Welcome back. Let's continue with our topic of property transactions. Recall that when we evaluate a property transaction, we need to ask a few questions. First, is there a realized gain or loss? Second, if there is a gain or loss, how much is recognized on the tax return? Third, now that the seller has received new property in the transaction, what's the basis of the new property acquired? Recall that to answer these questions, we need to know various key items. Regarding the realized gain or loss that the seller realized more in total value or amount realized, then the adjusted basis of the property that was given up in the transaction. To calculate the amount realized, we include not only cash received and the fair market value of other property received. We also need to include any relief of debt that the seller doesn't have to pay back anymore, and we have to subtract our selling expenses. Regarding adjusted basis, we take the original basis of the asset, subtract out cost recovery deductions, like accumulated depreciation and add any capital improvements. In this video and the next set of videos, we'll examine another very important question in property transactions. If some amount of gain or loss is recognized from a property transaction, that is we have to report it on your tax return. What is the character of that gain or loss? Is it ordinary or is it capital in character? First, before we can determine whether a recognized gain or loss is ordinary or capital and character, we need to know the holding period of the property. A short-term holding period is one in which an asset is held for one year or less, while a long-term holding period is one in which an asset is held for more than one year. The holding period technically begins on the day after the property is acquired and includes the day of properties disposition. Recall that in our previous videos on non-taxable exchanges, for example, when we discuss like-kind exchanges, the holding period includes the holding period of both the old asset and the new asset. In non-taxable transactions that involve carryover basis, like the gift gain basis scenario, we can add the former owner's holding period to the current owner's holding period. And recall that for Inherited property, the taxpayer can claim long-term holding period treatment no matter how long the asset is actually held by the air. So character is the key concept here. Character determines how the gain or loss is treated for tax purposes. In particular, it'll drive whether a recognized gain will be taxed at the lower preferential tax rates, or the higher ordinary tax rates. Or drive whether a recognized loss is deductible against ordinary income or deductible against other capital income. What determines the character of the gain or loss is based on the type of property that is sold or exchanged? Here, we have three types of assets, ordinary assets, capital assets and section 1231 assets. So we'll learn and master the types and treatments of these assets over the next few videos. So why does identifying the character matter? Again, it'll tell us which tax rates we should use to determine our tax liability. Specifically, the tax rates on net long-term capital gains are always lower than the tax rates for ordinary income. Thus, long-term capital gains are taxed at preferential rates and importantly, short-term capital gains are taxed at ordinary rates. So this is where the holding period really matters. Another reason character matters is that if you have a capital loss and you're an individual as opposed to a corporation. These losses are deductible only to the extent the exceed capital gains by up to $3,000 per year. Any losses that are greater than $3,000 are carried forward indefinitely and can be applied against future capital gain income. On the other hand, ordinary losses are typically deductible immediately and in whole against other income. So as I briefly mentioned before, there are three types of assets, ordinary, capital and section 1231 assets. First, let's talk about ordinary assets. Ordinary assets are created or used in a taxpayer's trade or business, and includes items such as inventory and accounts receivable. Ordinary assets are also business assets that are held for one year or less, that is short term, even if it's equipment. Again, if the ordinary asset is sold at a gain, the recognized gain is ordinary in character and thus taxed at ordinary tax rates. If the asset is sold at a loss, the loss is ordinary in character and the taxpayer can deduct the loss against other ordinary income. We will get the ordinary income tax rates using the regular tax tables that are found in the form 1040 instructions for the individual income tax return. Second, we have capital assets. Generally, these are assets that are held for investment, the production of income or personal use. This category includes assets such as stocks and bonds, a house or a personal car. Internal Revenue code section 1221 defines the types of assets but it doesn't actually define what a capital asset is, instead it defines what a capital asset is not. So here, capital assets are not property used in a trade or business for example, inventory or accounts receivable, or notes receivable acquired from the sale of services or property. So basically, a capital asset is not an ordinary asset. Next, a capital asset is not depreciable property or real estate used in a business. This is a section 1231 property. So capital asset is not a section 1231 asset. We'll actually talk much more about section 1231 assets in later videos. But for now, this is all you need to know about section 1231 assets. Capital assets are also not copyrights, not literary musical or artistic compositions, and not letters or similar property held by the creator or producer. They're not US government publications, and not supplies of a type regularly used or consumed in the ordinary course of business. For example, paper, pens, even gasoline for a vehicle. A bit more about patents here. The sale of patents can trigger automatic long-term capital gains or loss treatment regardless of whether the patent is a capital asset and regardless of the length of time the patent is held. Now to qualify for such treatment, all substantial rights to the patent must be transferred upon sale and only the holder of the patent is entitled to the special treatment. To be a holder, the person must be the creator or purchaser of the patents. Now, if you're a purchaser of a patent, the patent must be purchased from the creator before the patent is reduced to practice. Basically before it's developed for sale in order for a purchaser to also be a holder. The holder must be an individual. So for example, not a corporation. And finally, if the creator is employed by someone else, the creator's employer does not qualify as a holder. So in summary, we've discussed at a high level that the character of recognized gains and losses matters because the character will determine which tax rate the taxpayer will use to calculate his or her income tax liability. The type of asset will determine the character of the income or loss. We have three types of assets, ordinary, capital and section 1231. We'll talk about section 1231 assets in a later video. But for now, it's important to know that ordinary assets are subject to ordinary tax rates while capital assets are subject to preferential tax rates if those assets are held long-term. If capital assets are held short-term, their gains are taxed at ordinary tax rates.