By Gary Klott

Published: February 1, 1985

Investors received one of the few plums handed out on Capitol Hill last summer when Congress was busily cutting back on tax benefits to help trim the Federal budget deficit. They got a break on capital gains. The amount of time investors need to hold stocks or other assets for profits from their sale to be eligible for preferential tax treatment was reduced to six months and a day from one year and a day.

At the same time, however, Congress sharply restricted the capital gains that can be taken on bonds bought at a discount, and it put new limitations on the deductibility of interest on money borrowed to purchase bonds.

The reduced holding period for capital gains applies to assets acquired after June 22, 1984. So investors who purchased assets soon after that date and sold them in late December will be the first beneficiaries of the change and the only ones to benefit from the provision on 1984 tax returns.

Assets acquired before June 23 are still subject to the 12-month holding requirement to qualify for the favored tax treatment.

Short-term gains are taxed just like wages, at rates of up to 50 percent. But if the asset qualifies for long- term status by being held the required length of time before selling, only 40 percent of the profit is generally subject to tax. Thus, the effective tax rate on a long-term gain for people in the top 50 percent tax bracket is 20 percent.

The change in the holding period also affects assets purchased after June 22 and sold after six months at a loss. This becomes a long-term loss. Taxpayers with losses find the reduced holding period a disadvantage.

All capital losses are useful because they can be used to offset other income. But short-term losses are more valuable than long-term losses because they offset more income. A net short-term loss will offset other income, dollar for dollar. But it takes $2 of net long-term losses to offset $1 of ordinary income.

Capital losses are first used to offset capital gains. If losses exceed the gains, any excess can be used to cut ordinary income by as much as $3,000. After the $3,000 limit is reached, remaining losses can be carried over to a future year.

Pinched by Bond Provision

Although the reduced holding period for capital gains will benefit many taxpayers, some of them will feel pinched by the new limits on capital gains on bonds.

Under one provision, profits on bonds issued after last July 18 will no longer automatically qualify for the long-term capital gains tax treatment. The provision affects bonds purchased in the open market at a discount from face value.

Older bonds sell at cut-rate prices in the marketplace whenever brand- new bonds are being offered with higher interest rates. The older bonds, with their lower rates, have to sell at lower prices to compete.

Congress, contending that this discount is just a substitute for interest income, decided that gains on such bonds should be taxed just like interest income, at regular rates, instead of the lower long-term capital gain rates.

Discount to Be Amortized

If the bond is held to maturity, the difference between the purchase price and the redemption value would be taxed at regular rates. If sold earlier, part of the gain would be taxed at regular rates and part at capital gains rates.

Leon M. Nad, national director of technical tax services at Price Waterhouse, gave the example of a $1,000 bond with a 10-year maturity purchased by an investor one year after issuance at a price of $940. The $60 discount is assumed to be interest income for tax purposes, and it will have to be amortized over the remaining nine-year life of the bond.

If the bond were sold for a profit a year later, one-ninth of the $60 discount, or $6.67, would be assumed to have been accrued interest and would be taxed at regular rates. The rest of the gain, if any, would be taxed as a long-term capital gain.

The market discount provision should not alter any tax bills for 1984 since bonds issued after July 18 could not have been held long enough during 1984 for the gain to qualify for long-term capital gains tax treatment. Thus, any gain would be taxed at regular rates anyway.

Certain Bonds Exempted

A way around the new provision, says Steven D. Oppenheim, a tax partner at the accounting firm of Oppenheim, Appel, Dixon & Company, is to buy bonds issued before July 19. But eventually, he said, the newer bonds will likely yield more than pre- July 19 bonds because of the added tax bite. Exempt from the new provision are United States Savings Bonds, short-term obligations with a maturity of Yx.xc s x-exempt bonds.

Congress also put new limitations on interest expense deductions for money borrowed to purchase bonds. Even so, the tax law still generally acknowledges that it takes money to make money. So many of the expenses that investors incur in trying to produce more income are eligible for a tax deduction.

»To the extent you are able to directly attribute incurring an expense to an investment activity or income- producing activity, you are likely to succeed in claiming a deduction,» said Barry Salzberg, regional director of personal tax services at the accounting firm of Deloitte Haskins & Sells.

Items That Are Deductible

Safe deposit box rental fees are deductible if they are used to store stocks, bonds or other taxable investments. Investment advisory fees and custodial fees are also deductible.

Brokers’ commissions, however, are not, although they may be added to the cost of the asset for purposes of calculating the capital gain on the sale of the asset.

Travel expenses for trips to look after rental property are deductible. But the Internal Revenue Service and the courts do not give carte blanche.

In one instance, deductions were disallowed for a San Francisco resident who made several trips to San Diego to visit his fiancee and, while there, checked on a house that he owned and was trying to rent out. The Tax Court, which was upheld on appeal, ruled that the trips were essentially personal and that visiting the house he owned was only incidental.

The courts have also repeatedly disallowed deductions for trips to investigate prospective rental properties, contending that an existing interest in the property is needed for the costs to be deductible.

Investment Seminar Trips

In recent years, investment seminars have been a popular way for investors to make tax-deductible trips to resort areas. But a recent I.R.S. private letter ruling raises new concerns about such deductions.

An unidentified taxpayer who had investments in a car wash, a laundry and real estate, as well as stocks and mutual funds, attended a financial planning seminar covering basic concepts of financial planning, investments, wills, tax planning and the like. But the I.R.S. ruled that the investor could not deduct the cost of the seminar, arguing that the seminar was »of a generalized nature» and »lacked the requisite proximate relationship» to the investor’s income- producing activities.

»That’s the I.R.S.’s view, but that’s not necessarily the last word on it,» said Mr. Nad of Price Waterhouse. »If you’re taking a financial planning seminar of substance, then I think you’ve got a good crack at deductibility.»

Tomorrow: Married people and homeowners.

Chart of I.R.S. numbers to call for answers to taxpayer inquiries