 Hello, and welcome to the session in which we will discuss the concept of capital assets or section 1221. Now, why do we need to learn about capital assets? Well, the reason is, is when we dispose of an asset, when we sell of an asset, there are three elements that could affect the character of the gain or the loss recognized by the taxpayer. So, depending on what type of asset you have, and here we're dealing with capital asset, it's going to determine how you're going to be taxed or whether that loss is deductible or not. There are three elements that affect your tax status. One is the type of the asset that you are disposing of. Well, it's the tax status of it. What type of assets are we dealing with? And how do we know what type of an asset are we dealing with? Well, it's going to be based on the purpose and the use of the asset. And there are three types of assets that we need to be aware of. Capital assets, which is this, this is what we're going to be discussing today. What are capital assets or section 1221 asset, which is a truck. Section 1231 asset, which is also a truck. And ordinary asset, which is also a truck. So, we have three types of assets. Capital assets, section 1231 and ordinary assets. So, we need to know why all of them, they have the same example, truck. Well, it all depends on the purpose and the use of that asset. Now, when it comes to a truck, can you own a truck for personal use? And the answer, sure, why not? So, you can have a truck and you can have it for personal use. That becomes a capital asset. Also, capital asset, in addition to personal use asset, we're talking about personal investments, such as stocks, bonds and land. Those are usually capital assets that when we, when you think of them in your tax course on the C or the CPA exam. Now, what are section 1231 assets? I just told you, it's a truck. Well, how is that? How can a truck be a capital asset? How can a truck be section 1231? Well, you could also have a landscaping business and where you have a truck that's used for business. Well, if the truck is used for your, in your business, it becomes 1231, section 1231 truck. Simply put, section 1231 trucks are real and depreciable assets used in business. Real means building, land, real means doesn't move. And depreciable means furniture, vehicles, trucks, depreciable asset that are used in business. And they have one more category, you hold them for more than a year. Then we have a third category, ordinary asset. What's ordinary asset? Well, guess what? This is how we define it. If it's not a capital asset, not 1231, not 1221, then it's an ordinary asset, like a truck. Hold on a second. How can a truck be, we just said, you know, it could be a capital asset, could be a section 1231. Also, it could be, you could be a dealer of trucks and you could be selling those trucks as part of your inventory. The truck becomes a, an ordinary asset. So remember the purpose and the use determine the type of the asset that we are dealing with. That's the first thing. Second is how did you dispose of the asset? How did you, how did you, how did you dispose of it? Most commonly, you will sell it. You could also, you have to deal with it with exchange. And this is where we learn about exchange. You could lose the asset as a result of a theft or condemnation by government. And those have different rules as well. The third elements is the holding period. How long you had this asset for? Because the government gives you a preference if you hold it more than a year, more than a year. This is the period over which the asset was held by the taxpayer before being disposed of. Asset held for more, for one year or less result, ensure term capital gains, capital losses. However, assets held more than a year results in long term capital gains, long term capital losses. And it makes a difference. The holding period makes a difference on your taxes. So in this session, we're going to be focusing specifically on capital assets or section 1221. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. No obligation, no credit card required. So what is the definition of a capital asset? Well, basically I'm going to rehearse what I just said earlier. It's assets for personal use and most investment asset. Again, what we said stocks, bonds, think about this real or personal property that are held, not held for trade or business. Remember, if they're held for trade or business, they become section 1231, interest in a partnership, purchased copyright, literally artistic composition, stocks and securities. Usually, when you think of capital stocks, that's what you should be thinking of, stocks and bonds. Other assets held for investment purposes like land, miscellaneous assets identified by the Congress. If you're interested, go to the congress.gov and look up, see what Congress also classified as capital asset. But this is basically what capital assets are. Now, also the government executes specific things that you cannot count them as capital asset, executed specifically, inventory or stock in trade, which is basically what you're selling, what you are dealing with, which is classified as ordinary asset. That's for your business. Accounts receivable, notes receivable, same thing because those are generated from inventory or performing services, which is part of your business. Those are ordinary assets. Real property and depreciable property used in trade or business. Now, we are dealing with section 1231 assets and patent invention model or design, a secret formula or process, certain copyrights, literally musical, artistic composition, so on and so forth, or similar