All gains and losses aren't equal when you're paying taxes, especially when it comes to running a business. They're classified as either "ordinary" or "capital" gains or losses.
Gains and losses that are realized in the course of doing business and the sale of non-capital assets are typically ordinary. Those that result from selling or exchanging a capital asset are generally considered capital gains and capital losses. Different rules and tax rates apply to each type of gain and loss.
- Ordinary gains and losses are those that occur during the course of routine business.
- They involve the sale or transfer of non-capital assets, such as inventory, supplies, accounts receivable, and depreciable property.
- Ordinary losses are preferable to capital asset losses, because they can offset other sources of income, reducing the amount that you must pay taxes on.
- The tax rate for ordinary gains is often higher than that for long-term capital gains.
What Are Non-Capital and Capital Assets?
Ordinary gains and losses come from the sale or transfer of non-capital assets. Non-capital assets that you may use in your business include:
- Inventory and other property intended for sale to customers
- Supplies necessary to conduct your business
- Accounts receivable acquired in the ordinary course of doing business
- Depreciable property
- Real property used as rental property
- Intellectual property (such as copyrights or patents)
- Some commodities derivative financial instruments held by a commodities derivatives dealer
- Some hedging transactions
Certain copyrights that you sell or exchange can instead be treated as capital assets.
Gains and losses realized in the course of doing routine business are ordinary. Anything you own for personal use, such as your home or your personal investments, is a capital asset. The sale of an otherwise capital asset can be treated as an ordinary gain or loss if the exchange is made with a related person. This would be the case between the executor and a beneficiary of an estate or between you personally and your business entity.
Offsetting Ordinary and Capital Gains and Losses
Ordinary losses are considered better than capital losses. They can be used to offset your other sources of income. You can subtract any ordinary losses from the profit your business made. This reduces your taxable income.
Capital losses are more limited. They can be used to offset other forms of income, but they're subject to a $3,000 cap per year as a tax deduction.
Imagine that you have a capital gain of $5,000. You have a capital loss of $15,000. This is a net $10,000 loss.
- You can take $3,000 of that loss against your other income this tax year.
- You have a remaining $7,000 loss.
- This remaining loss carries over into the next three tax years: $3,000 in year two, $3,000 in year three, and $1,000 in year four.
Tax Rates for Ordinary and Capital Gains
Ordinary losses are easier to deduct than capital losses, but the tax rate for capital gains is often lower than the one for ordinary gains.
All ordinary gains are taxed as ordinary income according to your tax bracket for that particular year. Capital gains are either long-term or short-term, depending on how long you've owned them. Assets held for a year or less are considered short-term. They, too, are taxed as ordinary income according to your tax bracket.
Long-term gains from assets owned for more than a year are taxed at either 0%, 15%, or 20% for most situations. Certain high-income individuals and some specific assets, such as collectible pieces of art, are subject to higher tax rates. Most Americans pay no more than 15% on long-term capital gains.
Form 4797 and Schedule D
You must report any profit or loss from the sale of assets used in your trade or business using Form 4797 and its accompanying instructions. You would use Schedule D, "Capital Gains and Losses" and its accompanying instructions for personal assets.
You must allocate any gain realized between Form 4797 and Schedule D if the same asset was used for both business and personal purposes.
Maybe you use your home, which is depreciable, partly as a residence and partly as your office. You sell it at a gain. Allocate 10% of your gain on Form 4797 if your office space takes up 10% of your home's total square footage. The remaining 90% would be personal. It would be reported on Schedule D.
Gains on the sale of business assets that are not capital assets are ordinary gains. They're taxed at ordinary income tax rates. They don't qualify for capital gains treatment.
Enter your resulting gain or loss on line 14 of Form 1040 when you've completed Form 4797, and then attach Form 4797 to your tax return.
Frequently Asked Questions
What are the tax rates for ordinary gains for tax year 2021?
Ordinary gains are taxed just like regular income, so the tax brackets are the same. They range from 10% to 37% for the 2021 tax year, the return you’ll file in 2022. Only incomes of $9,950 or less are taxed at the 10% bracket as of 2021. This increases to $19,900 for married couples who file joint returns. Most American pay no more than 15% for long-term capital gains.
Can personal assets qualify as ordinary assets?
Personal property is considered to be a capital asset, but an exception exists for property that’s sold or transferred to a related person or entity, such as from you personally to your business.