What is Section 1231?

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Updated for 2012

What is Section 1231?

Section 1231 is the section of the Internal Revenue Code that governs the tax treatment of gains and losses on the sale or exchange of real or depreciable property used in a trade or business and held over one year.

Whether you sell one piece of Section 1231 property or your entire business, the rules of Section 1231 apply.

Form 4797 is used to report the sale of business property.

Holding period one year or less:

If depreciable business property is held one year or less, Section 1231 does NOT apply. Gain or loss is reported as ordinary gain or ordinary loss.

The Section 1231 Tax Advantage

The tax advantage that Section 1231 provides is:

A net Section 1231 gain is taxed at the lower capital gains rates.
A net Section 1231 loss is fully deductible as an ordinary loss.
- This means it is NOT subject to the $3,000 annual loss limitation that applies to capital losses.

Remember: Section 1231 applies to real and depreciable business property held over one year. Examples include, the sale or exchange of real property, such as unharvested crops where the land and crop are sold at the same time and to the same person; buildings, which are depreciable real property (called Section 1250 property); and machinery, furniture, and equipment, which are depreciable personal property (called Section 1245 property).

Here's How Section 1231 Works

If after combining all Section 1231 gains and losses, you end up with a net section 1231 gain:

The portion of the net Section 1231 gain that EXCEEDS nonrecaptured net Section 1231 losses of the previous five years (if any) is treated as long-term capital gain.
The portion of the gain that is EQUAL to or LESS than nonrecaptured net Section 1231 losses of the previous five years is treated as ordinary gain.

Nonrecaptured net Section 1231 losses:

Nonrecaptured net Section 1231 losses are net Section 1231 losses that occurred in prior years that were never used to convert any part of a net Section 1231 gain in a later year to ordinary income.

Section 1231 requires you to reduce a current year's net Section 1231 gain by any nonrecaptured net Section 1231 losses of the previous five years.

The total amount of nonrecaptured net section 1231 losses of the previous five years that equal or exceed the current year's net section 1231 gain, is reported as ordinary gain.

The amount by which the current year's net section 1231 gain exceeds nonrecaptured net Section 1231 losses of prior years is reported as long-term capital gain.

Example:

For 2011, you have a net section 1231 gain of $10,000
- A net section 1231 loss of $2,000 in 2006 (the fifth year prior to the current year)
- A $5,000 net section 1231 loss in 2008 (the third year prior to the current year
- Other than 2006 and 2008, you had no other gains or losses for the 5 years prior to the current year.

Result:

For the current year, 2011, your net section 1231 gain is $3,000 after applying the 2006 net section 1231 loss of $2,000 and the 2008 net section 1231 loss of $5,000 ($10,000 gain minus $7,000 in losses).
You report the $3,000 gain on Schedule D as a long-term capital gain.
The $7,000 of nonrecaptured net section 1231 losses have now been completely recaptured (offset against the current year's gain).
Report the recaptured net section 1231 loss of $7,000 as ordinary gain on Form 4797.

The Rationale for Recapturing Net Section 1231 losses of prior years

The difference between an ordinary loss and a capital loss is that an ordinary loss is fully deductible in the year it is realized, while a net capital loss is limited to a maximum annual deduction of $3,000 per year.

When net capital losses exceed net capital gains in any year by more than $3,000, the excess over $3,000 must be carried over to the next year and used in the computation of capital gains and losses of that year.

By using the six-year window of time (the current year plus the five previous years), you can't manipulate your section 1231 gains and losses by claiming a loss in one year to get the full deduction that year, then timing the recognition of a gain in a different year to get the benefit of the lower long-term capital gains rate in that year.

In other words, the recapture rule for net section 1231 losses provides an offsetting mechanism where you must offset a net section 1231 gain in any give year by the nonrecaptured net section 1231 losses of the five previous years.

Recaptured Depreciation:

When you sell Section 1231 property at a gain, the portion of the gain that is equal to the amount of depreciation you claimed (or could have claimed) is reported as ordinary gain.

This means, when selling depreciable personal property (Section 1245 property), only the portion of the gain that exceeds both nonrecaptured net Section 1231 losses of the previous five years and recaptured depreciation is treated as long-term capital gain, which is subject to the lower capital gains rates. The recaptured net Section 1231 losses of the previous five years and the amount of recaptured depreciation are reported as an ordinary gain and is subject to the regular income tax rates.

The rule for reporting recaptured depreciation as ordinary gain is:

Report as ordinary gain the SMALLER of:
- Depreciation allowed (or allowable), or
- The amount of the gain.

Section 1231 Transactions: What Are Section 1231 Transactions?

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