Capital Asset
Posted on October 16, 2008
Filed Under Capital Gains and Losses, Federal Income Tax
A capital gain or loss is realized upon the sale or exchange of a capital asset, which fact makes the definition of a capital asset an important topic in federal income taxation.
Financial Accounting Definition
In financial accounting, a capital asset is defined as an asset with a useful life of more than one year that is not bought or sold in the ordinary course of business. What is a capital asset for one business may be an item of inventory for another business. For example, automobile body shops are not in the business of buying and selling frame machines; instead, in this line of business, frame machines are used “on the floor,” that is, to repair damaged cars. On the other hand, the same property counts as inventory, a noncapital asset, for those who sell frame machines to body shops.
Income Tax Definition
For tax accountants and attorneys, the definition of a capital asset is broader and less tidy than the financial accounting definition. First, in federal income tax law, there is no requirement that a capital asset be part of a taxpayer’s trade or business; at the same time, a loss on the sale or exchange of a capital asset is allowed only if this asset is held for the production of income. Second, special rules apply to the sale, exchange, or other disposition of depreciable assets; although these assets are defined as noncapital assets by the Internal Revenue Code, this fact does not guarantee that they will receive ordinary income or loss treatment upon sale, exchange, or other disposition. Third, in the Code, a capital asset is defined in terms of what it is not; in other words, a capital asset is any property held by a taxpayer except for the following items:
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Inventory or stock in trade held primarily and principally for sale to customers in the normal course of business.
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Trade accounts or notes receivable arising from the sale of inventory or stock in trade to customers in the ordinary course of business.
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Depreciable property used in a trade or business.
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Real property used in a trade or business.
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A creative property is not a capital asset in the hands of its creator. A nonexhaustive listing of self-created properties would include copyrights, artistic and literary compositions, musical works, letters, and memoranda. Notice that a letter or a memorandum prepared by, say, an attorney for a client is not a capital asset in the hands of the client. In larger terms, a letter, memorandum, or other creative property is not a capital asset in the hands of its creator, a taxpayer for whom such property is produced, or a taxpayer whose basis in the property is a substituted basis (viz., a basis determined by reference to the basis in the hands of either the producer or recipient of the property). However, for tax years beginning after May 17, 2006, a self-created musical work or a copyright in such work is treated as a capital asset upon sale or exchange.
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Supplies regularly used in a taxpayer’s trade or business.
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U.S. government publications obtained by a taxpayer at less than full purchase price and held for sale to customers, a dealer’s store of commodities derivatives, or gain or loss on hedging transactions that are a regular part of a taxpayer’s trade or business.
In a nutshell, all assets held by a taxpayer are capital assets except those specifically excluded by the Code.
Additional relevant articles on the concept of a capital asset are listed below:
Many happy returns, Roger
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