Table of Contents
You must classify your gains and losses as either ordinary or capital (and your capital gains or losses as either short-term or long-term). You must do this to figure your net capital gain or loss.
For individuals, a net capital gain may be taxed at a lower tax rate than ordinary income. See Capital Gains Tax Rates in chapter 4. Your deduction for a net capital loss may be limited. See Treatment of Capital Losses in chapter 4.
-
Capital assets
-
Noncapital assets
-
Sales and exchanges between
related persons -
Other dispositions
Publication
-
550 Investment Income and Expenses
-
954 Tax Incentives for Distressed Communities
Form (and Instructions)
-
Schedule D (Form 1040)
Capital Gains and Losses -
4797
Sales of Business Property -
8594
Asset Acquisition Statement Under Section 1060
See chapter 5 for information about getting publications and forms.
Almost everything you own and use for personal purposes or investment is a capital asset. For exceptions, see Noncapital Assets, later.
The following items are examples of capital assets.
-
A home owned and occupied by you and your family.
-
Timber grown on your home property or investment property, even if you make casual sales of the timber.
-
Household furnishings.
-
A car used for pleasure or commuting.
-
Coin or stamp collections.
-
Gems and jewelry.
-
Gold, silver, and other metals.
A noncapital asset is property that is not a capital asset. The following kinds of property are not capital assets.
-
Stock in trade, inventory, and other property you hold mainly for sale to customers in your trade or business. Inventories are discussed in Publication 538, Accounting Periods and Methods. But, see the Tip below.
-
Accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of any properties described in (1).
-
Depreciable property used in your trade or business or as rental property (including section 197 intangibles defined later), even if the property is fully depreciated (or amortized). Sales of this type of property are discussed in chapter 3.
-
Real property used in your trade or business or as rental property, even if the property is fully depreciated.
-
A copyright; a literary, musical, or artistic composition; a letter; a memorandum; or similar property (such as drafts of speeches, recordings, transcripts, manuscripts, drawings, or photographs).
-
Created by your personal efforts,
-
Prepared or produced for you (in the case of a letter, memorandum, or similar property), or
-
Received from a person who created the property or for whom the property was prepared under circumstances (for example, by gift) entitling you to the basis of the person who created the property, or for whom it was prepared or produced.
But, see the Tip below.
-
-
U.S. Government publications you got from the government for free or for less than the normal sales price or that you acquired under circumstances entitling you to the basis of someone who got the publications for free or for less than the normal sales price.
-
Any commodities derivative financial instrument (discussed later) held by a commodities derivatives dealer unless it meets both of the following requirements.
-
It is established to the satisfaction of the IRS that the instrument has no connection to the activities of the dealer as a dealer.
-
The instrument is clearly identified in the dealer's records as meeting (a) by the end of the day on which it was acquired, originated, or entered into.
-
-
Any hedging transaction (defined later) that is clearly identified as a hedging transaction by the end of the day on which it was acquired, originated, or entered into.
-
Supplies of a type you regularly use or consume in the ordinary course of your trade or business.
You can elect to treat as capital assets certain musical compositions or copyrights you sold or exchanged. See Publication 550 for details.
-
Risk of price changes or currency fluctuations involving ordinary property you hold or will hold.
-
Risk of interest rate or price changes or currency fluctuations for borrowings you make or will make, or ordinary obligations you incur or will incur.
This section discusses the rules that may apply to the sale or exchange of property between related persons. If these rules apply, gains may be treated as ordinary income and losses may not be deductible. See Transfers to Spouse in chapter 1 for rules that apply to spouses.
If a gain is recognized on the sale or exchange of property to a related person, the gain may be ordinary income even if the property is a capital asset. It is ordinary income if the sale or exchange is a depreciable property transaction or a controlled partnership transaction.
-
A person and the person's controlled entity or entities.
