**PRESENT LAW AND BACKGROUND
**RELATING TO TAXATION OF**

**CAPITAL GAINS**

Scheduled for a Public Hearing

Before the 

HOUSE COMMITTEE ON WAYS AND MEANS

on February 12, 1998

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

February 6, 1998

JCX-4-98

**CONTENTS**
INTRODUCTION 		

	I.	PRESENT LAW AND LEGISLATIVE HISTORY		
- Present Law	 Legislative History	
	II.	DISCUSSION OF ISSUES		

APPENDICES		
Appendix A. 1996 Schedule D and worksheet to Form 1040Appendix B. 1997 Schedule D to Form 1040
**INTRODUCTION**

	The House Committee on Ways and Means has scheduled a public hearing on issuesrelating to capital gains on February 12, 1998.  This document,(1) prepared by the staff of the JointCommittee on Taxation, provides a discussion of present law, legislative history, and analysis ofissues related to the Federal income taxation of capital gains.

	Part I of the document is a description of present law and legislative history on capitalgains.  Part II is an analysis of issues.  Appendix A and B, respectively, present copies of IRScapital gains forms (Schedule D for Form 1040) for 1996 and 1997.

**I.  PRESENT LAW AND LEGISLATIVE HISTORY**

**A.  Present Law**

	In general, gain or loss reflected in the value of an asset is not recognized for income taxpurposes until a taxpayer disposes of the asset.  On the sale or exchange of capital assets, any gaingenerally is included in income, and the net capital gain of an individual(2) is taxed at maximumrates lower than the rates applicable to ordinary income.  Net capital gain is the excess of the netlong-term capital gain for the taxable year over the net short-term capital loss for the year.  Gainor loss is treated as long-term if the asset is held for more than one year.

	A capital asset generally means any property except (1) inventory, stock in trade, orproperty held primarily for sale to customers in the ordinary course of the taxpayer's trade orbusiness, (2) depreciable or real property used in the taxpayer's trade or business, (3) specifiedliterary or artistic property, (4) business accounts or notes receivable, or (5) certain U.S.publications.  In addition, the net gain from the disposition of certain property used in thetaxpayer's trade or business is treated as long-term capital gain.  Gain from the disposition ofdepreciable personal property is not treated as capital gain to the extent of all previousdepreciation allowances.  Gain from the disposition of depreciable real property is generally nottreated as capital gain to the extent of the depreciation allowances in excess of the allowances thatwould have been available under the straight-line method of depreciation.

	The maximum rate of tax on the adjusted net capital gain of an individual is 20 percent.  Inaddition, any adjusted net capital gain which otherwise would be taxed at a 15-percent rate istaxed at a 10-percent rate. These rates apply for purposes of both the regular tax and thealternative minimum tax.

	The "adjusted net capital gain" of an individual is the net capital gain reduced (but notbelow zero) by the sum of the 28-percent rate gain and the unrecaptured section 1250 gain.(3)  Thenet capital gain is reduced by the amount of gain which the individual treats as investment incomefor purposes of determining the investment interest limitation under section 163(d). 

	The term "28-percent rate gain" means the amount of net gain attributable to long-termcapital gains and losses from property held more than one year but not more than 18 months,gains and losses from the sale or exchange of collectibles (as defined in section 408(m) withoutregard to paragraph (3) thereof) held more than 18 months ("collectibles gain and loss"),  anamount of gain equal to the amount of gain excluded from gross income under section 1202,relating to certain small business stock ("section 1202 gain"),(4) the net short-term capital loss forthe taxable year, and any long-term capital loss carryover to the taxable year. 

	"Unrecaptured section 1250 gain" means any long-term capital gain from the sale orexchange of section 1250 property (i.e., depreciable real estate) held more than 18 months to theextent of the gain that would have been treated as ordinary income if section 1250 applied to alldepreciation, rather than only to a portion of the depreciation, reduced by the net loss (if any)attributable to the items taken into account in computing 28-percent rate gain.  The amount ofunrecaptured section 1250 gain (before the reduction for the net loss) attributable to thedisposition of property to which section 1231 applies shall not exceed the net section 1231 gainfor the year.  

