Capital vs. Non-Capital Assets

The classification of property as capital or non-capital determines how the IRS taxes your gains and allows you to deduct your losses. This distinction is one of the most tested concepts on the EA exam because it affects virtually every property transaction.

The IRC Section 1221 Approach: Exclusion-Based Definition

IRC Section 1221 defines a capital asset using a negative definition—it tells you what is NOT a capital asset rather than what is. The rule is simple:

Everything you own is a capital asset UNLESS it appears on the exclusion list.

This means your personal car, your investment portfolio, your home, and your jewelry are all capital assets by default. However, certain types of property receive different tax treatment and are specifically excluded.

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The Eight Non-Capital Assets (Memorize These!)

Under IRC Section 1221(a), the following are NOT capital assets:

1. Inventory and Property Held for Sale to Customers

Stock in trade or property held primarily for sale to customers in the ordinary course of business. A car dealer's inventory of vehicles, a retailer's merchandise, and a real estate developer's lots held for sale all qualify as inventory—not capital assets.

2. Depreciable Property Used in Trade or Business

Business equipment, machinery, and vehicles subject to depreciation under Section 167. Your business computer, delivery truck, and manufacturing equipment are not capital assets. However, they may qualify as Section 1231 property (discussed below).

3. Real Property Used in Trade or Business

Business real estate including buildings, warehouses, and land used in your business operations. Like depreciable property, business real estate is excluded from capital asset treatment but may receive favorable Section 1231 treatment.

4. Accounts and Notes Receivable

Trade receivables acquired from selling inventory or providing services in the ordinary course of business. When a plumber sends an invoice for services, that accounts receivable is not a capital asset.

5. Self-Created Intellectual Property

Copyrights, literary works, musical compositions, and artistic creations held by their creator (or someone who received them with a carryover basis). A songwriter's royalty rights are ordinary income property, not capital assets. However, patents are treated as capital assets under IRC Section 1235.

6. U.S. Government Publications

Government documents received from the U.S. Government for free or below public sale price, including the Congressional Record. If you purchase them at the public price, they become capital assets.

7. Commodities Derivative Financial Instruments (for Dealers)

Derivatives held by commodities derivatives dealers in connection with their dealing activities.

8. Hedging Transactions

Property held as part of a hedging transaction to manage price, currency, or interest rate risk in the ordinary course of business.

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Common Capital Assets (Examples)

Since everything NOT on the exclusion list is a capital asset, the following are capital assets:

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Section 1231 Property: The "Quasi-Capital Assets"

Section 1231 property occupies a special middle ground. It includes:

• Depreciable business property held more than one year
• Business real estate held more than one year
• Certain livestock, timber, coal, and iron ore

The "Best of Both Worlds" Treatment

Section 1231 gives taxpayers the most favorable treatment possible:

This is incredibly advantageous. If you sell business equipment at a gain, you get preferential capital gains rates. If you sell at a loss, you can deduct the full amount against ordinary income.

The 5-Year Lookback Rule

There's one important caveat: the 5-year lookback rule prevents taxpayers from taking ordinary loss deductions and then converting subsequent gains to capital gains. If you claimed net Section 1231 losses as ordinary deductions in any of the prior 5 years, your current year Section 1231 gains must first be recaptured as ordinary income up to the amount of those prior ordinary loss deductions.

Example: In 2021, you had a $15,000 Section 1231 loss (deducted as ordinary). In 2024, you have a $25,000 Section 1231 gain. The first $15,000 is recaptured and taxed as ordinary income. Only the remaining $10,000 qualifies for capital gains treatment.

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Why the Distinction Matters: Tax Rates and Deductibility

Capital Gains Tax Rates (2024)

Long-term capital gains (assets held more than one year) receive preferential tax rates:

High-income taxpayers may also owe the 3.8% Net Investment Income Tax (NIIT), bringing the maximum rate to 23.8%.

Short-term capital gains (assets held one year or less) are taxed at ordinary income rates (up to 37% in 2024).

Ordinary Income Rates (2024)

Ordinary income from non-capital assets is taxed at rates ranging from 10% to 37%, depending on taxable income and filing status.

Loss Deductibility: The Critical Difference

This is why Section 1231's "loss as ordinary" treatment is so valuable—you avoid the $3,000 annual limitation.

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Comparison Table: Capital vs. Non-Capital Assets

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EA Exam Tips

1. Start with the default: Assume property is a capital asset unless you can identify a specific exclusion.
2. Memorize the eight exclusions: Inventory, depreciable business property, business real estate, A/R, self-created works, government publications, commodities derivatives, and hedging transactions.
3. Section 1231 is favorable: Gains = capital treatment; losses = ordinary treatment. Know the 5-year lookback.
4. Watch for "held for sale": A key phrase that triggers ordinary (non-capital) treatment.
5. Personal vs. business: The same type of property (like real estate) can be capital or non-capital depending on how it's used.