Section 1231 Property
When assets are sold, the tax treatment of any gain or loss depends on how the asset was used. If the asset was a capital asset, then the gain or loss is a capital gain or loss. If the asset was held for resale, then the gain or loss is classified as ordinary income. The tax treatment of gain or loss for assets used in business is more complex. Since these rules are found in §1231 of the Internal Revenue Code, they are often called §1231 assets. Section 1221(a) stipulates that §1231 assets are not capital assets. Nonetheless, business assets held longer than 1 year qualify as §1231 assets, which may qualify for limited capital gain treatment. Business assets are not given capital gain treatment because they are depreciated over time, allowing the business to deduct the depreciation against ordinary income. Hence, the tax law does not permit a business to simply subtract its basis in the property as is done with most other property dispositions, because long-term gains are usually taxed at a lesser rate than ordinary gain, so a business that claimed substantial depreciation on property that was later sold at a long-term gain, would profit at the expense of the government. To prevent this, the tax code treats part or all the gain as depreciation recapture, in which that portion of the gain equal to the total amount of depreciation claimed on the property is taxed as ordinary gain, even if the property was held longer than 1 year. Any deductions claimed as first-year expensing, such as claiming the §179 deduction or bonus depreciation, is fully recaptured as ordinary income. However, after depreciation recapture is accounted for, any net long-term gain on §1231 property is treated as a long-term capital gain while losses are treated as ordinary losses.
The sale of property with business and personal use must be treated as 2 sales, with the basis, depreciation, and selling price allocated to the business- and the personal-use gain or loss. Since first-year expensing cannot be claimed for property not used more than 50% for business, first-year expensing is also recaptured if it was claimed on listed property, if business use for any year within the recovery period does not exceed 50%.
Example: The §179 Deduction Reduces Basis by the Amount of the Deduction
- You pay $2000 for a computer used 100% for business.
- You deducted $2000 as a §179 deduction.
- Later, you sell the computer for $800.
- Because the §179 deduction reduced your basis to 0, the entire amount of $800 is recognized as ordinary income.
Other sections of the tax code also determine how gain is computed on property in which depreciation has been claimed. Some depreciable business equipment and livestock is governed by IRC §1245, so it is sometimes called §1245 property. If the depreciated property was realty, then it is sometimes called a §1250 asset. The disposition of property subject to depreciation recapture is generally reported on Form 4797, Sales of Business Property.
Other types of disposition of property subject to recapture rules include gifts and inheritance of depreciable property, charitable donations, installment sales, like-kind exchanges and involuntary conversions. The donee of a gift receives the carryover basis of the donor and will also be subject to the recapture rules that would have applied if the donor had sold the property. The deduction for charitable donations is reduced by the depreciation claimed on the property. For installment sales, depreciation recapture is fully taxable in the year of the sale. If a partnership claims depreciation on property that is later distributed to a partner, then the partner will be subject to the depreciation recapture rules when the property is finally disposed of.
Section 1231 does not determine when gain or loss is realized, but only how the recognized gain or loss is classified: ordinary, capital, or §1231. Section 1231 property must either be depreciable property or real estate that was used in business. The disposition of §1231 property usually results in ordinary income rather than capital gains. However, under certain circumstances, §1231 allows the gain to be treated as a long-term capital gain, if the following requirements are met:
- the property was held longer than 1 year
- the disposition was from a sale, exchange, or involuntary conversion
- depreciation recapture provisions were satisfied
However, if the disposition of a §1231 asset results in a loss, then the loss is treated as an ordinary loss rather than a capital loss, which is deductible for adjusted gross income (to determine AGI). Individuals can deduct net losses of up to $3000 per year from other income; however, regular corporations cannot deduct net §1231 losses from other income.
Generally, any gains that recapture prior depreciation on the property is taxed as ordinary income; any gains above that amount is taxed as a capital gain. If several §1231 properties have been disposed of in a tax year, then the §1231 gains and losses must 1st be netted. If the result is a gain, then they can be combined with other capital gains and losses, with the result that any gain will be treated as a capital gain. However, if the netting of §1231 gains and losses results in a loss, then it is treated as an ordinary loss and deductible for AGI. If the property is donated to charity, then the appreciated property charitable contribution provisions apply.
Section 1231 property includes the following:
- depreciable property or real property used in business or to earn income, such as machinery and equipment, buildings, and land;
- depreciable or amortizable personal property, including §197 intangible assets;
- leaseholds held for business longer than 1 year;
- condemned nonpersonal use property held for longer than 1 year;
- livestock, excluding poultry, held for draft, breeding, dairy, or sporting purposes;
- sales of timber, coal, or iron ore;
- intangible assets that were purchased rather than created, such as patents, copyrights, or goodwill;
- casualties or thefts of non-personal-use property, but only if there is a net gain of such property. If there is a net loss, then both gains and losses of such property are removed from any further §1231 calculations.
- Un-harvested crops, but only if both the land and the crops are sold to the same buyer, the land was held for more than 1 year, and the seller has no option to reacquire the land.