	The unrecaptured section 1250 gain is taxed at a maximum rate of 25 percent, and the 28-percent rate gain is taxed at a maximum rate of 28 percent.  Any amount of unrecaptured section1250 gain or 28-percent rate gain otherwise taxed at a 15-percent rate is taxed at the 15-percentrate.

	For taxable years beginning after December 31, 2000, any gain from the sale or exchangeof property held more than five years which would otherwise be taxed at the 10-percent rate willinstead be taxed at an 8-percent rate.  Any gain from the sale or exchange of property held morethan five years and the holding period for which begins after December 31, 2000, which wouldotherwise be taxed at a 20-percent rate will be taxed at an 18-percent rate. A taxpayer holding acapital asset or property used in the trade or business on January 1, 2001, may elect to treat theasset as having been sold on that date for an amount equal to its fair market value, and havingbeen reacquired for an amount equal to such value.

**B. Legislative History**

**Reduced tax rate for capital gains**

	Noncorporate capital gains were taxable at reduced rates from 1921 through 1987. TheRevenue Act of 1921 provided for a maximum 12.5 percent tax on gain on property held forprofit or investment for more than two years (excluding inventory or property held for personaluse). Because of the relatively low tax rates on ordinary income during the 1920s and 1930s, thisprovision benefited only higher bracket taxpayers.

	The system of capital gains taxation in effect prior to the Tax Reform Act of 1986 datedlargely from the Revenue Act of 1942 ("1942 Act"). The 1942 Act provided for a 50-percentexclusion for noncorporate capital gains or losses on property held for more than six months. The1942 Act also included alternative maximum rates on capital gains taxes for noncorporate andcorporate taxpayers. The basic structure of the 1942 Act was retained under the Internal RevenueCode of 1954.

	The Revenue Act of 1978 increased the exclusion for noncorporate long-term capitalgains from 50 to 60 percent and repealed the alternative maximum rate. Together with concurrentchanges in the noncorporate minimum tax, this had the effect of reducing the highest effective rateon noncorporate capital gains from approximately 49 percent(5) to 28 percent. The reduction in themaximum individual rate from 70 to 50 percent under the Economic Recovery Tax Act of 1981reduced the maximum effective capital gains rate from 28 percent to 20 percent.

	The Tax Reform Act of 1986 ("1986 Act") repealed the provisions granting reduced ratesfor capital gains, fully effective beginning in 1988. The 1986 Act provided that the maximum rateon capital gains (i.e., 28 percent) would not be increased in the event the top individual rate wasincreased by a subsequent public law (unless that law specifically increased the capital gains tax).The Revenue Reconciliation Act of 1990 raised the maximum individual income tax rate to 31percent, and the Revenue Reconciliation Act of 1993 raised the top income tax rate to 39.6percent. Neither Act raised the maximum individual capital gains rate.

	The current capital gains tax rate structure described in Present Law, above, was enactedby the Taxpayer Relief Act of 1997 (the "1997 Act"). 

	The Internal Revenue Code of 1954 as originally enacted provided for an alternative taxrate of 25 percent on corporate capital gains. The Tax Reform Act of 1969 raised this rate to 30percent. The Revenue Act of 1978 reduced the corporate alternative rate to 28 percent, and the1986 Act repealed the corporate alternative rate.

**Holding period**

	Under the Revenue Act of 1921, the alternative maximum rate for capital gains applied toproperty held for more than two years. Since that time, Congress has, on several occasions,adjusted the holding period required for reduced capital gains taxation.

	The Revenue Act of 1934 provided for exclusion of varying percentages of capital gainsand losses depending upon the period for which an asset was held. Under that Act, 20 percent ofcapital gains was excludible if an asset was held for one to two years, 40 percent if an asset washeld for two to five years, and 60 percent if the asset was held for between five and 10 years.Where an asset had been held for more than 10 years, 70 percent of capital gains was excluded.

	The Revenue Act of 1938 provided for two classes of long-term capital gains. For assetsheld for 18 months to two years, a 33-percent exclusion was allowed. Where assets were held formore than two years, a 50-percent exclusion was provided. No exclusion was allowed for assetsheld for 18 months or less. The 1938 Act also provided alternative ceiling rates applicable to thesame holding periods as the capital gains exclusions.

