Capital Gains and Losses

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Capital Gains and Losses

If a taxpayer has a taxable gain or loss, it may be taxable as either as a capital gain or loss or ordinary gain or loss, depending upon the circumstances. The distinction between capital and non-capital is critical because of the favorable tax rates on capital gain income.

For the most part, anything the taxpayer owns for their personal purpose, pleasure or investment is a capital asset.

The following are examples of items that are not capital assets:

  1. Property held for sale to customers (inventory)
  2. Depreciable property used in the taxpayer's trade or business, even if fully depreciated
  3. Real property used in the taxpayer's trade or business
  4. A copyright, literary, musical, or other artistic composition that is created by the taxpayer's efforts
  5. Accounts or notes receivable acquired in the ordinary course of business
  6. Certain hedging transactions
  7. Supplies regularly used in the course of the taxpayer's business

Investment property is a capital asset. Stocks, stock rights and bonds are all capital assets except for when they are held by a securities dealer. Personal use property is a capital asset, and a taxpayer must report the gain from its sale as a capital gain. However, a taxpayer cannot deduct the loss from the sale of personal use property.

Nonbusiness bad debt is allowable as a short-term capital loss. If the taxpayer did not deduct the nonbusiness bad debt the year it became worthless, they have 7 years to amend the return.

Holding Period

Once the determination of capital versus non-capital is made, the holding period of the asset must be ascertained. If the taxpayer held the property for more than one year, then it is considered long-term property. If the property was held less than one year, it is considered short-term property. To determine how long the property was held, start counting the day after the property was acquired. The day the property was disposed of is included in the holding period.

For example, if the taxpayer bought property on January 1, 2005 and sold it on January 1, 2006, the holding period is not more than one year and is considered short-term property.

For stocks, the holding period begins the day after the trade date, not the settlement date and ends on the date you sold the stock.

If the taxpayer acquired property in a non-taxable trade (like-kind exchange), and the basis in the new property is determined in whole or in part by referencing the old property, the taxpayer's holding period in the new property begins on the day following the date the taxpayer acquired the old property.

If the property was acquired as a gift, and the taxpayer's basis is determined by referencing the donor's basis, then the taxpayer's holding period is considered to start the day the donor's holding period started.

For inherited property, any gain or loss is treated as long-term, regardless of how long the taxpayer held the property.

For real property, the holding period starts the day after the taxpayer either received title or took posession and assumed burdens of ownership, whichever happened first. An option agreement is not enough to start the holding period, there must be an actual contract of sale for the holding period to start.

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