The Tax Increase Prevention and Reconciliation Act of 2005 had previously increased the age from “under age 14” to “under age 18” beginning with tax year 2006. Now the age has been increased to “under age 19”, or to “under age 24” for full-time students – so it basically applies to all your dependent “children”.
The new increase in the age is effective for “tax years beginning after May 25, 2007”. For calendar year taxpayers, as most of us are, the new age is effective for the 2008 federal income tax return.
This means that 2007 is the last year that parents can sell investments that have been “gifted” to a college student dependent, or have been purchased in an account set up in the name of the dependent, and get the benefit of the lower 5% capital gain tax rate.
The cost basis of an investment that has been “gifted” and sold at a gain is the same as the donor’s cost basis. The “holding period” of a gifted investment for the “donee”, which determines capital gain tax treatment, begins when the investment was first purchased by the “donor”.
Let’s say the parents of a current college student purchased a stock for $10,000 in 2003. In 2006 they transfer title to the stock to their son as a gift. In 2007 the stock is sold by the son, age 19, for $15,000 to pay for his college tuition. The son would report a long-term capital gain of $5,000 on his 2007 Form 1040 and pay $250 (5%) in federal income tax on the gain.
If the parents had retained title of the stock and sold it for a $5,000 gain in 2007 to pay for their son’s tuition they would most likely pay $750 (15%) in federal income tax on the gain – or $500 more.
If the sale of the gifted stock took place in 2008 instead of 2007, depending on the extent of the son’s other “unearned” income, part, if not all, of the $5,000 gain would be taxed at the parents’ tax rate.
The change in the Kiddie Tax is especially bad news for parents who were hoping to take advantage of the 0% capital gains tax rate that replaces the 5% rate in 2008. CCH reports in its Tax Briefing on the Small Business and Work Opportunity Act portion of the war funding bill that earlier this year many Congresspersons had been calling for preventing dependents under age 24 from being able to take advantage of the 0% capital gains tax rate – and now they have their wish.
The Kiddie Tax was created by the Tax Reform Act of 1986 to keep parents from sheltering income by putting accounts in their children’s names. FYI, you can read about the history of the federal income tax on the TAX HISTORY Page of my website.
I must point out that the Kiddie Tax only applies to “unearned” – or investment – income, such as interest, dividends and capital gains. It does not apply to “earned” income – such as W-2 wages and net earnings from self-employment.