	In the 1942 Act, Congress eliminated the intermediate holding period for capital gainspurposes. The 1942 Act provided for two categories of capital assets: assets held for more thansix months (long-term capital assets), for which a 50-percent exclusion was allowed; and assetsheld for six months or less (short-term capital assets), for which no exclusion was provided. Thealternative tax rates on individual and corporate net capital gains (i.e., the excess of net long-termcapital gains over short-term capital losses) were based upon the same six-month holding period.

	A six-month holding period for long-term capital gains treatment remained in effect from1942 through 1976. The Tax Reform Act of 1976 increased the holding period to nine months for1977 and to one year for 1978 and all subsequent years. The Deficit Reduction Act of 1984reduced the holding period to six months for property acquired after June 22, 1984, and before1988. After 1988, the holding period for long-term capital gains has been one year.  The 1997 Actprovided different rates for long-term capital gains depending on the holding period of the asset. These rates are described above in the Present Law discussion.  

**Treatment of gain and loss on depreciable assets and land used in trade or business**

	Depreciable property used in a trade or business was excluded from the definition of acapital asset by the Revenue Act of 1938, principally because of the limitation on deductibility oflosses imposed by the Revenue Act of 1934. This step was motivated in part by the desire toremove possible tax deterrents to the replacement of antiquated or obsolete assets such asequipment, where depreciation would be fully deductible against ordinary income if the asset wereretained, but loss would be subject to the capital loss limitations if the asset were sold.

	The availability of capital gain treatment for gains from sales of depreciable assets stemsfrom the implementation of excess profits taxes during World War II. Many depreciable assets,including manufacturing plants and transportation equipment, had appreciated substantially invalue when they became subject to condemnation or requisition for military use. Congressdetermined that it was unfair to tax the entire appreciation at the high rates applicable to wartimeprofits. Accordingly, in the Revenue Act of 1942, gains from wartime involuntary conversionswere taxed as capital gains. The provision was extended to voluntary dispositions of assets since itwas not practical to distinguish condemnations and involuntary dispositions from sales forcedupon taxpayers by the implicit threat of condemnation or wartime shortages and restrictions.

	The Revenue Act of 1938 did not exclude land used in a trade or business from the capitalasset definition. Since basis would have to be allocated between land and other property forpurposes of depreciation in any event, the differing treatment of land used in a trade or businessand depreciable property used in a trade or business was not viewed as creating serious allocationdifficulties.

	However, in the Revenue Act of 1942, Congress excluded land used in a trade or businessfrom the definition of a capital asset and extended to such property the same special capitalgain/ordinary loss treatment afforded to depreciable trade or business property.

	In 1962, Congress required that depreciation on section 1245 property (generally,personal property) be recaptured as ordinary income on the disposition of the property. In 1964,Congress required that a portion of the accelerated depreciation on section 1250 property(generally, real property) be recaptured as ordinary income. Subsequent amendments generallyhave required that the entire amount of accelerated depreciation on section 1250 property berecaptured as ordinary income.  Any depreciation taken to the extent allowable under thestraight-line method is generally not recaptured as ordinary income, but rather creates capital gain. The 1997 Act provided that the capital gain attributed to the unrecaptured depreciation is taxed ata maximum rate of 25 percent, rather than at the lower rates applicable to capital gains generally.

**II.  DISCUSSION OF ISSUES**

**Preferential rate for capital gains**

	Many argue that higher income tax rates discourage sales of assets. Preferential tax rateson capital gains impose a smaller tax on redirecting monies from older investments to projectswith better prospects, which contributes to a more efficient allocation of capital. A secondargument for preferential capital gains tax rates is that they encourage investors to buy corporatestock, and especially encourage investors to provide venture capital for new companies, therebystimulating investment in productive business activities. Others argue that the capital gainspreference may be an inefficient mechanism to promote the desired capital formation. They arguethat a preferential capital gains tax rate, broadly applied, is not targeted toward any particular typeof equity investment.

