Introduction

You must classify your gains and losses as either ordinary or capital (and your capital gains or losses as either short-term or long-term). You must do this to figure your net capital gain or loss.

For individuals, a net capital gain may be taxed at a lower tax rate than ordinary income. See Capital Gain Tax Rates in chapter 4. Your deduction for a net capital loss may be limited. See Treatment of Capital Losses in chapter 4.

Capital gain or loss.   Generally, you will have a capital gain or loss if you sell or exchange a capital asset. You also may have a capital gain if your section 1231 transactions result in a net gain.

Section 1231 transactions.   Section 1231 transactions are sales and exchanges of property held longer than 1 year and either used in a trade or business or held for the production of rents or royalties. They also include certain involuntary conversions of business or investment property, including capital assets. See Section 1231 Gains and Losses in chapter 3 for more information.

Topics

This chapter discusses:

• Capital assets
• Noncapital assets
• Sales and exchanges between
  related persons
• Other dispositions

Useful Items

You may want to see:

Publication

• 550   Investment Income and Expenses
• 954   Tax Incentives for Empowerment Zones and Other Distressed Communities

Form (and Instructions)

• Schedule D (Form 1040)   Capital Gains and Losses
• 4797   Sales of Business Property
• 8594   Asset Acquisition Statement Under Section 1060

See chapter 5 for information about getting publications and forms.

Capital Assets

Almost everything you own and use for personal purposes or investment is a capital asset. For exceptions, see Noncapital Assets, later.

The following items are examples of capital assets.

• Stocks and bonds.
• A home owned and occupied by you and your family.
• Timber grown on your home property or investment property, even if you make casual sales of the timber.
• Household furnishings.
• A car used for pleasure or commuting.
• Coin or stamp collections.
• Gems and jewelry.
• Gold, silver, and other metals.

Personal-use property.   Property held for personal use is a capital asset. Gain from a sale or exchange of that property is a capital gain. Loss from the sale or exchange of that property is not deductible. You can deduct a loss relating to personal-use property only if it results from a casualty or theft.

Investment property.   Investment property (such as stocks and bonds) is a capital asset, and a gain or loss from its sale or exchange is a capital gain or loss. This treatment does not apply to property used to produce rental income. See Business assets, later, under Noncapital Assets.

Release of restriction on land.   Amounts you receive for the release of a restrictive covenant in a deed to land are treated as proceeds from the sale of a capital asset.

Noncapital Assets

A noncapital asset is property that is not a capital asset. The following kinds of property are not capital assets.

1. Property held mainly for sale to customers or property that will physically become part of merchandise for sale to customers. This includes stock in trade, inventory, and other property you hold mainly for sale to customers in your trade or business. Inventories are discussed in Publication 538, Accounting Periods and Methods.
2. Accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of any properties described in (1).
3. Depreciable property used in your trade or business or as rental property (including section 197 intangibles defined later under Dispositions of Intangible Property), even if the property is fully depreciated (or amortized). Sales of this type of property are discussed in chapter 3.
4. Real property used in your trade or business or as rental property, even if the property is fully depreciated.
5. A copyright; a literary, musical, or artistic composition; a letter; a memorandum; or similar property (such as drafts of speeches, recordings, transcripts, manuscripts, drawings, or photographs) -
   1. Created by your personal efforts,
   2. Prepared or produced for you (in the case of a letter, memorandum, or similar property), or
   3. Acquired from a person who created the property or for whom the property was prepared under circumstances (for example, by gift) entitling you to the basis of the person who created the property, or for whom it was prepared or produced. Letters and memorandums addressed to you and letters or memorandums prepared by persons under your administrative control are considered prepared for you even if you do not review them.
6. U.S. Government publications you got from the government for free or for less than the normal sales price or that you acquired under circumstances entitling you to the basis of someone who got the publications for free or for less than the normal sales price.
7. Any commodities derivative financial instrument held by a commodities derivatives dealer unless it meets both the following requirements.
   1. It is established to the satisfaction of the IRS that the instrument has no connection to the activities of the dealer as a dealer.
   2. The instrument is clearly identified in the dealer's records as meeting (a) by the end of the day on which it was acquired, originated, or entered into.
8. Any hedging transaction that is clearly identified as a hedging transaction by the end of the day on which it was acquired, originated, or entered into.
9. Supplies of a type you regularly use or consume in the ordinary course of your trade or business.

