A capital gain or loss occurs when an individual or business sell a “capital asset.” A capital gain occurs when the selling price of the asset is higher than the asset’s “basis.” A capital loss occurs when the selling price is less than the basis. The reason that Capital Assets are special is that they are taxed at favorable tax rates.
In order to understand how capital transactions work, we need to define what a “capital asset” is and how “basis” is determined. The definitions vary slightly for individuals and businesses, so we will look them separately.
Capital Transactions for Businesses
Capital Asset: Any asset that has a useful life of longer than a year, but is not intended for sale during the normal course of business.
Basis: The value of the asset which is used to determine the gain or loss. Businesses are required to depreciate all capital assets based on the Internal Revenue Code (IRC). Each year an asset’s basis is reduced and the amount of reduction is taken as a current year expense.
Depreciation Recapture: When a business sells a capital asset that has been depreciated, it potentially has two types of income. The first is the recapture of any depreciation taken. This is taxed as ordinary income. If the asset was sold for more than the original purchase price, then there is also a capital gain.
Depreciation Recapture Example: ABC Co buys an piece of equipment for $1,000 that is depreciated to $0 over 5 years according to the IRC. 7 years later, ABC Co sells the same piece of equipment for $1,200. In this case, ABC Co would recognize $1,000 of ordinary income since the asset was fully depreciated. It would also recognize $200 of capital gains at the favorable rate.
Capital Transactions for Individuals
Capital Asset: Any asset that an individual owns for personal or investment purposes.
Basis: The purchase price of the asset reduced by any purchasing and selling costs. Individuals are not allowed to depreciate capital assets under the IRC. Therefore there is no depreciation recapture to account for during the sale. If an individual owns investment real estate then assets are depreciated under the same rules as a business.
Capital Gain and Loss Taxation
A capital gain may be short term (one year or less) or long term (more than a year). Long-term capital losses are taxed at the favorable tax rate, short-term losses are taxed as ordinary income.
Long-Term Capital Gains Rates: Long-term capital gains are taxed at either 0%, 15%, or 20% depending on other income earned. For more detail on 2019 capital gains rates visit the IRS Website.
Determining capital gains and losses can become more complex if for example, you inherit the capital asset. Your business may also have a different book and tax basis. There are also special rules regarding depreciation recapture for real estate and for capital gains rates on collectibles. If the situation becomes more complex, contact a tax professional to ensure you are taking advantage of the capital gains tax rates.
