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Capital Assets... What Are They Really?

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By Roy Lewis

On the Tax Strategies discussion board, we use the words "capital gain" almost every day. Why? Because gains on the sale of capital assets held for more than one year are taxed using a preferred tax rate. So this becomes very important to all of us.

But it appears that many people are under the mistaken impression that everything is a capital asset, and will qualify for this preferred capital gain tax rate. Nothing could be further from the truth. So let's take a few minutes to try and define exactly what a capital asset really is.

Generally, everything you own and use for either personal purposes or investment purposes is a capital asset. Some examples of capital assets would be: stocks and bonds; principal residences; secondary or vacation residences (if not rented out); household furnishings; automobiles used for commuting or for personal purposes; coin collections (but, remember that there are special capital gains rules for collectibles); and gems or jewelry.

In fact, under the Internal Revenue Code, all property is considered a capital asset except for the following five types of property, which are specifically excluded from the definition of capital asset:

1. Stock in trade or other inventory property, and property held primarily for sale to customers in the ordinary course of your business. If you don't have a business, this may not be important to you. But consider the real estate developer who normally buys property, subdivides that property, and then sells off the lots. If the developer holds some of the property for more than one year, will he be able to use the preferred capital gains rate for this sale? Nope. Not at all. Why? Because this property is, for the developer, part of his stock in trade, held primarily for sale to customers in the ordinary course of his business. So, if you do have a business, you must be careful not to consider your "stock in trade" as a capital asset.

2. Accounts or notes receivable acquired in the ordinary course of your trade or business for services rendered, or from the sale of any of the types of property described in (1), above. Again, let's use the developer as an example. Assume that the developer decides to sell one of his lots by taking back a note against the property. Even if he holds this note for more than one year and then sells it to somebody else for a profit, the developer will not have a long-term capital gain on the sale of the note. Why? Because this was a note receivable acquired in the ordinary course of the developer's trade or business.

3. Depreciable personal property used in your trade or business (even though fully depreciated), and real property used in your trade or business. This is the one that trips many people up. Many people believe that rental property is a type of investment. But, for the purposes of this discussion, rental property would be considered "trade or business" property, and would not be considered a capital asset. It is certainly possible to receive long-term capital gain rates on the economic gain on the sale of the property, but any depreciation that you recover will not be treated as capital gain income.

For example, say that you bought a rental property in 1990 for $50,000. Over the years you claimed $9,000 in depreciation expense on the property. In 1999, you sell the property for $55,000. Your total gain on the sale of the property would amount to $14,000, but the first $9,000 of gain would be treated as recaptured depreciation, subject to special tax rates, but not the rates applied to normal long-term capital gains. But the remaining $5,000 would, in fact, qualify for long-term capital gain treatment. These rules can get even more complicated for personal property used in a trade or business (such as a business auto, business furniture and fixtures, your business computer, etc.). So, if you have business assets, be aware that there are special rules regarding the computation of the gain on the sale of these assets... and they are not the normal long-term capital gain rules.

4. A copyright, literary, musical or artistic composition, letter or memorandum, or similar property that is:

  1. created by your personal efforts;
  2. in the case of a letter, memorandum, or similar property, prepared or produced for you; or
  3. acquired from a person who created the property, or for whom the property was prepared, under circumstances in which your basis in the property is determined in whole or in part by reference to the basis of the person who created the property, or for whom it was prepared or produced (e.g., by gift).
This can get a bit tricky. But just understand that if you write the Great American Novel and hold on to the manuscript for more than a year, and then sell it for zillions of dollars, you will not receive long-term capital gain treatment on those zillions. Because you created the novel, the novel is not a capital asset in your hands.

5. U.S. government publications that you got from the government for free or for less than the normal sales price. I don't know of anybody who is making a killing selling U.S. government publications. But if you are someone who does, remember that these publications are not considered capital assets in your hands.

Just remember that the rules regarding the sale of any asset is determined by the type of asset sold. If you are selling a capital asset and have held it for more than one year, then my congratulations go out to you because you'll receive a preferred tax treatment on those gains. But make sure you know what you are selling and the tax treatment on the gain before you sell the property. You'll be glad you did. And, if you have any additional questions on these issues, please stop by the Tax Strategies discussion board and leave your question there.

This forum and the information provided here should not be relied on as a substitute for independent research to original sources of authority. The Motley Fool does not render legal, accounting, tax, or other professional advice. If legal, tax, or other expert assistance is required, the services of a competent professional should be sought. In other words, if you get audited, don't blame us.