-
A taxpayer and any trust in which the taxpayer (or his or her spouse) is a beneficiary unless the beneficiary's interest in the trust is a remote contingent interest; that is, the value of the interest computed actuarially is 5% or less of the value of the trust property.
-
An executor and a beneficiary of an estate unless the sale or exchange is in satisfaction of a pecuniary bequest.
-
An employer (or any person related to the employer under rules (1), (2), or (3)) and a welfare benefit fund (within the meaning of section 419(e) of the Internal Revenue Code) that is controlled directly or indirectly by the employer (or any person related to the employer).
-
A corporation in which more than 50% of the value of all outstanding stock, or a partnership in which more than 50% of the capital interest or profits interest, is directly or indirectly owned by or for that person.
-
An entity whose relationship with that person is one of the following.
-
A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest or profits interest in the partnership.
-
Two corporations that are members of the same controlled group as defined in section 1563(a) of the Internal Revenue Code, except that “more than 50%” is substituted for “at least 80%” in that definition.
-
Two S corporations, if the same persons own more than 50% in value of the outstanding stock of each corporation.
-
Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation.
-
-
A partnership and a partner who directly or indirectly owns more than 50% of the capital interest or profits interest in the partnership.
-
Two partnerships, if the same persons directly or indirectly own more than 50% of the capital interests or profits interests in both partnerships.
-
Stock or a partnership interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries. (However, for a partnership interest owned by or for a C corporation, this applies only to shareholders who directly or indirectly own 5% or more in value of the stock of the corporation.)
-
An individual is considered as owning the stock or partnership interest directly or indirectly owned by or for his or her family. Family includes only brothers, sisters, half-brothers, half-sisters, spouse, ancestors, and lineal descendants.
-
For purposes of applying (1) or (2), stock or a partnership interest constructively owned by a person under (1) is treated as actually owned by that person. But stock or a partnership interest constructively owned by an individual under (2) is not treated as owned by the individual for reapplying (2) to make another person the constructive owner of that stock or partnership interest.
A loss on the sale or exchange of property between related persons is not deductible. This applies to both direct and indirect transactions, but not to distributions of property from a corporation in a complete liquidation. For the list of related persons, see Related persons next.
If a sale or exchange is between any of these related persons and involves the lump-sum sale of a number of blocks of stock or pieces of property, the gain or loss must be figured separately for each block of stock or piece of property. The gain on each item is taxable. The loss on any item is nondeductible. Gains from the sales of any of these items may not be offset by losses on the sales of any of the other items.
-
Members of a family, including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).
-
An individual and a corporation if the individual directly or indirectly owns more than 50% in value of the outstanding stock of the corporation.
-
Two corporations that are members of the same controlled group as defined in section 267(f) of the Internal Revenue Code.
-
A trust fiduciary and a corporation if the trust or the grantor of the trust directly or indirectly owns more than 50% in value of the outstanding stock of the corporation.
-
A grantor and fiduciary, and the fiduciary and beneficiary, of any trust.
-
Fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts.
-
A tax-exempt educational or charitable organization and a person who directly or indirectly controls the organization, or a member of that person's family.
-
A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest or profits interest in the partnership.
-
Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation.
-
Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation.
-
An executor and a beneficiary of an estate unless the sale or exchange is in satisfaction of a pecuniary bequest.
-
Two partnerships if the same persons directly or indirectly own more than 50% of the capital interests or profits interests in both partnerships.
-
A person and a partnership if the person directly or indirectly owns more than 50% of the capital interest or profits interest in the partnership.
-
Stock or a partnership interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries. (However, for a partnership interest owned by or for a C corporation, this applies only to shareholders who directly or indirectly own 5% or more in value of the stock of the corporation.)
-
An individual is considered as owning the stock or partnership interest directly or indirectly owned by or for his or her family. Family includes only brothers, sisters, half-brothers, half-sisters, spouse, ancestors, and lineal descendants.
-
An individual owning (other than by applying (2)) any stock in a corporation is considered to own the stock directly or indirectly owned by or for his or her partner.
