IRC 1221 (Explained: What It Is And All You Need To Know)

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How does the tax code define a capital asset?

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Let me explain to you what Internal Revenue Code 1221 is all about and how it works!

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What Is IRC 1221

IRC 1221 refers to Section 1221 of the Internal Revenue Code titled “Capital asset defined”.

The notion of a capital asset is defined under the tax code, allowing individuals and companies to properly determine what is and what is not a capital asset for tax purposes.

In essence, for the purpose of IRS code 1221, a capital asset is any “property held by the taxpayer (whether or not connected with his trade or business).

In other words, when a company or individual acquires an asset or property, that asset is a capital asset regardless of the fact that it may be directly linked to the company’s business or individual trade.

Capital Gains

Under the tax code, depending on the nature of the transaction, you will need to either report an ordinary income or capital gains (to the extent you are making a profit or money).

Capital gains are given special tax treatment and in general are favorable to the taxpayer.

When a property is considered a capital asset, the sale or disposition of that property can result in a capital gain or loss. 

On the other hand, when a property is not a capital asset, then the sale or disposition of that property will be treated as ordinary income and taxed accordingly.

Capital Assets 

In order to distinguish between capital gains and ordinary income, Section 1221 of the tax code defines what is a capital asset and indicates what is not a capital asset.

In simple terms, any asset, no matter how long a taxpayer will hold on to it, will be a capital asset except for those specifically excluded by tax code 1221.

However, the following items are not considered as capital assets specifically under the IRS tax code 1221:

• Stock used as inventory and primarily destined for sale to customers
• Business property and real estate used in business or trade
• Copyright, music, artistic composition, or similar property held by the taxpayer that created it or who has the property with the same basis as the person who created it
• Accounts receivable or notes receivable in the course of business
• Short-term non-interest bearing government obligations
• US government publications 
• Other miscellaneous classes of property 

To better understand IRC 1221, let’s look at the outline of this tax code provision.

IRC 1221 Overview

Section 1221 IRC is broken down into several paragraphs and subparagraphs.

Here is the outline of Internal Revenue Code 1221:

• IRC 1221(a) In general
• IRC 1221(b) Definitions and special rules
  • IRC 1221(b)(1) Commodities derivative financial instruments
  • IRC 1221(b)(2) Hedging transaction
  • IRC 1221(b)(3) Sale or exchange of self-created musical works
  • IRC 1221(b)(4) Regulations

How IRC 1221 Works

Let’s see how Section 1221 of the Internal Revenue Code works.

General Rule

The general rule under IRC 1221(a) is that the term “capital asset” is any property held by a taxpayer without taking into consideration if the property is related to his trade or business.

The provision states:

Exception

IRC Sec 1221 also presents certain exceptions to the general rule.

Here are the types of assets that are not included within the definition of capital assets under 1221 IRC:

• IRC 1221(a)(1) Stock in trade of the taxpayer is considered as inventory or primarily used for sale to customers in the course of business
• IRC 1221(a)(2) Property that is subject to the allowance for depreciation under Section 167 or real property used in trade or business 
• IRC 1221(a)(3) Patent, invention, model, design, secret formula, copyright, literary, musical, artistic composition, letter or memorandum, or something similar under certain conditions
• IRC 1221(a)(4) Accounts or notes receivable 
• IRC 1221(a)(5) A publication of the US government in certain conditions
• IRC 1221(a)(6) Any commodities derivative financial instruments held by a commodities derivatives dealer under certain conditions
• IRC 1221(a)(7) Any hedging transactions which is clearly identified as such 
• IRC 1221(a)(8) Supplies used in the ordinary course of business 

Commodities Derivative Financial Instruments

IRS 1221 defines the notion of commodities derivative financial instruments and commodities derivatives dealer as follows:

• IRC 1221(b)(1)(a) A commodities derivatives dealer is a person who regularly enters into or terminates positions in commodities derivative financial instruments in his or her course of trade or business
• IRC 1221(b)(1)(B)(i) A commodities derivative financial instrument is any contract or financial instrument relating to commodities that its value is calculated in reference to a specified index 
• IRC 1221(b)(1)(B)(iI) A specified index is a combination of fixed or variable rate, price, or amount based on objectively determinable financial information, not within the control of the parties, and not unique to any of the parties

Hedging Transactions

The Internal Revenue Code provision 1221 also defines hedging transactions.

In essence, under IRC 1221(b)(2)(A), a hedging transaction is any transaction that is intended to manage the risk of price change, currency fluctuation, interest rate with regards to borrowings, and manage other types of risk.

IRC Section 1221 Takeaways 

So there you have it folks!

What does IRC Section 1221 relate to?

How does the tax code define capital assets?

In a nutshell, any property held by a taxpayer whether or not related to the taxpayer’s trade or business is a capital asset.

26 USC 1221 specifics certain exceptions, namely:

• Stock used as inventory and primarily destined for sale to customers
• Business property and real estate used in business or trade
• Copyright, music, artistic composition, or similar property held by the taxpayer that created it or who has the property with the same basis as the person who created it
• Accounts receivable or notes receivable in the course of business
• Short-term non-interest bearing government obligations
• US government publications 
• Miscellaneous classes of property 

The distinction of what’s a capital asset or not is important as it will allow a taxpayer to determine if it will need to report a capital gain (or loss) or ordinary income.

Capital gains generally have a preferential tax treatment and so it’s important that a proper distinction is made when a property is sold triggering either capital gains or losses or leading to ordinary income that must be reported in the fiscal year.

I hope I was able to explain to you what IRC 1221 is all about, how a capital asset is defined under the tax code, and what’s not a capital asset.

Remember, this article is intended to give you general information to get you started in your research.

If you have a specific legal issue or questions relating to a transaction or property in question, be sure to consult a tax attorney or tax professional for guidance and advice.

Good luck!

Let’s look at a summary of our findings.

Understanding IRC 1221

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