	The United States has a relatively low rate of household saving, currently less than 5percent of disposable income. By reducing the tax on realized capital gains, the after-tax return tohousehold saving is increased. Economic evidence is ambiguous on whether, and in whatmagnitude, household saving responds to changes in the after-tax rate of return.

	Proponents of a further reduction in capital gain tax rates observe that many of our majortrading partners have lower marginal tax rates on the realization of capital gains than does theUnited States. Opponents of a capital gains preference argue that the fact that marginal tax rateson capital gains are higher in  the United States than in other countries does not implyautomatically that American firms are at a competitive disadvantage. 

	Preferential capital gains treatment on a disposition of corporate stock might be viewed asameliorating the double taxation of corporate earnings. The first step of double taxation occurs atthe corporate level; the second step occurs at the shareholder level as dividends are paid or asshares that have increased in value (presumably by retained earnings) are sold. However, anyrelief that a capital gains preference provides from the burden of double taxation applies only toretained corporate earnings. Distributed earnings still would be generally subject to doubletaxation.

	Opponents of a further reduction in the rate of tax on capital gains argue that appreciatingassets already enjoy a preferential rate of tax and a tax benefit from the deferral of tax on accruedappreciation until the asset is sold.  The benefit of deferral reduces inflationary effects. Proponentsof a further preference for capital gains contend that the benefit of deferral is insufficient to makeup for more than very modest inflation. Moreover, they note that not taxing accrued appreciationis an inherent aspect of a realization-based tax system.

	To the extent that preferential rates may encourage investments in stock, opponents haveargued that the preference tilts investment decisions toward assets that offer a return in the formof asset appreciation rather than current income such as dividends or interest. On the other hand,it is argued that asset neutrality is not an appropriate goal because risky investments that producea high proportion of their income in the form of capital gains may provide a social benefit notadequately recognized by investors in the marketplace.

	Opponents of the preferential capital gains rate contend that it also encourages taxpayersto enter transactions designed to convert ordinary income to capital gains. On the other hand, it isargued that such "conversion" opportunities are simply an additional tax incentive for types ofinvestments the capital gains preference is intended to encourage.

**Holding period for preferential taxation**

	Present law provides different tax rates applicable to income from the realization of capitalgains depending upon the type of asset (e.g., shares of stock in a corporation versus certaindepreciable real estate) and the holding period (e.g., stock held for nine months versus stock heldfor nine years).  These different tax rates add complexity to the Code, complicate financialplanning, require more detailed record keeping by the taxpayer, require more difficult forms tocomplete when computing tax liability, and increase the likelihood of inadvertent error. Elimination of one or more of these different rates would reduce complexity.

	Tax rates that decrease with the length of the holding period may distort taxpayers'choices regarding the optimal time to make sales and redeploy their investment funds to achievean efficient mix of expected return and risk.  Proponents of tax rates that vary by length of thetaxpayer's holding period argue that it is important to encourage long-term investment.  Theyargue that longer holding periods, which effectively lock investors into their investments forperiods longer than they might choose in the absence of taxation, promote a more long-run viewby the managers of corporations.  They contend that because of short-term trading, the stockmarket forces corporate managers to pursue short-term profits and that short-term profits maycome at the expense of funding research and development or other long-term investments.  Theyargue that if corporate management took a longer run view, then different, more productive,investments would be chosen and the nation's economic growth would accelerate.

	Opponents of capital gains tax rates that vary by holding period note that there is noeconomic reason why the holding period of investors should affect the planning horizon ofcorporate managers as long as all shareholders desire to see the value of their holdings maximized. Opponents further observe that there is little or no empirical evidence that companies in which theturnover rate of the company's shares is high engage in investment strategies different from thoseof companies in which the turnover rate of the company's shares is low.  They cite the high valuesplaced on certain technology stocks as evidence that the stock market is willing to pay for returnswhich accrue in the future.  In addition, the step-up in an asset's basis upon the taxpayer's deathprovides a significant incentive for long-term holding.  Further, opponents point out that tax ratesthat vary by holding period affect only domestic taxpayers and that tax-exempt organizations(e.g., pension funds) and foreign investors account for a substantial amount of trading volume. By locking taxpayers into their present investments as market opportunities change, the efficiencyof capital markets may be reduced, thereby reducing potential gains in aggregate economicgrowth.