-
For purposes of applying (1), (2), or (3), stock or a partnership interest constructively owned by a person under (1) is treated as actually owned by that person. But stock or a partnership interest constructively owned by an individual under (2) or (3) is not treated as owned by the individual for reapplying either (2) or (3) to make another person the constructive owner of that stock or partnership interest.
Example 1.
Your brother sold stock to you for $7,600. His cost basis was $10,000. His loss of $2,400 was not deductible. You later sell the same stock to an unrelated party for $10,500, realizing a gain of $2,900 ($10,500 - $7,600). Your recognized gain is only $500, the gain that is more than the $2,400 loss not allowed to your brother.
This section discusses rules for determining the treatment of gain or loss from various dispositions of property.
The sale of a business usually is not a sale of one asset. Instead, all the assets of the business are sold. Generally, when this occurs, each asset is treated as being sold separately for determining the treatment of gain or loss.
A business usually has many assets. When sold, these assets must be classified as capital assets, depreciable property used in the business, real property used in the business, or property held for sale to customers, such as inventory or stock in trade. The gain or loss on each asset is figured separately. The sale of capital assets results in capital gain or loss. The sale of real property or depreciable property used in the business and held longer than 1 year results in gain or loss from a section 1231 transaction (discussed in chapter 3). The sale of inventory results in ordinary income or loss.
-
Goodwill or going concern value could, under any circumstances, attach to them.
-
The use of the assets would constitute an active trade or business under section 355 of the Internal Revenue Code.
-
Class I assets are cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposit).
-
Class II assets are certificates of deposit, U.S. Government securities, foreign currency, and actively traded personal property, including stock and securities.
-
Class III assets are accounts receivable, other debt instruments, and assets that you mark to market at least annually for federal income tax purposes. However, see section 1.338-6(b)(2)(iii) of the regulations for exceptions that apply to debt instruments issued by persons related to a target corporation, contingent debt instruments, and debt instruments convertible into stock or other property.
-
Class IV assets are property of a kind that would properly be included in inventory if on hand at the end of the tax year or property held by the taxpayer primarily for sale to customers in the ordinary course of business.
-
Class V assets are all assets other than Class I, II, III, IV, VI, and VII assets.
Note. Furniture and fixtures, buildings, land, vehicles, and equipment, which constitute all or part of a trade or business are generally Class V assets. -
Class VI assets are section 197 intangibles (other than goodwill and going concern value).
-
Class VII assets are goodwill and going concern value (whether the goodwill or going concern value qualifies as a section 197 intangible).
Example.
The total paid in the sale of the assets of Company SKB is $21,000. No cash or deposit accounts or similar accounts were sold. The company's U.S. Government securities sold had a fair market value of $3,200. The only other asset transferred (other than goodwill and going concern value) was inventory with a fair market value of $15,000. Of the $21,000 paid for the assets of Company SKB, $3,200 is allocated to U.S. Government securities, $15,000 to inventory assets, and the remaining $2,800 to goodwill and going concern value.
Intangible property is any personal property that has value but cannot be seen or touched. It includes such items as patents, copyrights, and the goodwill value of a business.
Gain or loss on the sale or exchange of amortizable or depreciable intangible property held longer than 1 year (other than an amount recaptured as ordinary income) is a section 1231 gain or loss. The treatment of section 1231 gain or loss and the recapture of amortization and depreciation as ordinary income are explained in chapter 3. See chapter 8 of Publication 535, Business Expenses, for information on amortizable intangible property and chapter 1 of Publication 946, How To Depreciate Property, for information on intangible property that can and cannot be depreciated. Gain or loss on dispositions of other intangible property is ordinary or capital depending on whether the property is a capital asset or a noncapital asset.
The following discussions explain special rules that apply to certain dispositions of intangible property.