property held by the original developer or artist. Those are also not capital asset, certain publication of the US government and supplies used in business, anything is used in business. It's not capital asset. Let's take a look at this warm up example just to see if we can identify which one is a capital asset. We have a list of items here. We have an account receivable, trade receivable, we have automobile for personal use, vehicle for business use, real property held for business. Which one of those is a capital asset? And the answer is it's the automobile for personal use. The trade account receivable, ordinary asset, vehicle held for business, assuming it's more than a year, section 1231, real property held for business, section 1231, assuming you held it for more than a year. Now we need to discuss gains and losses. Now we know what capital assets are. Let's discuss gains and losses. Well gains and losses results from the sale or exchange of that capital asset. For income tax purposes, capital gains and capital losses must be separated from other gains and losses because they are taxed differently. So that's the crack of the lesson here. Why do we have to differentiate if something is a capital gain or a capital loss? Because it's taxed differently than ordinary assets. So we have ordinary assets or section 1231 assets. And we have capital asset. The way you tax capital asset, whether you have a gain or a loss, is different than the way you treat those. Because there's some sort of a preference treatment here. That's why you want to make sure you are dealing with capital asset. Therefore, once realized, gain and losses must be classified as either ordinary or capital gains and losses. So that's why capital gains and losses, they have kind of special treatment. So capital gains and capital losses should be classified into one of three categories. We could have short term capital gain. And just want to let you know, if you have a short term capital gain, if you have a capital asset and you sold it and you held it for less than a year, guess what? There's no preference. In other words, it's ordinary tax rate. Whatever your ordinary tax rate is, you'll be taxed on that. Or you could have short term capital loss. It's basically, it's a loss, but that loss for less than a year. We'll talk about losses shortly. You could have long term capital gain, long term capital gains. You could have a long term capital, short term capital gain, long term capital gain. We said the short term, easy, taxed based on your ordinary tax rate. How about long term capital gain? This is where we have the preference. It's going to be the lesser of your ordinary rate or some sort of a preference rate, 0, 15, 20%. We'll talk about that. And there are other categories. We have a 25% category and 28% categories for certain assets we'll discuss on the next slide. But this just kind of give you the big picture. So long term capital gain, this is where the advantage is they could be taxed at a lower rate than your ordinary tax rate. Then we have obviously long term capital loss. Notice we have one in three, we have short term capital gain, long term capital gain, short term capital loss, long term capital loss. Now let's talk about losses first. Losses from personal use assets. So if you have the car, you use it for personal use. You use it for personal use. You go on vacation. You go to the grocery store to buy food. You take your kids to the park. Personal use assets are not deductible. When you sell it and incur a loss, that's not deductible. However, up to $3,000 of net capital losses other than personal use assets are deductible. What are we talking about here? We're talking about stocks, bonds, investments. And remember, memorize this. Make sure you know this because they always strip you. Yes, personal use assets are not deductible, but up to 3,000. So if I buy stocks and Apple and Amazon in Google and I incur a loss and I happen to incur $5,000 of losses for a particular year, the government says, guess what? Of that 5,000, you can deduct 3,000 against your ordinary income. So I can lower my taxes by $3,000. And any remaining, which is the 2,000, can be carried forward indefinitely. Make sure you memorize this. And I'm going to show you the tax form where that goes, capital gains slash losses. So it goes right on the tax form. So some taxpayer like myself who always lose in the stock market every year will have a loss of $3,000 and I deduct that there. So it's deducted against your ordinary income. It's deductible. Now, also you need to know personal bad debt, which is called non-business bad debt. So if you lend someone money for personal use, it's treated as short-term capital loss in the year they become completely worthless. So that individual never pays you. It becomes short-term capital loss. And we'll talk about that later on in a separate session. Let's talk about capital gains. The net capital gains are classified as follow. We have net capital, net short-term capital gain. Remember, short-term capital gain, as I told you when I started, it stacks based on your ordinary tax rate. So there's no preference for that. And that rate, for example, for year 2022, and you could be watching this in 2024, 2025, who knows maybe 2026, those rates will change. But right now the tax rate is between, it could be tax 10 to 37%. And the tax rate could change depending on the year you're watching this. So this 10 and 37% could change. I'm just warning you. Net long-term capital gain. Now, long-term is treated a little bit differently. Those are the assets that you hold for more than a