Section 1221: Capital Assets
Definition
Section 1221 is part of the Internal Revenue Code (IRC) and provides a detailed definition of what constitutes a capital asset. Rather than listing all capital assets, Section 1221 specifies what is not considered a capital asset, which helps determine how different properties and holdings are treated for tax purposes.
Exclusions from Capital Assets:
- Inventory: Properties held primarily for sale in the ordinary course of business, such as lots of a subdivider.
- Receivables: Money owed to a business that arises from sales, including notes received from the sale of lots by a subdivider.
- Copyrights: Held by the creator or specified other parties.
- Certain U.S. Securities: Defined under specific conditions.
- Real or Depreciable Property: Used in trade or business (covered under Section 1231).
Inclusions as Capital Assets:
- Personal Residence: The home owned and used by an individual.
- Raw Land: Held as an investment.
- Mortgages: Held as investments.
Examples
Inventory
A real estate developer who holds subdivided lots for sale: These lots are considered inventory and do not qualify as capital assets.
Receivables
Notes received from the sale of lots by a developer: These receivables are not capital assets as they are collected in the course of business.
Copyrights
A book manuscript held by its author: This manuscript is not a capital asset as it is an original work held by the creator.
Personal Residence
An individual’s primary home: This property is a capital asset as it is personal real estate.
Raw Land
Vacant land purchased for future resale: This property is considered a capital asset as it is held as an investment.
Mortgages
A mortgage note purchased as an investment: This financial instrument qualifies as a capital asset.
Frequently Asked Questions
1. What is the purpose of Section 1221?
Section 1221 identifies what is and isn’t considered a capital asset for tax purposes, impacting how gains or losses from sales are treated.
2. Why is inventory not considered a capital asset?
Inventory is not a capital asset because it is property held primarily for sale in the ordinary course of business, making it subject to different tax treatments.
3. How does Section 1221 affect real estate investors?
For real estate investors, properties like personal residences and raw land can be capital assets, allowing for potential favorable tax treatment on gains.
4. Are mortgages always considered capital assets?
Mortgages held as investments are considered capital assets; however, mortgages held as part of a business operation (like a bank’s lending portfolio) might not be.
5. What are the tax implications of not being a capital asset?
Non-capital assets generally do not benefit from capital gains tax rates and are taxed as ordinary income, which may result in higher tax rates.
Related Terms
Capital Gains Tax
The tax imposed on the profit from the sale of a capital asset, typically subjected to lower rates compared to ordinary income.
Section 1231
Defines gains and losses for real or depreciable property used in a trade or business, offering potential tax benefits different from capital assets.
Depreciation
The process of allocating the cost of a tangible asset over its useful life, affecting the value of non-capital asset properties used in business.
Online Resources
- Internal Revenue Service (IRS) - Publication 544: Sales and Other Dispositions of Assets.
- Investopedia - Section 1221 Overview: Detailed guide on Section 1221.
- IRS - Capital Gains and Losses: Relevant tax topics relating to capital gains and losses.
References
- Internal Revenue Code - Section 1221.
- IRS: Publication 544, Sales and Other Dispositions of Assets.
- Investopedia: Various articles and explainer pages.
Suggested Books for Further Studies
- “Taxation of Individuals and Business Entities” by Annette Nellen, James C. Young, William A. Raabe, and David M. Maloney.
- “Principles of Real Estate Practice” by Stephen Mettling, David Cusic, and Fillmore Galaty.
- “The Real Estate Investor’s Handbook: The Complete Guide for the Individual Investor” by Steven D. Fisher.
- “Federal Income Tax: Examples and Explanations” by Joseph Bankman, Daniel Shaviro, and Kirk J. Stark.
