0% Capital Gains and Qualified Dividends in 2008 for Qualifying Taxpayers

Most people are familiar with the provision from the Jobs and Growth Tax Reconciliation Act of 2003 that lowered the tax rate on long-term capital gains and qualified dividends to 15%. However, that act contained another provision relating to long-term capital gains and qualified dividends that didn’t receive much attention as it will not affect many taxpayers and did not take effect until 2008. That being said, it could provide a nice tax savings opportunity for those in a low tax bracket, such as some college students, young adults, retirees with limited taxable income or whose income consists primarily of tax-exempt securities, etc.

This provision provides for a 0% tax rate on long-term capital gains and qualified dividends for taxpayers that would be subject to the 10% and 15% tax brackets. In other words, married taxpayers with taxable income of less than $65,100, and single taxpayers with taxable income of less than $32,550 may be able to benefit. For example, a young married couple with $60,000 of compensation, $1,000 of interest income, $20,000 of itemized deductions and $7,000 of personal exemptions (taxable income of $34,000) may be able to recognize $31,100 in long-term capital gain or qualified dividend income, without incurring any additional federal tax liability (a potential tax savings of $4,665). 

A potential problem exists for many taxpayers whose income may be low enough to benefit from this tax law, as they often may not own the securities necessary to generate any long-term capital gains or qualified dividends. In this case, a gift of marketable securities could enable them to take advantage of this opportunity. The recipient receives the donor’s tax basis and holding period, so the subsequent sale of the securities could generate the desired long-term capital gain, or simply holding the security may generate the desired qualified dividend income. However, the Internal Revenue Service taxes unearned income recognized by most children through age 17 (through age 23 if a full time student) at the parents’ rate (the “kiddie-tax”), so this will not work for everyone. You should talk to your tax advisor before engaging in this strategy to determine whether any kiddie-tax and/or gift tax implications arise.

This provision is effective for the 2008 through 2010 tax years. However, there is speculation that the law could be changed depending on who wins the presidential election, so this strategy should be re-evaluated each year. Furthermore, this law only applies to the federal tax return, so there may be state income taxes to consider.

Because of the income limitations and the kiddie-tax rules, this strategy has limited application. However, it provides an opportunity to turn otherwise taxable income into tax-free income for those who are able to take advantage of it.