year. They're separated into basically several categories. The first one is gains on sale of collectibles and qualified small business stock. We'll talk about qualified small business stock in a separate session. But for now, if you sold a collectible or qualified small business stock and you hold it for more than a year, you're taxed at 28%. Now, what are collectibles? Collectibles is any art of war, krag, antique, metal or gem, stamp, alcoholic beverage, historical object, objects as document, clothes, so on and so forth. Those are called collectibles. So you buy them, you hold them for a year, you sell them. Guess what? It's, as long as it's qualified as collectible, then you are taxed at 28%. Don't worry about the qualified small business stock. We'll talk about that in a separate session. So that's one category. Then we have another category under long-term capital gain and this is unrecapture depreciation, which is all we have to know now is we have a category called unrecapture depreciation and which is computed. How do we compute this? The lesser of the gain realized on the sale of a qualified real property or the accumulated depreciation taken on that property. Don't worry for now. We're going to have a whole session about this unrecapture depreciation but no, certain long-term capital asset, if they are considered unrecapture depreciation, they're taxed at, the unrecapture depreciation attacks at 25%. And here comes the most common one we're going to be dealing with, other long-term capital gain and losses, which is namely the gains on the sale of long-term asset held, capital asset held for long-term and qualified dividend. We also have a category called dividend, specifically qualified dividend. Those are taxed at 0, 15 and 20%. The application of this rate depends on your tax bracket. So let's summarize what's on this slide because there's a lot of information and, you know, there's a lot of percentages being thrown around. So here we go. We have basically three categories of long-term capital gain, three categories. One is the, think of them as the collectibles and those taxed at 28%. Then we have the second one is the unrecaptured depreciation and those assets are taxed at 25%. And we have the one that's used the most, 0, 15 and 20%. So notice if you really think about it, we have one, two, three, four, five. So your net long-term capital gain could be subject to 28, 25, 0, 15 or 20, depending what's the asset that we're dealing with. And sometimes on the third category, depending on where you stand, where you stand according to the taxable income and your filing status. So let's talk about the 0, 15 and 20%. And don't worry, we're going to work examples about this just in case you're wondering, that's not enough. It is not enough. We have to work examples. But let's just look for this, just let's look at a little bit more at the numbers to see how this 0, 15 and 20% comes into place. And again, this is for year 2022. These figure will change. So if you're studying this in 2023, don't email me, said Professor Farhad, you know, it's not matching my book, it's not matching my CPA course, it will not match. But all we have to do is now it changes, the rate will change. So when do you get 0%, which is that's what you want? Well, if the taxpayer taxable income is less than or equal to 40,400, simply put, if you're single and your taxable income is less than 40,400, the government says, look, you bought an asset, you hold it for more than a year. Don't worry about it, we're not gonna, you're not gonna pay taxes on that because you held it more than a year. Remember, this is for long term short term, it gets taxed ordinary income. Now, if you're married, you have double this amount 80,800. Now, if your taxable income is more than 40,400 up to 445,850 and you're single, now at this point, you will pay 15% on that long term capital gain. Now, if you're married, it could go up to half a million 501,600. Guess what? If you make a lot of money, according to the IRS, which is any amount, if you're single, any amount above 455,800 or any amount above 501,600 married filing jointly, any amount above that, your long term capital gain will become 20%. Simply put here, it's 20%. Although it's 20%, remember, when you are in the half a million dollar taxable income, your tax rate is 37, so you will take the 20% because otherwise, if it's ordinary income, you will be taxed at 37. So, although it's 20, it's still good. It's a tax preference treatment. And those same percentages here, they also apply to qualified dividends. So, when we talk about dividend, specifically qualified dividend, qualified dividend are taxed the same way, 0%, 15%, 20%, depending on your taxable income and filing status. Let's talk about ordinary gains because we said you're taxed either at your ordinary gain for short term and for long term, either the lesser of your ordinary gain or tax preference. Now, let's go back here. Now, if you happen to have, which is not likely, but if you happen to be in this tax bracket right here, and your ordinary happens to be 12%, which is not likely, then your ordinary would apply, not the 15, because the 15 is the preference, but if your ordinary is lower, we'll take the 15, but that's not likely. Now, ordinary gains. So, ordinary gains are fully taxable at ordinary tax rate, which is like, what's ordinary gain here? Short term capital gains. Short term capital gain are subject to ordinary gains, ordinary tax rate. Now, for 2022, here's the tax table. Once again, this might change, of course, in 2023, not might, it will change. Okay? So, here's how it works. If you're