Section 1231 property does not include the following:
- property held for less than the long-term holding period, usually 1 year;
- property held for resale (since it is not depreciable);
- intangible assets that were created by the taxpayer, such as copyrights, or where the creator's tax basis is transferred with the property, such as a gift, since intangible assets created by the taxpayer are not capital assets under the tax code;
- accounts and notes receivables that arose in the conduction of a trade or business;
- certain United States government publications, and
- non-personal-use property that was ever subject to a casualty and whether the casualty losses exceed the casualty gains, in which case, the gains and losses for each individual casualty are treated as ordinary.
- If the basis of business or investment property was decreased because of a casualty, then this offsets ordinary income, so any subsequent gain from the disposition of the property will also be treated as ordinary income. Thus, this treatment echos depreciation recapture.
However, gain on a sale to a related party is treated as ordinary income if the property is depreciable by the buyer. In this context, related party is defined as a controlled entity:
- corporations that are members of the same controlled group;
- a corporation or a partnership where either direct or indirect ownership by the taxpayer exceeds 50%;
- any combination of a corporation, partnership, or S corporation where the taxpayer's ownership exceeds 50% for each entity.
Section 1231 History
The tax treatment of §1231 assets evolved over a period during the Great Depression and World War II. Before 1938, business property was classified as capital assets. Thus, the disposition resulted in either in capital gain or loss. However, if the business retained the property, then it could be fully depreciated against ordinary income, so the tax law gave better treatment to those businesses that retained the property rather than disposed of the property. To eliminate this inequity, Congress classified gains and losses from the disposition of business property as ordinary gains or losses until 1942. During World War II, businesses were often forced to dispose of their property through condemnation, since the government needed property for the war effort. This resulted in a large tax bill, because the gains were substantial during World War II when resources were scarce. Taxes could be deferred on such involuntary conversions by reinvesting in similar property. However, such property was not readily available during World War II, since there were many shortages. Because of this, Congress changed the law in 1942, creating §1231, that allowed businesses to claim the preferential capital gain treatment for gains but to deduct losses against ordinary income.
Casualty or Theft of Section 1231 Assets
When §1231 assets are lost or damaged through casualty or theft, then special netting rules apply. First, casualty gains and losses of long-term non-personal use capital assets must be netted separately from casualty gains and losses of §1231 assets. Non-personal use capital assets are assets held by individuals as an investment but who are not dealers in the asset.
Then the results of the 2 nettings are netted together. If the results are a net loss, then the gains are treated as ordinary gains while §1231 casualty losses are deductible for adjusted gross income (AGI), but the non-personal-use capital asset casualty losses are deductible from AGI and the deduction is limited to the amount exceeding 2% of AGI. So if AGI = $100,000 and the casualty loss = $3,000, then $3,000 – ($100,000 × .02) = $1,000 is deductible.
If the result is a net gain, then it is treated as a §1231 gain. The §1231 rules do not apply to personal-use property casualty gains and losses. If the netting results in a net gain, then it is a capital gain, but a net loss is deductible from AGI to the extent that it exceeds 10% of AGI.
The gains of personal-use property condemnation are considered capital assets that are not subject to §1231, so gains are treated as capital gains, but losses on personal-use property are always nondeductible.
Summary: Section 1231 Netting Procedure
The treatment of §1231 gains and losses are determined by the following netting rules, where losses are subtracted from gains:
- Net gains and losses of casualties and thefts of §1231 assets and of long-term nonpersonal-use capital assets. (A net gain from a casualty results when insurance reimbursements are greater than the adjusted basis in the property.)
- If the result is a gain, then add to other §1231 gains and go to Step 3.
- Else if Casually Losses > Casualty Gains, then casualty gains must be separated from §1231 losses — casualty gains are taxed as ordinary income while §1231 asset casualty losses are deductible for AGI; all other casualty losses are deductible from AGI. Casualty gains and losses are not used any further in computing other net §1231 gains and losses.
- Net §1231 gains, including gains from Step 2, and losses.
- If the result is a net loss, then the gains are separated from the losses and treated as ordinary income. Remaining §1231 losses are deductible for AGI; casualty losses are deductible from AGI.
- If the result of the previous step was a net gain, then the lookback provision applies, where non-recaptured net §1231 losses from the 5 prior tax years must be summed. Then:
- Ordinary Gain = Non-recaptured §1231 Losses of Previous 5 Years that are offset by a §1231 gain in the current year.
- Long-Term Capital Gain = Net §1231 Gain – Non-Recaptured §1231 Losses of Previous 5 Years Currently Taxed as Ordinary Gain.
Example: Netting §1231 Gains and Losses to Calculate Ordinary Income and Long-Term Capital Gains of §1231 Property
You have a net §1231 gain of $3000 for 2018 and a net nonrecaptured §1231 loss of $2200 from the prior 5 years. Calculate what portion of the $3000 is taxed as ordinary income and what is taxed as long-term capital gain.
|Year||Section 1231 Losses|
|Net Nonrecaptured §1231 Losses for Prior 5 Years|
|Net Nonrecaptured Loss from Prior 5 Years||($2,200)|
|Calculation of Ordinary Income and Long-Term Capital Gain on Net §1231 Gain|
|Net §1231 Gain for 2018||$3,000|
|Ordinary Income = Recapture of Net Loss Deduction from Prior 5 Years =||$2,200|
|Long-Term Capital Gain or Loss of 1231 Property = 2018 Net §1231 Gain – Portion of §1231 Gain Taxed As Ordinary Income =||$800|