	Other proponents of multiple capital gains tax rates argue that reducing rates on assetsthat have been held for longer periods may provide some rough offset for the effect of inflation onthe value of the assets.  Opponents note that such offset is quite rough and may not account forthe fact that taxation upon realization already provides an effective reduction in the tax burden. 

	Once a regime of differential rates by holding period has been chosen, the cutoff lengths ofthe holding period are somewhat arbitrary.  Economic analysis can provide little rationale forfavoring a distinction between a short-term gain taxed at ordinary income tax rates and a longerheld gain which receives some sort of preferential rate.  At different times during the past 25years, the Congress has made this distinction six months, nine months, one year, and, mostrecently, 18 months. 

**Distributional effects of a reduction in the taxation of capital gains**

	A further exclusion from income for gain on the sale of capital assets will benefit directlythose taxpayers who hold assets with accrued capital gains. Information is somewhat scantregarding the distribution of assets with accrued capital gains among different taxpayers. Taxreturn data contain information on which taxpayers have realized capital gains in the past. Thesedata reveal that many taxpayers realize a capital gain from time to time, but the majority of thedollar value of gains realized are by taxpayers who frequently realize capital gains.  The largestshare of the dollar value of gains realized by those taxpayers who frequently realize capital gains isby higher income taxpayers.  As a result, it is higher-income taxpayers who have the greatest taxliability from the realization of capital gains.

**Complexity of IRS tax forms**

	Unlike prior law, the capital gains reduction enacted by the 1997 Act is a multiple ratesystem:  28 percent for the sum of gain from collectibles, includible small business gain,(6) gainproperly taken into account before May 7, 1997, and gain from assets held between 12 and 18months; 25 percent for unrecaptured real estate depreciation; and 20 percent (10 percent for gainotherwise taxed at 15 percent) for the remainder of the net capital gain.  In addition, in 2001, gainfrom assets held for more than 5 years will be eligible for an 8-percent rate rather than a 10-percent rate and in 2006 assets held more than 5 years and acquired after 2000 will be eligible foran 18-percent rate rather than a 20-percent rate.

	Prior to 1987, individuals were allowed a 60-percent deduction for the net capital gain, asystem that resulted in a different maximum effective rate for each tax rate bracket.  Under thepre-1986 Act rules, no special tax computation was necessary, because a deduction was allowedin computing taxable income and then the tax was computed using the regular tax rate schedule ortable.  In addition, because the deduction was a single fixed percentage, it was unnecessary toapply differing percentages to different components of the net capital gain.  Under this system,individuals in any tax bracket reporting capital gain only from mutual fund distributions couldreport 40 percent of the gain on Form 1040 and not file a Schedule D (the form to report capitalgains).

	Under the rules in effect from 1991 through 1996, only individuals in the 31-percent orhigher tax brackets were required to make the tax computation on the 13-line worksheet toSchedule D, because individuals with taxable incomes below the 31-percent bracket received nobenefit of capital gains.  (See Appendix A for a copy of the 1996 schedule D and capital gainworksheet.)  Under the 1991-1996 rules, capital gain distributions from mutual funds forindividuals in the 15- or 28-percent tax bracket could be reported directly on Form 1040 withoutfiling a Schedule D.  In 1994, 5.8 million taxpayers reported capital gain distributions in this way. 

	Under the rules enacted in the 1997 Act, every individual with a net capital gain (includingthose whose only capital gain is from mutual fund distributions) needs to complete the 36-line taxcomputation on Schedule D to receive the benefit of the lower capital gain rate.  (See Appendix Bfor a copy of the 1997 Schedule D.)  The multiple rate system adopted by the 1997 Act requiresForm 1099s and Schedule Ks received by holders of interests in pass-through entities, such asmutual funds, REITS, partnerships, trusts, estates, and Sub S corporations to report multiplecategories of gain so that the investor may properly compute the capital gains tax.  Additionalcalculations will have to be added to Schedule D and additional reporting will be required in both2001 and 2006 when the additional capital gain rates become effective.

