A capital asset is any property of significant value such as a home, investment property or art that can be sold or exchanged for a gain. The capital asset can be owned by an individual or a business.
In the case of a business, the asset cannot be part of its inventory. For example, the desks owned by the business would be considered capital assets, but not if the desks are part of what the business offers to sell in its normal course.
Likewise, if a taxpayer owns a piece of property, the property may be determined to be a capital asset depending on the taxpayer’s purpose in holding the property. This purpose can be particularly important for people who own homes, which can be held as primary residences or investment properties.
You realize a capital gain when you sell your asset for more than you purchased it. Conversely, you have a capital loss if you sell it for less. You realize a capital gain when you sell the capital asset.
If your asset is simply sitting there appreciating value, there is no capital gain realized until the asset is actually sold. If you have earned a capital gain, this will trigger income tax reporting requirements. For example, if there is a capital gain, this is considered part of your taxable income and will impact your tax obligation.
If you have realized a net capital gain from the sale of your capital asset, this will be factored into your income tax, which will determine what you owe or whether you are entitled to a tax refund. In the United States, individuals and corporations must report their capital gains.
The Internal Revenue Service will start by determining whether there has been a long-term or short-term loss or gain. Assets held for more than a year before being sold or exchanged would be classified as long-term.
Assets held for less would be considered short-term. To determine the length of time you have held the asset, count from the day after you acquired it until the day you sold it. There are exceptions to these general rules, such as for property acquired by gift or from an inheritance.
Long-term assets are generally taxed at a lower rate than other assets. Short-term assets are taxed at a higher rate. The length of time you own the asset and your income tax bracket will factor significantly in determining what you will be taxed.
If you have realized a net capital gain –the amount by which your long-term capital gain exceeds your net short-term capital loss—then that gain will be taxed at a lower rate than your ordinary income.
Most taxpayers will have their net capital gain taxed no higher than 15%. Some taxpayers in the lowest tax brackets (between 10% and 15%) actually pay no capital gains taxes. It will be higher if the taxpayer’s taxable income exceeds the thresholds for ordinary tax rate (in the 39.6% bracket, you will pay 20%).
There are other exceptions as well. For example, some net capital gains are subject to a 25% to 28% tax rate (depreciated real estate and collectibles). You should consult with a qualified tax professional to ensure you are taking advantage of all the exceptions provided.
If you have realized no profits from the sale of your capital asset, you may be entitled to deduct that from your income for tax reporting purposes. For example, you may be able to deduct a capital loss on your investment property.
An investment loss is used to offset a capital gain of the same kind. That is, short-term losses are deducted against short-term gains and long-term losses are deducted against long-term gains.
You can generally avoid capital gains tax on the sale of your house if it is your primary residence. To avoid paying a capital gains tax, you must have owned and lived in your home for at least two years in a five-year period before the sale and must not have excluded the gain from another home sale in the same two-year period. If these conditions are met, you can exclude up to $250,000 of your gain as a single filer and up to $500,000 as joint filers.
The federal income tax reporting obligations are extremely complicated and can result in serious consequences for anyone who fails to satisfy them. You can consult with a licensed tax professional, like an accountant, to understand your reporting obligations. A business attorney can also be helpful if you have a taxable estate or if you are the subject of an IRS proceeding.