Capital assets are property. Capital assets can be real property, such as a home or land, or they can be personal property, such as jewelry or artwork. Both individuals and businesses may own capital assets.
The law requires the sale of capital assets to be taxed. If the property owner sells a capital asset at a price that is greater than the price they paid for that asset, the individual has realized what the law refers to as capital gain.
The amount of profit, or the difference between the sales price and the initial purchase price, or capital gain, is taxed. Capital gains are considered to be a portion of an individual’s income. This income is subject to a special tax called the capital gains tax.
Capital assets are essentially any assets, whether or not they are connected to a trade or business, except for the following items:
- Stock in trade and other inventory of the individual;
- Property which is primarily held for sale to customers in the ordinary course of business;
- Depreciable property and real property used in a trade or business;
- A literary work, a musical, a copyright, an artistic composition, a letter or memorandum, or similar property that is held:
- by the taxpayer who created the property; or
- for a letter or memorandum, by the taxpayer for whom the property was prepared or produced; or
- by a taxpayer whose basis in the property is determined by referring to the basis of the individual who created it or the individual for whom the property was prepared;
- Accounts and notes receivables that were acquired in the ordinary course of business for services provided or for:
- Sale of stock in trade;
- Inventory; or
- Property normally held for sale to customers;
- United States government publications that are acquired by the taxpayer or received from another individual who bought the property at a price that is lower than the price which the publications are sold to the public;
- A commodities derivative financial instrument that is held by a commodities derivatives dealer;
- Hedging transactions that are clearly identified as such; and
- Supplies that are regularly used or consumed by the individual during the ordinary course of business.
What Are Some Examples of Capital Assets?
There are several common examples of capital assets, including:
- Stocks and bonds held as an investment;
- A personal residence;
- A personal automobile; and
- Personal jewelry.
What Are Capital Gains?
A capital gain is when an individual who holds a capital asset makes money on the sale of that asset. As noted above, when an individual exchanges or sells a capital asset at a gain, they may benefit from the beneficial capital gains tax rate. On the other hand, if the individual exchanges or sells a capital asset at a loss, they may only use the capital losses to offset their capital gains.
There is a special rule that applies to individual taxpayers. They may use up to $3,000 of capital loss to offset against their non-capital income each year. Any disallowed capital losses that remain for the taxpayer are typically carried forward to offset any future capital and non-capital income.
For example, suppose an individual purchases a piece of empty land. At the time of purchase, the land cost $100,000. The individual purchased that land in hopes that a future development or the passage of time would make it more valuable.
Suppose that after a few years, oil is found under that land. Oil is a very valuable resource. Land that contains oil is considered to be valuable property.
Therefore, as a result of the oil discovery, the value of that property rises from $100,000 to $600,000. If the owner sells the property at the higher value of $600,000, they have realized a capital gain.
The amount of a capital gain equals the increased price minus the purchase price. So, in this example, $600,000 minus $100,000. In this case, the amount of capital gain is $500,000.
What Is the Capital Gains Tax?
The Internal Revenue Code outlines who must pay taxes, when they must be paid, and the rate of taxation. This Code also requires that individuals pay taxes on their capital gains. The rate of taxation on capital gains depends upon whether the capital gain is long term or short term.
Generally, the Internal Revenue Service (IRS), the governmental body that administers the tax code, considers assets held for one year or less prior to being sold to be short term assets.
The one year time period begins on the day after the capital is purchased. The one year time period stops on the date of sale.
Typically, the capital gains tax rate for a short term gain is the same amount at which an individual’s ordinary income is taxed. This amount is referred to as their tax bracket.
As of the year 2020, there are seven ordinary income tax brackets, which are:
- 10 percent;
- 12 percent;
- 22 percent;
- 24 percent;
- 32 percent;
- 35 percent; and
- 37 percent.
In the United States, taxation is progressive. In other words, the greater an individual’s income, the higher of a percentage rate at which that income is taxed. For example, the income of an individual making $600,000 would be taxed as follows:
- The first $9,875 is taxed at 10%;
- Income between $40,126 and $82,525 is taxed at 22%; and
- All income above $518,400 is taxed at the highest possible amount, 37%.
As noted above, short term capital gains are taxed at the same rate as the individual’s tax bracket. In this case, since the individual earns $600,000, the tax rate on their short term capital gains will be 37%.
Long term capital assets are assets held for more than one year prior to their sale. The amount of capital gain on a long term capital asset is subject to capital gains tax.
The tax rate for long term capital gains is one of three percentages:
The tax rate depends on the individual’s taxable income and tax filing status, such as being single or married. Generally, long term capital gains are taxed at a lower tax rate than short term capital gains.
Is a Patent a Capital Asset?
Unlike a copyright, a patent is typically a capital asset in the hands of its original inventor or the unrelated party who purchased the patent from the original inventor. A patent may be excluded from being treated as a capital asset if the inventor is a professional who is in the business of selling patents to customers. It is important to note that exceptions may apply to a professional inventor if certain requirements are met.
Will My Residence Qualify as a Capital Asset if I Am Renting It Out?
If an individual holds their residence for rent, it will be considered to be used in a trade or business and will, therefore, not be a capital asset. However, that property may still qualify for capital treatment if the requirements are met.
Complications arise when an individual changes their purpose for having the residence. In those cases, the character of the asset must be determined on a case by case basis using the facts and circumstances of the individual.
Do I Need an Attorney to Help Me with My Tax Problems?
It is important to have the assistance of an experienced tax attorney for any tax problems you may have. Tax laws are numerous, complicated, and ever changing.
Although there are numerous tax preparation software on the market that may advertise to help you with tax problems, they cannot provide the same level of personal service as an experienced and knowledgeable tax attorney can. If you are unsure about the characterization of an asset or you need representation before the IRS, a tax attorney can help you.