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Module 6
1. Capital Assets
Before we can discuss the tax treatment of capital assets, we must first get an understanding
of what they are. First, the IRS does not define a capital asset. Like the definition of gross
income, it is defined by exclusion. The tax code (Section 1221) essentially states what is not a
capital asset. The excluded items are:
1.
2.
3.
4.
5.
Items used in a trade or business
Accounts or notes receivable
Certain derivative instruments
Government publications
Certain literary, copyright, and artistic compositions
The tax benefit of capital assets comes from the gain (or income that comes from the sale of a
capital asset). Typically, if a capital asset is held for more than one year, the gain is taxed at
capital-gain rates. These rates are lower than the tax rates applied to ordinary income. Ordinary
income is the income earned most frequently from working a job, owning a business, or
contracting.
The beneficial tax rates are a reward for the acquisition of capital assets. Some of the most
popular investment capital assets are securities (stocks and bonds) and real estate. There is a
benefit derived from the economy by investing in such assets because there is a multiplier when
you acquire such assets. Stocks add capital to a corporation that allows it to hire employees,
acquire equipment, inventory etc. Investing in real estate employs contractors, realtors, attorneys,
etc.
Let’s take a share of stock. When you acquire a share of stock that is capital for a corporate
entity, the resources that you provide allows that entity to grow into new markets, hire new
employees, or acquire new equipment. Each of these actions can help a company grow. If the
company grows, you as a shareholder benefit from the increased value of the shares of stock
purchased. If you allow the entity more than one year to use your invested capital, upon sale of
that stock would come lower tax rates on the gain.
When a taxpayer sells a capital asset, the taxpayer realizes a gain or loss. We discussed this in
the previous section. In this section, we will discuss how gain and loss is determined. The gain or
loss is determined by subtracting what is referred to as the asset basis from the sale proceeds.
Using a residence as an example, the basis is essentially the cost of the capital asset minus any
allowed depreciation plus any capital improvements (additional costs for property fixtures).
Personal use assets (personalty) fall under that category of capital assets. Jewelry is a capital
asset. If the jewelry is later sold for more than the purchase price, there is capital gain (and yes, it
must be reported). The good news is that (assuming the jewelry was held for more than one year)
favorable capital-gains rates would apply. Unfortunately, there is a downside. If the jewelry
dropped in value and it was sold for less than the purchase price, the loss is not allowed. The
deductibility of losses from the sale of personal capital assets is prohibited.
2. Asset Basis and Basis Adjustment
It is important to review cost recovery concepts in an individual tax course because the concepts
are very important to sole proprietors, real estate investors, and investors in flow-through
entities. The potential depreciation deduction may be significant. In addition, some of the
concepts also apply to other investment vehicles where basis is tracked. For example, stock has
basis even though it is not depreciated. The concept of basis is still applied when selling stock.
The basis of an asset is typically the cost of the asset. The cost may include other expenses
required to obtain the asset, such as setup costs. It is important to understand that basis refers to
the asset that may be depreciated. With real property (or realty), the costs should be allocated
between the actual structure and the land because land does not depreciate. Keeping with the
real-property example, let’s look at some things that change basis.
Basis increases when the economic value or life of the asset is extended. If a roof is replaced on a
home, the economic life and value of the property are increased. The items that increase basis
(particularly for durable, tangible assets) are called capital improvements. These are items that
are typically fixtures to the property.
These costs do not include regular maintenance costs like painting, cleaning, or regular
replacement items. It does include an addition to the home.
Another example of a capital improvement would be the replacement of an engine in a car. This
extends the life and economic value. Regular costs like an oil change, filter change, and annual
maintenance would not count as improvements that would add to basis.
The decrease to basis typically comes from the use of the asset. The use of a long-term tangible
asset over time is called depreciation. Other terms for depreciation are amortization (with the use
of an intangible asset) and depletion (with the use of natural resources). In tax, the term cost
recovery is used. We cover the cost-recovery concepts on the next page. The following video
covers the cost-basis concepts as they relate to securities.
Cost Basis Calculator
http://www.youtube.com/watch?v=DnWbcoFZ4yw
3. Cost-Recovery Concepts
The tax code allows a business to recover the cost that it invests in an asset. The U.S.
Supreme Court affirmed this position in Doyle v. Mitchell Bros. Co. (1916). This is referred to as
the Recovery of Capital Doctrine.
First, let’s understand that terminology. The cost-allocation terms are essentially the same to an
accountant and a tax preparer. There are three different terms used to describe cost recovery
depending upon the type of long-term asset for which cost is recovered.
Tangible assets use the popular term depreciation.
Intangible assets use the term amortization.
Natural resources use the term depletion.
There are various methods used to recover the cost of an asset used in business. Basically, there
is the straight-line method and then there are various forms of accelerated methods. The
determination of the cost-recovery amount depends upon:
1. The amount of recovery time
2. The amount of cost that is to be recovered
3. The percentage of business use
The amount of cost that is recovered is tracked on what is called the asset basis. The asset basis
is equal to asset cost minus the accumulated depreciation plus capital improvements. Capital
improvements are costs that extend the expected asset life.