from zero to 10,275, you pay 10%, then any amount, 10% times 10,275, whatever that amount is happens to be. If your taxable income between 10,275 and 41,775, you'll have to pay in taxes $1,027.50 plus 12% of the amount above 12,275. At this point, you became in the 12% tax bracket. So, when you have 10,275 or less, we say you're in the 10% tax bracket. When your taxable income between 10,275 and 41,775, well, you're going to pay this amount on the first 10,275 plus you're going to pay 12% on the amount above 10,275. And now you're in the 12% tax bracket. If your taxable amount is 41,775 up to 89,075, you're going to have to pay the amount that you paid earlier, which is the amount of 10%, the amount that you paid here, whatever the tax happens to be, which is happens to be both of them, $4,807.05. And you know what? Let me just compute them for you this way you understand where this number is coming from because this is a teaching course. I should not assume anything. So, if we take 41,775 minus 10,275, and that's going to give us 31,500. So, this is the amount above 10,000. And we're going to multiply this by 12% times 0.12. And that's going to give us 3,780 plus the 1075, 1027.5 plus 1027.5. And voila, this is we have $4,807.50. So, this is where this number is coming from. It's the taxes that you paid on this amount plus now you're in the 22% tax bracket, any amount above 41,447, which is the difference between 89,075 and this amount, you'll pay 22%. And it just, it's a progressive then you become in the 24% tax bracket, 32% tax bracket, up to 37 tax bracket. At some point, at some point in our history, that the highest tax bracket was 90%. Simply put, you make that extra dollar, the government takes 90% out of it and taxes. But again, this is when we had back in the 60s for different reasons. But the point is, this will change. So, this is the ordinary tax rate for individual. So, long-term capital gain receive a preferential treatment. So, you don't use this table when you're computing long-term capital gain. You would use this table when you are dealing with short-term capital gains because the money gets added to the ordinary income. And those rates for individuals, not for corporations. Now, corporations don't have a tax rate for capital gain and another one for ordinary income. For corporation, ordinary income and capital gains are the same thing. Also, for corporation, you can deduct capital losses against capital gains only. Don't worry about corporation, we'll deal with this in a separate session, just because sometime what they do is they try to trick you. Now, let's take a look at examples. Actually, one example then we'll look at more. In 20x3, Mary, a single taxpayer reported the following transaction involving capital asset. Gain on the disposition of land helped for an investment purpose for two years. So, if she has a gain on this land, how is that gain taxed? Well, it's a capital asset, land for investment, it's long-term. Therefore, it's long-term. So, what does that mean long-term? It's going to be either 0, 15 or 20%, depending how much, what's her, how much, how well off or not well off Mary is. Okay, because remember 0, 15 and 20%. Loss on the disposition of personal car purchased four years ago. She sold her car, she incurred the loss of 1,100. Well, to share too bad, that's not too bad actually holding a car for four years then selling it at a loss, but there's nothing you can do with that loss. It's a personal use asset. Gain on a sale of ABC stock acquired eight months ago is an investment. Great, we purchased an investment, we have a gain, the gain is 750. Yes, it's going to be short-term capital gain. It means it's going to be, it's going to be taxed as ordinary income, no preference for that. Gain on the sale of a wrangler used for recreational activities helped for three years, 1,400. Now you sell that wrangler that you used for recreation activities. I don't know how you did it after three years, maybe you must have been really changed the engine and really made it look good and you have a gain. Well, guess what? It's a personal use, but guess what? It's taxable as long-term capital gain. So notice your personal use long-term capital gain is taxable, but your losses from the car, from the vehicle is not. That would be nice if you could take the 1,400, the 1,100 and reduce and net them out, but you can't do that. You can't do that. Losses, personal use just, it doesn't exist. And I told you why in the past, because think about it, we always, we all purchase assets for personal use, personal computers, personal furniture, cell phones, and when we use them they lose value. So if the government says, guess what? Go ahead and sell them and we'll give you a tax deduction. Everyone will be buying stuff using them, then sell them at a loss and no one will pay, will ever pay any taxes. So just kind of give you the extreme to remind you why personal use assets are not personal losses on personal use asset are not deductible. However, gains, if you enjoy a gain, then you have the ability to pay taxes. Guess what? Pay your taxes. So this is how it works. Basically, what should you do now? We are going to have to work more examples, go to far have lectures, look at additional resources, MCQs, examples, true false, that's going to help you understand this topic. Whether you are a student or a CPA candidate, capital assets, long-term capital gains, short-term capital gains, long-term capital losses, short-term capital losses are extremely important topic. Or if you are also an EA enrolled agent, good luck, study hard, and of course, stay safe.