Property held mainly for sale to customers.   Stock in trade, inventory, and other property you hold mainly for sale to customers in your trade or business are not capital assets. Inventories are discussed in Publication 538.

Business assets.   Real property and depreciable property used in your trade or business or as rental property (including section 197 intangibles defined later under Dispositions of Intangible Property) are not capital assets. Their treatment is discussed in chapter 3.

Letters and memorandums.   Letters, memorandums, and similar property (such as drafts of speeches, recordings, transcripts, manuscripts, drawings, or photographs) are not treated as capital assets if your personal efforts created them or if they were prepared or produced for you. Nor is this property a capital asset if your basis in it is determined by reference to the person who created it or the person for whom it was prepared. For this purpose, letters and memorandums addressed to you are considered prepared for you. If letters or memorandums are prepared by persons under your administrative control, they are considered prepared for you whether or not you review them.

Commodities derivative financial instrument.   A commodities derivative financial instrument is a commodities contract or other financial instrument for commodities (other than a share of corporate stock, a beneficial interest in a partnership or trust, a note, bond, debenture, or other evidence of indebtedness, or a section 1256 contract) the value or settlement price of which is calculated or determined by reference to a specified index (as defined in section 1221(b) of the Internal Revenue Code).

Commodities derivative dealer.   A commodities derivative dealer is a person who regularly offers to enter into, assume, offset, assign, or terminate positions in commodities derivative financial instruments with customers in the ordinary course of a trade or business.

Hedging transaction.   A hedging transaction is any transaction you enter into in the normal course of your trade or business primarily to manage any of the following.

1. Risk of price changes or currency fluctuations involving ordinary property you hold or will hold.
2. Risk of interest rate or price changes or currency fluctuations for borrowings you make or will make, or ordinary obligations you incur or will incur.

Sales and Exchanges
Between Related Persons

This section discusses the rules that may apply to the sale or exchange of property between related persons. If these rules apply, gains may be treated as ordinary income and losses may not be deductible. See Transfers to Spouse in chapter 1 for rules that apply to spouses.

Gain Is Ordinary Income

If a gain is recognized on the sale or exchange of property to a related person, the gain may be ordinary income even if the property is a capital asset. It is ordinary income if the sale or exchange is a depreciable property transaction or a controlled partnership transaction.

Depreciable property transaction.   Gain on the sale or exchange of property, including a leasehold or a patent application, that is depreciable property in the hands of the person who receives it is ordinary income if the transaction is either directly or indirectly between any of the following pairs of entities.

1. A person and the person's controlled entity or entities.
2. A taxpayer and any trust in which the taxpayer (or his or her spouse) is a beneficiary unless the beneficiary's interest in the trust is a remote contingent interest; that is, the value of the interest computed actuarially is 5% or less of the value of the trust property.
3. An executor and a beneficiary of an estate unless the sale or exchange is in satisfaction of a pecuniary bequest.
4. An employer (or any person related to the employer under rules (1), (2), or (3)) and a welfare benefit fund (within the meaning of section 419(e) of the Internal Revenue Code) that is controlled directly or indirectly by the employer (or any person related to the employer).

A person's controlled entity is either of the following.

1. A corporation in which more than 50% of the value of all outstanding stock, or a partnership in which more than 50% of the capital interest or profits interest, is directly or indirectly owned by or for that person.
2. An entity whose relationship with that person is one of the following.
   1. A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest or profits interest in the partnership.
   2. Two corporations that are members of the same controlled group as defined in section 1563(a) of the Internal Revenue Code, except that more than 50% is substituted for at least 80% in that definition.
   3. Two S corporations, if the same persons own more than 50% in value of the outstanding stock of each corporation.
   4. Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation.

Controlled partnership transaction.   A gain recognized in a controlled partnership transaction may be ordinary income. The gain is ordinary income if it results from the sale or exchange of property that, in the hands of the party who receives it, is a noncapital asset such as trade accounts receivable, inventory, stock in trade, or depreciable or real property used in a trade or business.

A controlled partnership transaction is a transaction directly or indirectly between either of the following pairs of entities.

• A partnership and a partner who directly or indirectly owns more than 50% of the capital interest or profits interest in the partnership.
• Two partnerships, if the same persons directly or indirectly own more than 50% of the capital interests or profits interests in both partnerships.

Determining ownership.   In the transactions under Depreciable property transaction and Controlled partnership transaction, earlier, use the following rules to determine the ownership of stock or a partnership interest.

