When paying taxes, all gains and losses are not equal, 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.
When you are calculating your taxes, different rules and tax rates apply to each type of gain and loss. Here's how you can tell when you've incurred an ordinary gain and how to report it.
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 a rental property
- Intellectual property (such as music, literature, or art)
- 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.
In general, 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, such as between the executor and the beneficiary of an estate or between you (personally) and your business entity.
Offsetting Ordinary and Capital Gains and Losses
Ordinary losses are generally considered preferable to capital losses, because they can be used to offset your other sources of income. You can subtract any ordinary losses from the profit your business made, to reduce 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.
For example, imagine you have a capital gain of $5,000 and a capital loss of $15,000—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. However, 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 considered either long-term or short-term, depending on how long they're held. Assets held for a year or less are considered short-term, and 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. For personal assets, you would use Schedule D, "Capital Gains and Losses," and its accompanying instructions.
If the same asset was used for both business and personal purposes, you must allocate any gain realized between Form 4797 and Schedule D.
Consider this example:
- You use your home—which is depreciable—partly as a residence and partly as your office.
- You sell your home at a gain.
- If your office space takes up 10% of your home's total square footage, allocate 10% of your gain on Form 4797. The remaining 90% would be personal and would be reported on Schedule D.
Gains on the sale of business assets that are not capital assets are ordinary gains and are taxed at ordinary income tax rates. These gains do not qualify for capital gains treatment.
When you've completed Form 4797, enter your resulting gain or loss on line 14 of Form 1040. Then, attach Form 4797 to your tax return.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.