Section 197 intangibles are certain intangible assets acquired after August 10, 1993 (after July 25, 1991, if chosen), and held in connection with the conduct of a trade or business or an activity entered into for profit whose costs are amortized over 15 years. They include the following assets.
-
Goodwill.
-
Going concern value.
-
Workforce in place.
-
Business books and records, operating systems, and other information bases.
-
Patents, copyrights, formulas, processes, designs, patterns, know how, formats, and similar items.
-
Customer-based intangibles.
-
Supplier-based intangibles.
-
Licenses, permits, and other rights granted by a governmental unit.
-
Covenants not to compete entered into in connection with the acquisition of a business.
-
Franchises, trademarks, and trade names.
For more information, see chapter 8 of Publication 535.
-
Recognize gain on the transfer of the property.
-
Pay income tax on the gain at the highest tax rate.
For more information about making the election, see section 1.197-2(h)(9) of the regulations. For information about reporting the tax on your income tax return, see the Instructions for Form 4797.
The transfer of a patent by an individual is treated as a sale or exchange of a capital asset held longer than 1 year. This applies even if the payments for the patent are made periodically during the transferee's use or are contingent on the productivity, use, or disposition of the patent. For information on the treatment of gain or loss on the transfer of capital assets, see chapter 4.
This treatment applies to your transfer of a patent if you meet all the following conditions.
-
You are the holder of the patent.
-
You transfer the patent other than by gift, inheritance, or devise.
-
You transfer all substantial rights to the patent or an undivided interest in all such rights.
-
You do not transfer the patent to a related person.
-
The individual whose effort created the patent property and who qualifies as the original and first inventor.
-
The individual who bought an interest in the patent from the inventor before the invention was tested and operated successfully under operating conditions and who is neither related to, nor the employer of, the inventor.
-
The rights are limited geographically within a country.
-
The rights are limited to a period less than the remaining life of the patent.
-
The rights are limited to fields of use within trades or industries and are less than all the rights that exist and have value at the time of the transfer.
-
The rights are less than all the claims or inventions covered by the patent that exist and have value at the time of the transfer.
-
Members of your family include your spouse, ancestors, and lineal descendants, but not your brothers, sisters, half-brothers, or half-sisters.
-
Substitute “25% or more” ownership for “more than 50%” in that listing.
If you transfer or renew a franchise, trademark, or trade name for a price contingent on its productivity, use, or disposition, the amount you receive generally is treated as an amount realized from the sale of a noncapital asset. A franchise includes an agreement that gives one of the parties the right to distribute, sell, or provide goods, services, or facilities within a specified area.
-
A right to disapprove any assignment of the interest, or any part of it.
-
A right to end the agreement at will.
-
A right to set standards of quality for products used or sold, or for services provided, and for the equipment and facilities used to promote such products or services.
-
A right to make the recipient sell or advertise only your products or services.
-
A right to make the recipient buy most supplies and equipment from you.
-
A right to receive payments based on the productivity, use, or disposition of the transferred item of interest if those payments are a substantial part of the transfer agreement.
If you own a tract of land and, to sell or exchange it, you subdivide it into individual lots or parcels, the gain normally is ordinary income. However, you may receive capital gain treatment on at least part of the proceeds provided you meet certain requirements. See section 1237 of the Internal Revenue Code.
Standing timber held as investment property is a capital asset. Gain or loss from its sale is reported as a capital gain or loss on Schedule D (Form 1040). If you held the timber primarily for sale to customers, it is not a capital asset. Gain or loss on its sale is ordinary business income or loss. It is reported in the gross receipts or sales and cost of goods sold items of your return.
Farmers who cut timber on their land and sell it as logs, firewood, or pulpwood usually have no cost or other basis for that timber. These sales constitute a very minor part of their farm businesses. In these cases, amounts realized from such sales, and the expenses of cutting, hauling, etc., are ordinary farm income and expenses reported on Schedule F (Form 1040), Profit or Loss From Farming.
