The tax law generally looks more favorably on income classified as capital gains than on other types of income—at least for pass-through entities. On the flip side, the tax law provides special treatment for capital losses. To understand how capital gains and losses affect your business income you need to know what items are subject to capital gain or loss treatment and how to determine gains and losses. This post provides a short and straight foreward explanation.
If you own property used in or owned by your business, “gain or loss“ on the disposition of the property generally is treated as “capital gain or loss“.
Capital gains and losses are gains and losses taken on capital assets.
Capital assets property held for investment and other property not otherwise excluded from capital asset treatment. For example: your interest in a partnership or stocks and securities is treated as a capital asset.
Most property is treated as capital assets. Excluded from the definition of capital assets are:
- Property held for sale to customers or property that will physically become part of merchandise for sale to customers (inventory)
- Accounts or notes receivable generated by your business (e.g., accounts receivable from the sale of inventory)
- Depreciable property used in your business, even if already fully depreciated (e.g., telephones
- Real property used in your business (e.g., your factory)
- A copyright; literary or artistic composition; a letter or memorandum; or other similar property (e.g., photographs, tapes, manuscripts) created by your personal efforts or acquired from the creator by gift or in another transaction entitling you to use the creator’s basis
Under a special rule, self-created musical works qualify for capital asset treatment, if the musician so elects.
Determining the Amount of Gain or Loss
The difference between the amount received for your property on a sale, exchange, or other disposition, and your adjusted basis in the property is your gain or loss.
Amount Received – The cash, fair market value of property, and relief of liability you get when you dispose of your property. For example: if you own a computer system for your business and you upgrade with a new system and sell your old system to another business, any cash you receive is considered an amount received. Upon the sale, you receive $5,000 cash, plus the buyer agrees to pay the remaining balance of $2,000 on a bank loan you took to buy the system; your amount received is $7,000 ($5,000 cash, plus $2,000 liability relieved).
Adjusted Basis – This is your basis in the property, adjusted for certain items. Start with the original cost if you bought the property (the cash and other property you paid to acquire it). Even if the cash did not come out of your pocket—for example, if you took a loan—the cash you turn over to the seller is part of your basis. Adjust the basis by reducing it for any depreciation claimed (or that could have been claimed) and any casualty loss you claimed with respect to the property. For example, if your original computer system cost you $10,000, and you claimed $2,000 depreciation, your adjusted basis is $8,000.
You adjust basis—upward or downward—for certain items occurring in the acquisition of the asset or during the time you hold it. Amounts that increase basis include:
- Improvements or additions to property.
- Legal fees to acquire property or defend title to it.
- Selling expenses (e.g., a real estate broker’s fee or advertising costs).
- Unharvested crops sold with the land. Amounts that decrease basis include:Amortized bond premiums.
- Cancellation of income adjustments (e.g., debt forgiveness because of bankruptcy or insolvency or on farm or business real property).
- Casualty losses that have been deducted (e.g., insurance awards and other settlements).
- Depletion allowances with respect to certain natural resources.
- Depreciation, amortization, first-year expensing, and obsolescence. (You must reduce the basis of property by the amount of depreciation that you were entitled to take even if you failed to take it).
- Investment credit claimed with respect to the property. (The full credit decreases basis but one-half of the credit claimed after 1982 is added back for a net reduction of one-half of the credit.
- Return of capital. (Dividends on stock are paid out of capital or out of a depletion reserve instead of earnings and profits or surplus).
You do not adjust basis for selling expenses and related costs. These amounts are factored into the amount received (they reduce the amount received on the transaction).