Preparing Income Taxes - Why You Need to Know About Capital Assets

The IRS is in the business of collecting revenue to support our government. It collects taxes on various forms of money we "accumulate". We are taxed on income we earn; on interest we receive on savings, on dividends from stock we own, and from gains or losses from the sale of our possessions. The IRS Tax Code often categorizes these possessions using negative definitions. It is very confusing! According to the IRS, "our stuff" might belong to some category of property UNLESS it is listed as an exception to that category! For example, in IRS-speak, capital assets are defined as any property that is not explicitly listed as an exception! Sounds crazy (or deviously clever)? Let's start with that negative definition...

Some stuff is real and some stuff is personal. Real stuff is typically associated with "dirt"; like real estate, buildings, or just land. Personal stuff is anything that is not real! Personal property is "movable". Your car, your refrigerator, and your lawn mower are stuff you can hold, move, or break. This "stuff" or property is tangible; it has "substance" and usually some intrinsic value. You can also have intangible property like pieces of paper called stocks and bonds. The value of the "paper" is in the rights of ownership it conveys; they are examples of intangible personal property.

Thus, almost all the "stuff" you own for personal or investment use is a capital asset. Your car, your refrigerator, your lawn mower are examples of personal-use property. The definition begins to blur though because while your home is real, personal use property, a rental home that is not your residence would be business-use property. That rental is maintained to produce some form of income. It might also be considered investment-use property because it has the potential to increase in value over time.

But there is an even more important classification the IRS relies on to collect revenue: holding period. When "stuff" is owed for periods of time that exceed 12 months and a day, the gain or loss from the sale of that property is classified as long-term rather than short-term. The net capital gain is the difference between more preferably long-term gains (or losses) over short-term gains (or losses). The tangible "stuff" you use for non-business or personal reasons is called a capital asset. When you sell this kind of "stuff", any profit or amount over the "original cost" is considered a capital gain and, most important, is taxable. You are required by law to report a capital gain on your income tax return. Depending upon the size of a capital gain, you might also need to make an estimated tax payment! You calculate the gains or losses on Form 1040, Schedule D, Capital Gains and Losses and transfer the net amount to Line 13 in the income section on the top page of your IRS Form 1040. You can find out more information on the IRS website, IRS.gov.

Preparing Income Taxes - 2 Ways Capital Assets Save You Money

What is a capital asset? Tax authorities like the Internal Revenue Service and state taxing authorities expect you to report any capital gains or losses on your annual income tax return. This information is reported on IRS Form 1040, Schedule D, Capital Gains and Losses and then transferred as a "cumulative" net amount to Line 13 in the income section on the top page of your IRS Form 1040. You can't file an income tax return that has capital gains or losses using IRS Form 1040A if you are required to file Schedule D to report the income.

Why should you care what is or is not a capital asset? It is important because it could save you money! Tax rates applied to capital gains income are often significantly lower than a person's marginal income tax rates. In other words, you often owe less tax if you sell a capital asset! For 2009 and 2010, a taxpayer in the 15% marginal income tax bracket will pay 0% on any net capital gains! But there is yet another way it can save you money.

The second way you can save money is if your capital loss is greater than your capital gains for the tax year. If gains are less than your losses, you have a cumulative or net loss. This means you can deduct up to $3000 ($1,500 if you are married but filing separately) from your income tax. If the loss is greater than this annual limit, you can "carry forward" the unused loss into future years until it is all used up. There is a catch, though. You can deduct a capital loss only on investment property; you can't deduct a capital loss on personal use property. This distinction is important; you typically don't own investment property, according to IRS code, for personal enjoyment! It is also important to remember that if you anticipate a significantly large taxable capital gain during the year, you are required to make estimate tax payments (even though it will be taxed at a preferentially lower rate).

Your understanding of the definition of a capital asset and how you dispose of it is an important part of managing your personal finances. More information is available in IRS Publication 544, Sales and Other Dispositions of Assets or on the IRS website, IRS.gov. Knowing the "rules" about capital assets could save you lots of cash AND grief.

Preparing Income Taxes - How Do I Report Information on a 1099-A?

The reporting of any cancellation of debt (COD) involves two different information documents; an IRS Form 1099-A, Acquisition or Abandonment of Secured Property and an IRS Form 1099-C, Cancellation of Debt. An IRS Form 1099-A is specifically provided to both tax authority and tax payer when a lender forecloses, repossesses, or has reason to suspect property is abandoned. Whether or not you receive either of these documents in a timely fashion, you must report cancellation of debt you have owed on your personal income tax. Acts of repossession, abandonment, or foreclosure are treated as a sale or exchange of property and the rules of gain or loss apply. Any income arising from the cancellation of a recourse debt is taxable whether or not property is returned or surrendered.

The IRS Form 1099-A is information form that includes the balance of outstanding debt, the fair market value of the property involved, a description of the property, and whether the debt is classified as recourse or non-recourse. Specifically, in Box 5, a "Yes/No" check box indicates whether or not the borrower is personally liable for repayment of the debt. The information in this single box on the form is critical because, if the box is marked "No", the debt is classified as non-recourse; that is, the borrower is not personally liable for the debt. In the case of a recourse debt however, the buyer is not only liable but, under cancellation of that debt, may have a gain, and thus additional taxable income, from the removal of the burden to repay the obligation. Where a recourse loan leads to foreclosure or repossession, the Form 1099-A provides critical information about additional taxes owed on that debt-generated income.

The sale information reported on a Form 1099-A is transferred to the IRS Form 1040 Schedule D, Capital Gains and Losses if the property was categorized as personal - use and there was a reported gain; losses are not reported. If the property was considered an investment, information is entered on Schedule D and ordinary gain/loss rules apply to the transaction. If the Form 1099-A describes business property, an IRS Form 4797, Sales of Business Property is completed and the results are, in turn, transferred to IRS Form 1040 Schedule C (business, sole proprietorship), E (rental), or F(farm).

The proper transfer of information from an IRS Form 1099-A to your income tax return is best left to an experienced tax preparer. You should expect to also include an IRS Form 1040 Schedule D with your tax return. Do NOT overlook COD events when filing your income tax return. For more information, visit the IRS website, IRS.gov.