Nicholas Frey

Capital assets are assets that are held for investment purposes or personal use. Selling a capital asset triggers tax consequences, with the type of tax treatment varying depending on whether the asset has been held for a short-term or long-term period. This article will discuss what a capital asset is and the tax implications of selling it, including the difference between ordinary income and capital gains and losses. We will also examine the tax advantages of selling long-term capital assets and how the preferential tax treatment brackets of long-term capital gains are linked to your ordinary income tax bracket.

What is a Capital Asset?

A capital asset is any asset that is not held for sale in the ordinary course of a taxpayer's trade or business. Examples of capital assets include stocks, bonds, real estate, and personal property such as cars and jewelry. Assets held for investment purposes, such as stocks and bonds, are also considered capital assets.

The Tax Implications of Selling a Capital Asset

When a taxpayer sells a capital asset, they may realize either a capital gain or a capital loss. A capital gain is the difference between the sale price and the taxpayer's basis in the asset, while a capital loss is the difference between the basis and the sale price. If the sale price is greater than the basis, the taxpayer realizes a capital gain, and if the sale price is less than the basis, the taxpayer realizes a capital loss.

Short-Term vs. Long-Term Capital Gains

The tax treatment of a capital gain or loss depends on whether the asset has been held for a short-term or long-term period. If the asset has been held for one year or less, it is considered a short-term capital gain or loss, while if it has been held for more than one year, it is considered a long-term capital gain or loss.

Short-term capital gains are taxed as ordinary income, meaning they are subject to the same tax rates as the taxpayer's other income, such as wages or business profits. Long-term capital gains, on the other hand, are subject to preferential tax treatment.

Tax Advantages of Selling Long-Term Capital Assets

Long-term capital gains are taxed at lower rates than short-term capital gains and ordinary income. The tax rates for long-term capital gains are 0%, 15%, or 20%, depending on the taxpayer's ordinary income tax bracket. For example, in 2022, a taxpayer in the 10% or 12% ordinary income tax bracket would pay 0% on long-term capital gains, while a taxpayer in the 32% or higher bracket would pay 20%.

In addition to the lower tax rates, taxpayers can also use long-term capital losses to offset long-term capital gains. If the capital losses exceed the capital gains, the taxpayer can use up to $3,000 of the remaining losses to offset ordinary income, with any excess losses carried forward to future tax years.

Ordinary Income vs. Capital Gains and Losses

It is important to distinguish between ordinary income and capital gains and losses. Ordinary income is income earned from sources such as wages, business profits, and interest income. It is taxed at the taxpayer's marginal tax rate, which increases as income increases.

Capital gains and losses, on the other hand, are derived from the sale of capital assets and are taxed separately from ordinary income. As mentioned above, long-term capital gains receive preferential tax treatment, while short-term capital gains are taxed as ordinary income.

Case Law and Internal Revenue Code Examples

One important case regarding capital gains taxation is the Supreme Court case of Commissioner v. Glenshaw Glass Co. In this case, the Court defined "income" as "undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." This definition has been used in subsequent cases to determine whether a transaction results in taxable income or not.

The Internal Revenue Code (IRC) also provides rules for the taxation of capital gains and losses. For example, IRC Section 1222 defines a capital asset and Section 1221 excludes certain assets, such as inventory and property used in a trade or business, from the definition of a capital asset.

In summary, a capital asset is a long-term asset held for investment purposes or personal use. Selling a capital asset can result in either a capital gain or a capital loss, with the tax treatment depending on whether the asset has been held for a short-term or long-term period. Long-term capital gains receive preferential tax treatment, with lower tax rates and the ability to offset gains with losses. It is important to distinguish between ordinary income and capital gains and losses, as they are taxed separately. The IRC and case law provide further guidance on the taxation of capital gains and losses.