Capital Asset

Posted on October 16, 2008 
Filed Under Capital Gains and Losses, Federal Income Tax | 1 Comment

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:

  1. Inventory or stock in trade held primarily and principally for sale to customers in the normal course of business.
  2. Trade accounts or notes receivable arising from the sale of inventory or stock in trade to customers in the ordinary course of business.
  3. Depreciable property used in a trade or business.
  4. Real property used in a trade or business.
  5. 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.
  6. Supplies regularly used in a taxpayer’s trade or business.
  7. 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

Qualifying Widow

Posted on October 12, 2008 
Filed Under Federal Income Tax, Filing Status | Leave a Comment

A taxpayer can file as a qualifying widow(er) if she or he meets all of the following tests:

  1. The taxpayer’s spouse died in one of the two previous tax years. If, say, taxpayer’s spouse died in 2006 and taxpayer satisfies tests 2 through 4 below, then she (or he) can file as a qualifying widow(er) in 2007 and 2008.
  2. The taxpayer has not remarried in the current tax year.
  3. In the year the spouse died, the taxpayer was eligible to file a joint return.
  4. The taxpayer maintains for the entire year a household that serves as the principal residence for the taxpayer’s dependent child, stepchild, adopted child, or foster child and the taxpayer pays more than 50% of the cost of keeping up such household. The category of foster children includes grandchildren and other children who are members of the taxpayer’s household for the entire year. Temporary absences for school, illness, vacation, military service, and time spent at a juvenile detention center count toward the residency test for dependents and household members.

Although a qualifying widow(er) files an individual return at the more favorable married-filing-jointly tax rates, she or he cannot use married-filing-jointly status. In other words, a qualifying widow(er) is able to claim a personal dependency exemption and exemptions for dependents and household members but cannot take an exemption for the deceased spouse or lay hold of other benefits associated with married-filing-jointly status.

Supplementary relevant articles on the topic of qualifying widow(er) filing status are listed below:

Many happy returns, Roger

Married Filing Separately

Posted on October 8, 2008 
Filed Under Federal Income Tax, Filing Status | Leave a Comment

There are two major reasons for a married individual to file a separate return. One reason is to avoid joint liability by seeking innocent spouse relief. The other reason is to increase allowable itemized deductions for several categories of expenditures by lowering the floor or threshold amount that these expenditures must exceed in order to be deductible.

(Note: To enhance the readability of this article, the wife is depicted as the innocent spouse; of course, one can, with the same result, substitute husband for wife.)

Before I discuss the reasons for filing separately, the reader should be aware that if one spouse elects to file separately, then the other spouse must also file a separate return. In addition, if the spouse who files separately chooses to itemize deductions rather than take the standard deduction, the other spouse must also itemize deductions.

Innocent Spouse Relief
Each spouse who signs a joint return is individually responsible for any taxes due as well as the accuracy of the return. But a wife who files separately is not responsible for either the husband’s tax liability or the accuracy of his return.

However, the issue of joint liability for a married couple is more complicated. After filing a joint return, a wife may seek relief from the negative consequences of the husband’s actions, namely, relief from a deficiency assessment the proximate cause of which is the husband’s decision to file an erroneous return. To qualify for relief, the wife must file Form 8857 (Request for Innocent Spouse Relief) with the Internal Revenue Service and satisfy the following conditions:

  1. The couple’s tax liability is understated because the joint return is corrupted by omissions (income earned but not reported) and erroneous items (unjustified deductions and credits).
  2. When she signed the return she didn’t know, or have reason to believe, there was an understatement of tax.
  3. All the facts and circumstances show it would not be fair to hold her responsible for the understatement of tax.

An innocent spouse may also seek relief under separation of liability. A wife seeking separation of liability relief is required to pass the following tests:

  1. The wife filed a joint return.
  2. The wife is no longer legally married to, or separated from, her spouse. Alternatively, the wife will pass this subtest if she has been living apart from her spouse for at least twelve months when Form 8857 is filed with the IRS.

Notice that the burden of proof is on the spouse seeking separation of liability relief.

In addition, a spouse who fails to qualify for either innocent spouse relief or separation of liability relief may petition for equitable relief. The heuristic for equitable relief is a facts and circumstances test, and the burden of proof is on the spouse seeking relief.

Finally, injured spouse relief is available to a wife whose husband has not paid child support, spousal support, or student loans and other federal debts and a portion of the couple’s overpayment of tax on a joint return is appropriated by authorities to settle in part, or in full, these past-due obligations. In this set of circumstances, the wife can claim injured spouse relief and recoup her portion of the overpayment if she meets all of the following tests:

  1. She is not required to pay her husband’s delinquent obligations or past-due loans.
  2. She earned and reported income on the joint return.
  3. She made and reported income tax payments on the joint return.

Lowering the Floor for Itemized Deductions
A key intermediate figure on a joint return, adjusted gross income (AGI), combines the incomes of two individuals; this feature of a joint return makes it difficult for a couple to take advantage of available deductions by itemizing. Specifically, many are subject to a 2%, 7.5%, or 10% of AGI floor (viz., the threshold amount itemized deductions must exceed in order to produce a tax benefit); the higher the AGI, the more difficult it is for a joint filer to meet this threshold. But if husband and wife file separate returns, especially when, say, large medical expenses are attributable to and paid by the husband, then the applicable floor of AGI will be lower and the corresponding odds higher that the husband, as a separate filer, will realize a tax benefit by itemizing.

The flip side is that several credits and deductions are available only to joint filers. For example, a married individual who files separately is not eligible to claim the child and dependent care credit, the earned income credit, education credits (e.g., Hope and lifetime learning credits), or the credit for the elderly or permanently disabled. Moreover, a separate filer is barred from claiming an individual retirement arrangement (IRA) deduction for a nonworking spouse or converting from a traditional IRA to a Roth IRA, deducting student loan interest, or writing off up to $25,000 in losses from real estate rental activities. For more information on the advantages and disadvantages of filing separately, click on and .

Additional relevant articles on married-filing-separately status are listed below:

Many happy returns, Roger

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