Capital Asset Defined: What Is and Isn’t Included

The classification of property as a capital or non-capital asset determines how its sale or exchange is taxed. This distinction has significant financial consequences, as the tax treatment for gains on capital assets can be more favorable. A proper understanding of these rules is important for financial planning.

The General Rule for Capital Assets

The tax code’s starting assumption is that nearly everything a person owns for personal purposes or holds for investment is a capital asset. The general rule is that if an asset doesn’t fall into one of the specific exclusions defined by the IRS, it is considered a capital asset.

This means that personal items, such as a home or household furnishings, are considered capital assets. Property held for investment purposes, like stocks, bonds, and mutual funds, also fits this definition. The gain from the sale of these assets is treated as a capital gain, while a loss on personal-use property is not deductible.

Property Excluded from Capital Asset Status

The Internal Revenue Code defines a capital asset by specifically listing what is not included. This method of definition by exclusion means that any property not on this list is a capital asset. These exclusions generally relate to property used in a trade or business or items that generate ordinary income.

• Stock in trade or inventory, which includes any property held by a business primarily for sale to customers in the ordinary course of its operations. The income generated from selling these items is treated as ordinary business income, not as a capital gain.
• Accounts or notes receivable that are acquired in the ordinary course of business, such as when a business provides goods or services on credit. When the business collects on these receivables, the money is considered ordinary income.
• Depreciable property and real property used in a trade or business, including assets like office buildings, machinery, and company vehicles. While these are not capital assets, they receive special treatment under Section 1231, allowing gains to potentially be taxed at lower capital gains rates while losses can be deducted as ordinary losses.
• Copyrights, as well as literary, musical, or artistic compositions, when held by the person whose personal efforts created them. This rule ensures that authors and artists report the income from selling their works as ordinary income, and it also applies if the asset was received as a gift from the creator.
• Certain U.S. government publications received from the government for free or for less than the public price. This narrow exclusion prevents the conversion of what is essentially a benefit into a capital gain.

How an Asset’s Use Determines Its Classification

The classification of an asset as capital or non-capital often depends entirely on how the owner uses it. The same type of property can be treated differently for tax purposes based on its context. Consider a vehicle as a practical example.

If an individual purchases a car for personal commuting and family errands, it is classified as a capital asset. Should they sell the car for more than their purchase price, the profit would be a capital gain. A loss on the sale of this personal-use car, however, would not be tax deductible.

If that same model of vehicle is purchased by a business for making deliveries, its classification changes to depreciable property used in a trade or business. As such, it is not a capital asset. The business can take depreciation deductions, and upon its sale, the transaction is governed by the rules for business property.

Finally, if a car dealership holds that vehicle on its lot, its purpose is for sale to customers and it is considered inventory. The profit from its sale is recorded as ordinary income for the dealership.

Common Examples of Capital and Non-Capital Assets

A personal residence you own and live in is a capital asset, and when sold, the transaction is a capital one. A painting purchased for personal enjoyment or precious metals held for investment are also capital assets. In contrast, non-capital assets include items previously discussed, like a delivery truck owned by a business. The goods on a retail store’s shelves are another clear example of a non-capital asset, as they are inventory held for sale.