1. Stock or a partnership interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries. (However, for a partnership interest owned by or for a C corporation, this applies only to shareholders who directly or indirectly own 5% or more in value of the stock of the corporation.)
2. An individual is considered as owning the stock or partnership interest directly or indirectly owned by or for his or her family. Family includes only brothers, sisters, half-brothers, half-sisters, spouse, ancestors, and lineal descendants.
3. For purposes of applying (1) or (2), stock or a partnership interest constructively owned by a person under (1) is treated as actually owned by that person. But stock or a partnership interest constructively owned by an individual under (2) is not treated as owned by the individual for reapplying (2) to make another person the constructive owner of that stock or partnership interest.

Nondeductible Loss

A loss on the sale or exchange of property between related persons is not deductible. This applies to both direct and indirect transactions, but not to distributions of property from a corporation in a complete liquidation. The following are related persons.

1. Members of a family, including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).
2. An individual and a corporation if the individual directly or indirectly owns more than 50% in value of the outstanding stock of the corporation.
3. Two corporations that are members of the same controlled group as defined in section 267(f) of the Internal Revenue Code.
4. A trust fiduciary and a corporation if the trust or the grantor of the trust directly or indirectly owns more than 50% in value of the outstanding stock of the corporation.
5. A grantor and fiduciary, and the fiduciary and beneficiary, of any trust.
6. Fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts.
7. A tax-exempt educational or charitable organization and a person who directly or indirectly controls the organization, or a member of that person's family.
8. A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest or profits interest in the partnership.
9. Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation.
10. Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation.
11. An executor and a beneficiary of an estate unless the sale or exchange is in satisfaction of a pecuniary bequest.
12. Two partnerships if the same persons directly or indirectly own more than 50% of the capital interests or profits interests in both partnerships.
13. A person and a partnership if the person directly or indirectly owns more than 50% of the capital interest or profits interest in the partnership.

If a sale or exchange is between any of these related persons and involves the lump-sum sale of a number of blocks of stock or pieces of property, the gain or loss must be figured separately for each block of stock or piece of property. The gain on each item is taxable. The loss on any item is nondeductible. Gains from the sales of any of these items may not be offset by losses on the sales of any of the other items.

Partnership interests.   The nondeductible loss rule does not apply to a sale or exchange of an interest in the partnership between the related persons described in (12) or (13) above.

Controlled groups.   Losses on transactions between members of the same controlled group described in (3) earlier are deferred rather than denied.

For more information, see section 267(f) of the Internal Revenue Code.

Ownership of stock or partnership interests.   In determining whether an individual directly or indirectly owns any of the outstanding stock of a corporation or an interest in a partnership for a loss on a sale or exchange, the following rules apply.

1. Stock or a partnership interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries. (However, for a partnership interest owned by or for a C corporation, this applies only to shareholders who directly or indirectly own 5% or more in value of the stock of the corporation.)
2. An individual is considered as owning the stock or partnership interest directly or indirectly owned by or for his or her family. Family includes only brothers, sisters, half-brothers, half-sisters, spouse, ancestors, and lineal descendants.
3. An individual owning (other than by applying (2)) any stock in a corporation is considered to own the stock directly or indirectly owned by or for his or her partner.
4. For purposes of applying (1), (2), or (3), stock or a partnership interest constructively owned by a person under (1) is treated as actually owned by that person. But stock or a partnership interest constructively owned by an individual under (2) or (3) is not treated as owned by the individual for reapplying either (2) or (3) to make another person the constructive owner of that stock or partnership interest.

Indirect transactions.   You cannot deduct your loss on the sale of stock through your broker if under a prearranged plan a related person or entity buys the same stock you had owned. This does not apply to a cross-trade between related parties through an exchange that is purely coincidental and is not prearranged.

Property received from a related person.   If, in a purchase or exchange, you received property from a related person who had a loss that was not allowable and you later sell or exchange the property at a gain, you recognize the gain only to the extent it is more than the loss previously disallowed to the related person. This rule applies only to the original transferee.

Example 1.   Your brother sold stock to you for $7,600. His cost basis was $10,000. His loss of $2,400 was not deductible. You later sell the same stock to an unrelated party for $10,500, realizing a gain of $2,900 ($10,500 - $7,600). Your recognized gain is only $500, the gain that is more than the $2,400 loss not allowed to your brother.

Example 2.   Assume the same facts as in Example 1, except that you sell the stock for $6,900 instead of $10,500. Your recognized loss is only $700 ($7,600 - $6,900). You cannot deduct the loss not allowed to your brother.

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