In taxation, most asset recovery takes place under the Modified Asset Cost Recovery System.
Under this system, assets are assigned to a property class that is determined by the expected
property life. Assets are depreciated when the asset is put into service by the business. However,
the dates are set according to the conventional time frame. An asset that has a mid-year
conventional time frame is assumed to be put in service in the middle of the year regardless of
when the asset is actually put into service. Likewise, an asset with a mid-month convention is
assumed to be put into service of the middle of the month that the asset was put into service
regardless of when it was actually put into service.
Businesses may elect to expense certain assets that are put into service. Section 179 expense
election allows a company to expense up to $500,000 of the cost of a tangible asset. This election
is also annually limited by:
1. The extent to which the asset cost exceeds $2,000,000
2. The taxable income of the business
Module 7
1. The Effect of Holding Period
In Module 6, we discussed the concepts of basis and cost recovery. These concepts are
important in determining gain or loss from the sale of a capital asset. The gain or loss is
calculated by subtracting the basis of the capital asset when sold (or otherwise disposed of) from
the fair market value of what was received for the capital asset. The taxpayer has an advantage
when there is a gain from the sale of a capital asset. That gain is taxed at a more favorable rate.
We will discuss the rates on Page III.
Holding
Sales
Purchase
Asset
Basis
Sales Date
Period (in
Price
Date
days)
Stock A
$100
$200
1/2/2000
6/12/2013
4910
Stock B
$500
$400
4/12/2012
7/12/2013
456
Stock C
$400
$600
1/23/2013
12/12/2013
323
Stock D
$200
$150
2/2/2013
12/31/2013
332
The favorable gain rates apply only when a capital asset had been held for more than one year. If the
capital asset is held for one year or less, then the gain for the sale is taxed at the same rates that would
normally apply to the taxpayer (called ordinary tax rates). From the example above, you see that Stock A
and Stock B were held for more than 365 days.
2. Netting of Capital Gains and Losses
Once the holding period has been established for each capital asset, the gain or loss on each asset
is then calculated. This gain or loss for each asset is then netted to determine the overall capital
gain or loss for the tax period. The table below extends our example from Page I with gain or
loss from each asset sale characterized.
Holding Period Gain/
Character
(in days)
Loss
6/12/2013
4910
$100 LTCG
7/12/2013
456
-$200 LTCL
12/12/2013
323
$200 STCG
12/31/2013
332
-$50
STCL
Asset Basis Sales Price Purchase Date Sales Date
Stock A
Stock B
Stock C
Stock D
$100
$600
$400
$200
$200
$400
$600
$150
1/2/2000
4/12/2012
1/23/2013
2/2/2013
Long-term capital gain (LTCG): A capital asset held for more than one year sold for more than its
basis
Short-term capital gain (STCG): A capital asset held for one year or less sold for more than its basis
Long-term capital loss (LTCL): A capital asset held for more than one year sold for less than its basis
Short-term capital loss (STCL): A capital asset held for one year or less sold for less than its basis
Here are the steps in the netting process:
1. Net all capital gains as short-term or long-term
a. NetLTCL = $100 (LTCG + LTCL; or $100 - $200)
b. NetSTCG = $150 (STCG + CTCL; or $200 - $50)
2. Net NetLTCL with NetSTCG to get NetSTCG = $50 (=$150 - $100)
3. Since the overall gain is short-term, it is taxed as ordinary income.
You can also use the table below as a cheat sheet for the netting process and the character of the
resulting income
Stock A
Stock B
Stock C
Long
Term
$100
$100
$0
Short
Term
$0
$50
$100
Stock D
$0
Stock E
Asset
Gain/Loss
Character
$100
$150
$100
LTCG
LTCG
STCG
-$100
-$100
STCL
$100
$50
$150
Stock F
-$100
$200
$100
LTCG=%100
STCG=$50
STCG
Stock G
-$100
-$100
-$200
STCL
Tax Effect on Current
Period
Capital Gain
Capital Gain
Ordinary
Offset Ordinary Income up to
$3,000
Capital = $100; Ordinary
=$50
Ordinary
Offset Ordinary Income up to
$3,000
3. Taxation of Capital Gains
Capital gains and losses are netted. If a capital asset is held for more than one year and is sold at
a gain (this gain is referred to as LTCG), the beneficial tax rates apply. If the capital asset is sold
at a gain and held less than a year (STCG), it is treated as ordinary income and the ordinary
(unfavorable) tax rates apply.
The capital-gains rates range between 0% and 20% depending upon your ordinary income-tax
bracket. The ordinary income-tax rates range from 10% to 39.6%. There are losses and gains that
can potentially come from several capital assets.
The gains and losses from the sale of capital assets appear on Schedule D. That makes the gain
or loss a gross income amount if it is positive (net capital gain) or a deduction (net capital loss)
for AGI if it is negative.
Positive amounts that are net short-term capital gains are taxed as ordinary income.
Positive amounts that are net long-term capital gains are taxed at the favorable capitalgains rates.
Negative amounts are from netted capital losses and are limited to $3,000 against
ordinary income.
Excess capital losses are carried forward to be netted or deducted on a future tax return.