Code. Inherited property (Sec. 1223 (11) and (12)) and certain patents (Sec. 1235) are deemed to have a holding period of more than 18 months, allowing the 10- and 20-percent rates to apply. Amounts treated as ordinary income by reason of section 1231(c) will be allocated among categories of net section 1231 gain in accordance with IRS forms or regulations. The bill clarifies that the amount treated as long-term capital gain or loss on a section 1256 contract is treated as attributable to property held for more than 18 months.

Under the bill, in applying section 1233(b) where the substantially identical property has been held more than one year but not more than 18 months, any gain on the closing of the short sale will be considered gain from property held not more than 18 months, and the substantially identical property will have be treated as held for one year on the day before the earlier of the date of the closing of the short sale or the date the property is disposed of. in applying section 1233(d) where, on the date of the short sale, the substantially identical property has been held more than 18 months, any loss on the closing of the short sale will be treated as a loss from the sale or exchange of a capital asset held more than 18 months. Finally, in applying section 1092(f), any loss with respect to the option shall be treated as a loss from the sale or exchange of a capital asset held more than 18 months, if at the time the loss is realized, gain on the sale or exchange of the stock would be treated as gain from the sale or exchange of a capital asset held more than 18 months.

The bill reorders the rate structure under sections 1(h)(1) and 55(b)(3) without any substantive change.

The bill makes minor technical changes, including a provision to reduce the minimum tax preference on certain small business stock to 28 percent, beginning in 2006.

Effective Date

The provision applies to taxable years ending after May 6, 1997.

2. Rollover of gain from sale of qualified stock (Sec. 6005(f) of the Bill, Sec. 313 of the 1997 Act, and Sec. 1045 of the Code)

Present Law

The 1997 Act provided that gain from the sale of qualified small business stock held by an individual for more than six months can be "rolled over" tax-free to other qualified small business stock.

Explanation of Provision

Under the bill, a partnership or an S corporation can roll over gain from qualified small business stock held more than six months if (and only if) at all times during the taxable year all the interests in the partnership or S corporation are held by individuals, estates, and trusts with no corporate beneficiaries.

Effective Date

The provision applies to sales on or after August 5, 1997, the date of enactment of the 1997 Act.

3. Exclusion of gain on the sale of a principal residence owned and used less than two years (Sec. 6005(e)(1) and (2) of the Bill, Sec. 312(a) of the 1997 Act, and Sec. 121 of the Code)

Present Law

Under present law, a taxpayer generally is able to exclude up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. To be eligible for the exclusion, the taxpayer must have owned the residence and used it as a principal residence for at least two of the five years prior to the sale or exchange. A taxpayer who fails to meet these requirements by reason of a change of place of employment, health, or unforeseen circumstances is able to exclude a fraction of the taxpayer's realized gain equal to the fraction of the two years that the requirements are met.

Explanation of Provision

The bill clarifies that an otherwise qualifying taxpayer who fails to satisfy the two-year ownership and use requirements is able to exclude an amount equal to the fraction of the $250,000 ($500,000 if married filing a joint return), not the fraction of the realized gain which is equal to the fraction of the two years that the ownership and use requirements are met. For example, an unmarried taxpayer who owns and uses a principal residence for one year then sells at realized gain of $500,000 may exclude $125,000 of gain (one-half of $250,000) not $250,000 of gain (one-half of the realized gain). Similarly, an unmarried taxpayer who owns and uses a principal residence for one year then sells at a realized gain of $50,000 may exclude the entire $50,000 of gain since it is less than one half of $250,000. The exclusion is not limited to $25,000 (one-half of the $50,000 realized gain).

In addition, the bill provides that if a married couple filing a joint return does not qualify for the $500,000 maximum exclusion, the amount of the maximum exclusion that may be claimed by the couple is the sum of each spouse's maximum exclusion determined on a separate basis.

Effective Date

The provision is effective as if included in section 312 of the 1997 Act.

4. Effective date of the exclusion of gain on the sale of a principal residence (Sec. 6005(e)(3) of the Bill, Sec. 312(d)(2) of the 1997 Act, and Sec. 121 of the Code)

Present Law

The exclusion for gain on sale of a principal residence under the 1997 Act generally applies to sales or exchanges occurring after May 6, 1997. A taxpayer may elect, however, to apply prior law to a sale or exchange (1) made before the date of enactment of the Act, (2) made after the date of enactment pursuant to a binding contract in effect on such date, or (3) where a replacement residence was acquired on or before the date of enactment (or pursuant to a binding contract in effect on the date of enactment) and the prior-law rollover provision would apply.

Explanation of Provision

The bill clarifies that a taxpayer may elect to apply prior law with respect to a sale or exchange on the date of enactment of section 312 of the 1997 Act.