Different rules apply if you owned the timber longer than 1 year and elect to either:
-
Treat timber cutting as a sale or exchange, or
-
Enter into a cutting contract.
Timber is considered cut on the date when, in the ordinary course of business, the quantity of felled timber is first definitely determined. This is true whether the timber is cut under contract or whether you cut it yourself.
Under the rules discussed below, disposition of the timber is treated as a section 1231 transaction. See chapter 3. Gain or loss is reported on Form 4797.
-
Own or hold a contractual right to cut the timber for a period of more than 1 year before it is cut, and
-
Cut the timber for sale or for use in your trade or business.
Example.
In April 2007, you had owned 4,000 MBF (1,000 board feet) of standing timber longer than 1 year. It had an adjusted basis for depletion of $40 per MBF. You are a calendar year taxpayer. On January 1, 2007, the timber had a fair market value (FMV) of $350 per MBF. It was cut in April for sale. On your 2007 tax return, you elect to treat the cutting of the timber as a sale or exchange. You report the difference between the fair market value and your adjusted basis for depletion as a gain. This amount is reported on Form 4797 along with your other section 1231 gains and losses to figure whether it is treated as capital gain or as ordinary gain. You figure your gain as follows.
FMV of timber January 1, 2007 | $1,400,000 |
Minus: Adjusted basis for depletion | 160,000 |
Section 1231 gain | $1,240,000 |
The fair market value becomes your basis in the cut timber and a later sale of the cut timber including any by-product or tree tops will result in ordinary business income or loss.
-
You are the owner of the timber.
-
You held the timber longer than 1 year before its disposal.
-
You kept an economic interest in the timber.
Gold, silver, gems, stamps, coins, etc., are capital assets except when they are held for sale by a dealer. Any gain or loss from their sale or exchange generally is a capital gain or loss. If you are a dealer, the amount received from the sale is ordinary business income.
You must treat the disposal of coal (including lignite) or iron ore mined in the United States as a section 1231 transaction if both the following apply to you.
-
You owned the coal or iron ore longer than 1 year before its disposal.
-
You kept an economic interest in the coal or iron ore.
For this rule, the date the coal or iron ore is mined is considered the date of its disposal.
Your gain or loss is the difference between the amount realized from disposal of the coal or iron ore and the adjusted basis you use to figure cost depletion (increased by certain expenses not allowed as deductions for the tax year). This amount is included on Form 4797 along with your other section 1231 gains and losses.
You are considered an owner if you own or sublet an economic interest in the coal or iron ore in place. If you own only an option to buy the coal in place, you do not qualify as an owner. In addition, this gain or loss treatment does not apply to income realized by an owner who is a co-adventurer, partner, or principal in the mining of coal or iron ore.
The expenses of making and administering the contract under which the coal or iron ore was disposed of and the expenses of preserving the economic interest kept under the contract are not allowed as deductions in figuring taxable income. Rather, their total, along with the adjusted depletion basis, is deducted from the amount received to determine gain. If the total of these expenses plus the adjusted depletion basis is more than the amount received, the result is a loss.
-
A related person whose relationship to you would result in the disallowance of a loss (see Nondeductible Loss under Sales and Exchanges Between Related Persons, earlier).
-
An individual, trust, estate, partnership, association, company, or corporation owned or controlled directly or indirectly by the same interests that own or control your business.
Recognized gain on the disposition or termination of any position held as part of certain conversion transactions is treated as ordinary income. This applies if substantially all your expected return is attributable to the time value of your net investment (like interest on a loan) and the transaction is any of the following.
-
An applicable straddle (generally, any set of offsetting positions with respect to personal property, including stock).
-
A transaction in which you acquire property and, at or about the same time, you contract to sell the same or substantially identical property at a specified price.
-
Any other transaction that is marketed and sold as producing capital gain from a transaction in which substantially all of your expected return is due to the time value of your net investment.
For more information, see chapter 4 of Publication 550.
More Online Publications |