What Are Ordinary Gains and How Are They Taxed?
The tax on profit from a sale depends on the asset's classification. Learn why some gains are taxed as ordinary income at standard progressive rates.
An ordinary gain is a profit recognized for tax purposes from the sale or exchange of certain business-related assets. This income is generated from a business’s regular day-to-day operations rather than from the sale of long-term investments. The Internal Revenue Code defines ordinary income as any gain from the sale of property that is not a capital asset. The profit is considered “ordinary” because it stems from the primary activities of a business or from assets that are not classified as capital assets.
Differentiating Ordinary Gains from Capital Gains
The primary distinction between an ordinary gain and a capital gain lies in the nature of the asset sold. A capital asset is property held for personal use or investment, such as stocks, bonds, and a personal residence. When these assets are sold for a profit, the result is a capital gain.
The tax code excludes certain types of property from the definition of a capital asset, meaning their sale results in ordinary gains. Assets that are not considered capital assets include inventory held for sale to customers, accounts receivable, and depreciable property used in a business. For example, real estate held by a developer for the purpose of selling to customers is treated as inventory, and the profit from its sale generates ordinary gains.
The holding period of an asset does not change a business asset’s fundamental character from non-capital to capital. The core issue is the asset’s function within the business. To determine if an asset is held for investment or for sale to customers, factors like the nature of the property’s acquisition and the frequency of sales are considered.
Common Sources of Ordinary Gains
Ordinary gains arise from several common business transactions. The most frequent source is the sale of inventory. When a business sells the goods or products it was created to sell, the entire profit from that sale is classified as ordinary income.
Another source is the sale of accounts or notes receivable. If a business sells its outstanding customer invoices to a third party, the transaction can result in an ordinary gain or loss because accounts receivable are not capital assets.
A more complex source of ordinary gains is depreciation recapture. Businesses take annual tax deductions for the depreciation of assets like machinery and equipment, which reduces the asset’s adjusted cost basis. The adjusted basis is its original purchase price minus accumulated depreciation. If the business later sells that asset for a price higher than its adjusted basis, the IRS requires the “recapture” of the depreciation previously claimed. For instance, a company buys equipment for $10,000 and over three years, it claims $6,000 in depreciation, reducing the equipment’s adjusted basis to $4,000. The company then sells the equipment for $7,000. The gain on the sale is $3,000, and because this is less than the total depreciation taken, the full $3,000 is treated as an ordinary gain. This rule prevents taxpayers from converting ordinary income into a more favorably taxed capital gain.
Tax Treatment of Ordinary Gains
Ordinary gains are taxed at the same rates as other forms of ordinary income, such as wages, salaries, and interest. These gains are added to the taxpayer’s other income and are subject to the progressive federal income tax brackets, which range from 10% to 37% depending on taxable income and filing status. Short-term capital gains, from assets held for one year or less, are also taxed as ordinary income.
This treatment contrasts with the taxation of long-term capital gains, which are profits from the sale of capital assets held for more than one year. Long-term capital gains are taxed at preferential rates of 0%, 15%, or 20%, depending on the taxpayer’s income level.
For example, a $20,000 gain classified as ordinary could be taxed at a marginal rate as high as 37%, resulting in a tax liability of $7,400. If that same gain qualified as a long-term capital gain for a high-income taxpayer, it would be taxed at 20%, for a tax liability of $4,000.
Reporting Ordinary Gains on Tax Forms
Properly reporting ordinary gains requires using Form 4797, Sales of Business Property. This form is used to report gains or losses from the sale or exchange of assets used in a trade or business, including gains subject to depreciation recapture. Part II is used for reporting ordinary gains and losses, including gains from business property held for one year or less. Part III is specifically designed to calculate the ordinary income portion of a gain that is due to depreciation recapture.
Once the calculations on Form 4797 are complete, the resulting ordinary gain is transferred to the taxpayer’s main tax return. For individual taxpayers, this amount flows to Schedule 1 of Form 1040, where it is combined with other sources of income.
Filing Form 4797 requires careful documentation, including the asset’s original cost, the date it was acquired and sold, and a record of all depreciation deductions claimed. This is needed to correctly calculate the adjusted basis and determine the amount of any gain that must be recaptured as ordinary income.