What Is A Capital Asset?

Most people who have investments such as stock and bonds are aware that stocks and bonds are capital assets and that the sale of stocks and bonds may be subject to the long-term capital gains rates of taxation that are much more advantageous than the tax rates on ordinary income. However, many investors are not aware exactly what constitutes the definition of a capital asset under the IRS rules and that not all capital assets are treated equally.

Actually, the term capital asset has a broad definition. A capital asset is virtually any property with just a couple of exceptions. For example, property held as inventory in a trade or business is not a capital asset. Neither is depreciable property held by a trade or business although depreciable property held by a trade or business may receive capital gains tax treatment under the complicated IRS Code Section 1231 rules.

Basically, all the property that can be considered to be capital assets can be divided into two categories. One category is investment property and the other category is personal use property. These categories are important because of the difference in tax treatment of each one.

Capital assets that are considered investment property include stocks, mutual funds, bonds, land, art, gems, stamps, and coins. A gain on any of these is capital gain. However, for those assets held for a year or less the capital gain is short-term capital gain and is subject to regular or ordinary tax rates. For assets held more than one year, the more favorable long-term capital gains rates apply. A loss on any of these assets is a capital loss. Capital losses can be used to offset other capital gains but only $3,000 of capital losses can be used to offset ordinary income in any one year. Any capital losses that can’t be used in any particular year can be carried forward indefinitely to offset future capital gains or ordinary income.

Capital assets that are considered personal use property include personal residences, cars, jewelry, furniture, art, coins, and stamp collections. For those personal use assets that are sold at a gain, the rules discussed above for investment property apply. However, an important distinction for personal use assets is that losses are NOT deductible. That seems unfair since the profits of personal uses assets are taxable, but that’s just the way the tax laws are.

Keep in mind that for the years 2008 through 2010, for those taxpayers whose top tax bracket is either 10% or 15%, that their long-term capital gain tax rate on any capital assets sold will be 0%.