	Because, under the 1997 Act, amounts taxed at the various rates are based, not on grossgains from within a category, but rather on net amounts of gain, rules for netting gains and lossesare needed.  The net gain must be arrived at by offsetting gains within a category by losses fromwithin the same category as well as net long-term losses from other categories, net short-termcapital losses, long-term capital loss carryovers, and ordinary losses.  Also, lower capital gainrates must be computed for income otherwise taxed at the 15-percent rate.  The 1997 Act (asproposed to be amended by the Tax Technical Corrections Act of 1997) sets forth rules formaking these computations.  Many of the additional lines added to the Schedule D for 1997 areneeded to do these computations.

	Further, section 1231 provides, in general, that if there is a net long-term gain from certainassets used in a trade or business, then all the gains and losses comprising that net gain are capitalgains and losses.  However, if there is a net section 1231 loss, then all the gains and losses areordinary gains and losses.  When there was only one category of long-term gain and loss, any losswould offset the tax on any gain, dollar-for-dollar, whether or not the gains and losses are allcharacterized as capital or ordinary.  Under the 1997 Act multiple rate system, because section1231 gains and losses, if treated as long-term capital gains and losses, may fall into differing ratecategories,  a "notch" may be created where the net amount turns from positive to negative.  The1997 Act dealt with this problem by, in part, limiting 25-percent gain from section 1231 assets tothe net section 1231 gain.  This too adds additional computational complexity.

	Finally, beginning in 1997, any individual having a net capital gain and needing to computethe tentative minimum tax amount is required to fill out a 22-line tax computation on Form 6251(Alternative Minimum Tax).

	If one or more of the categories of capital gain were eliminated, the tax computation couldbe simplified.(7)  However, a rate structure that is different for all taxpayers for income from capitalgains as opposed to the rate structure on other income requires all taxpayers with any net capitalgain to file a Schedule D, and compute their tax on net capital gain separately from ordinaryincome.  While requiring more taxpayers to undertake more computations and file more formsincreases the complexity of the individual income tax,  present law reduces the tax burden onincome from capital gains compared to prior law.

**APPENDIX A**

**1996 Schedule D and worksheet to Form 1040**

**[NOT AVAILABLE IN ON-LINE VERSION]**

**APPENDIX B**
**1997 Schedule D to Form 1040
**[NOT AVAILABLE IN ON-LINE VERSION]**

1.   This document may be cited as follows:  Joint Committee on Taxation, *Present Law andBackground Relating to Taxation of Capital Gains*(JCX-4-98), February 6, 1998.
2.   For purposes of this discussion, an individual includes a trust or estate.
3.   The description of present law includes the technical corrections provisions of Title VI(section 605(d)) of H.R. 2676, the "Tax Technical Corrections Act of 1997," as passed by theHouse on November 5, 1997.
4.   This results in a maximum effective regular tax rate on qualified gain from small businessstock of 14 percent.
5.   The 49-percent rate resulted in certain cases where the taxpayer was subject to theindividual "add-on" minimum tax and the maximum tax "earned income" limitation. 
6.   For gain of $10 million or less from a single qualifying small business stock, only 50percent of the qualifying gain is includible.  This creates an effective tax rate equal to 14 percent.
7.   After August 13, 1998, gain from certain small business stock will be eligible for a 50-percent exclusion.  The includible portion of the gain will be subject to the maximum 28-percentrate and 42 percent of the gain will be a minimum tax preference.  This results in a 14-percentmaximum regular tax rate (7.5 percent for gain otherwise in the 15-percent bracket) and a 19.88-percent alternative minimum tax rate.  The treatment of this gain could be simplified by reducingthe exclusion to 30 percent, by treating the includible gain in the same manner as any other capitalgain eligible for the 20- and 10-percent maximum rates, and by repealing the minimum taxpreference.  The maximum regular tax rate would remain 14 percent (7 percent for gain otherwisein the 15-percent bracket) and the alternative minimum tax rate would be 19.5 percent.****