Effective Date

The provision is effective as if included in section 312 of the 1997 Act.

E. Amendments to Title IV of the 1997 Act Relating to Alternative Minimum Tax

1. Election to use AMT depreciation for regular tax purposes (Sec. 6006(b) of the bill, Sec. 402 of the 1997 Act, and Sec. 168 of the Code)

Present Law

For regular tax purposes, depreciation deductions for certain shorter-lived tangible property may be determined using the 200-percent declining balance method over 3-, 5-, 7-, or 10-year recovery periods (depending on the type of property). For alternative minimum tax ("AMT") purposes, depreciation on such property placed in service after 1986 and before 1999 is computed by using the 150-percent declining balance method over the longer class lives prescribed by the alternative depreciation system of section 168(g). A taxpayer may elect to use the methods and lives applicable to AMT depreciation for regular tax purposes.

The 1997 Act conformed the recovery periods (but not the methods) used for purposes of the AMT depreciation to the recovery periods used for purposes of the regular tax, for property placed in service after 1998. The 1997 Act did not make a conforming change to the election to use the pre-1998 AMT recovery methods and recovery periods for regular tax purposes.

Explanation of Provision

For property placed in service after 1998, a taxpayer would be allowed to elect, for regular tax purposes, to compute depreciation on tangible personal property otherwise qualified for the 200-percent declining balance method by using the 150-percent declining balance method over the recovery periods applicable to the regular tax (rather than the longer class lives of the alternative depreciation system of Sec. 168(g)).

Effective Date

The provision is effective for property placed in service after December 31, 1998.

2. Clarification of the small business exemption (Sec. 6006(a) of the Bill, Sec. 401 of the 1997 Act, and Sec. 55 of the Code)

Present Law

The corporate alternative minimum tax is repealed for small corporations for taxable years beginning after December 31, 1997. A small corporation is one that had average gross receipts of $5 million or less for a prior three-year period. A corporation that meets the $5 million gross receipts test will continue to be treated as a small corporation exempt from the alternative minimum tax so long as its average gross receipts do not exceed $7.5 million.

Explanation of Provision

The provision clarifies the application of the $5 million and $7.5 million gross receipts tests that a corporation must meet to be a small corporation exempt from the AMT. Under the provision, in order for a corporation to qualify as a small corporation exempt from the AMT for a taxable year, the corporation's average gross receipts for all 3-taxable-year periods beginning after December 31, 1993 and ending before such taxable year must be $7.5 million or less. The $7.5 million amount is reduced to $5 million for the corporation's first 3-taxable-year period (or portion thereof) beginning after December 31, 1993, and ending before the taxable year for which the exemption is claimed.

If a corporation's first taxable year beginning after December 31, 1997 (the first year the exemption is available) is its first taxable year (and the corporation does not lose its status as a small corporation because it is aggregated with one or more corporations under section 448(c)(2) or treated as having a predecessor corporation under section 448(c)(3)(D)), the corporation will be treated as an exempt small corporation for such year regardless of its gross receipts for such year.

The operation of the gross receipts tests for the small corporation AMT exemption is demonstrated by the following examples.

Example 1.--Assume a calendar-year corporation was in existence on January 1, 1994. In order to qualify as a small corporation for 1998 (the first year the exemption is available), (1) the corporation's average gross receipts for the 3-taxable-year period 1994 through 1996 must be $5 million or less and (2) the corporation's average gross receipts for the 1995 through 1997 period must be $7.5 million or less. If the corporation qualifies for 1998, the corporation will qualify for 1999 if its average gross receipts for the 3-taxable-year period 1996 through 1998 also is $7.5 million or less. If the corporation does not qualify for 1998, the corporation cannot qualify for 1999 or any subsequent year.

Example 2.--Assume a calendar-year corporation is first incorporated in 1999 and is neither aggregated with a related, existing corporation under section 448(c)(2) nor treated as having a predecessor corporation under section 448(c)(3)(D). The corporation will qualify as a small corporation for 1999 regardless of its gross receipts for such year. in order to qualify as a small corporation for 2000, the corporation's gross receipts for 1999 must be $5 million or less. If the corporation qualifies for 2000, the corporation also will qualify for 2001 if its average gross receipts for the 2-taxable-year period 1999 through 2000 is $7.5 million or less. If the corporation does not qualify for 2000, the corporation cannot qualify for 2001 or any subsequent year. If the corporation qualifies for 2001, the corporation will qualify for 2002 if its average gross receipts for the 3-taxable-year period 1999 through 2001 is $7.5 million or less.

Effective Date

The provision is effective for taxable years beginning after December 31, 1997.