Ordinary Income vs Capital Gains

Whilst the definition for ordinary income and capital gains is straightforward, understanding how they work and which is the preferable route to take to achieve wealth growth, net of tax, is more complex depending upon what transaction it is being linked to.

Ordinary income incorporates revenue that is received from work and other regular earning activities. For example, weekly or monthly wages, business revenue, interest and dividends received on investments would be classed as earned or ordinary income.

Capital gain is the profit (or loss) made on the sale of an asset. In other words, it is the difference between what you paid for that assets and what you sold it for. For example, capital gains would operate for any shares that you bought and subsequently sold on the stock market and any business assets, such as property or goodwill that you purchased then sold at a later date.It should be noted that in the vast majority of cases, a persons private residence is not normally subject to capital gains rules, although a second property might fall into this category. To give an financial instance, if you bought shares on the stock market at a cost of $10 per share and sold them later for $15, you will have made a capital gain of $5 per share.

In terms of which method of acquiring revenue is the more advantageous of the two, this depends upon the need for that income. As most people have to pay living expenses on a regular basis obviously there is a need for a weekly or monthly income and this is normally satisfied by paid employment, which provides ordinary income. If you have enough wealth to not worry about a regular income, you could earn more money by investing in assets that will achieve capital gains. However, unlike a wage, you can also lose money on buying and selling assets.

The taxation aspect that relates to ordinary income and capital gains, whilst relatively straightforward, has some anomalies within it to be considered. Ordinary income, after allowing for a base level of personal allowance, which is free of tax, is taxed at an increasing rate depending upon the level of that income. The only exception to this rule is dividend income from shares, for which different tax rules apply.

In essence, capital gains are taxed at lower rates than ordinary income. However, it is the definition of the IRS meaning of capital gains where it becomes more complex.

It we take the example of selling a business property or asset. A one off or occasional sale of this nature would be considered to be taxed as with the capital gains rules, as long as that asset has been held for more than one year. However, if you make a business out of selling such assets, it is highly likely that the profits made will be treated as ordinary income and taxed accordingly. The more regular the gains become the more likely it is that the IRS may want to determine these gains as being part of the persons or corporations ordinary income.

A similarly position would arise with the purchasing and sale of stock market shares. Here there is a difference between short=term and long-term capital gains As mentioned earlier, short-term capital gains, being those held for less than a year, would fall into the category of ordinary income for tax purposes. The profit from shares held for more than one year would be treated for tax purposes as being capital gains.

There are other complexities within the rules surrounding capital gains taxation that may need to be considered. Therefore, it is highly advisable, if a significant proportion of your annual revenue comes from what you consider to be a capital gain environment, that you engage the service of an accountant who has the relevant expertise to advise you in these areas.