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How to Recapture Nonrecaptured Net Section 1231 Losses
Purpose of the Loss Recapture Rule
The reason nonrecaptured section 1231 losses must be recaptured over a five-year period is to prevent gain and loss manipulation from year to year.
For example, if a taxpayer could anticipate when a gain or loss will be realized on the sale of section 1231 property, such sales could be timed to take gains in one year and losses in a different year. In this way, all gains would be taxed at the lower capital gain rates and all losses would be fully deductible as ordinary losses.
IRS Publication 544, page 28, states the following:
Your nonrecaptured section 1231 losses are your net section 1231 losses of the previous 5 years that have not been applied against a net section 1231 gain. Therefore, if in any of your five preceding tax years you had section 1231 losses, a net gain for the current year from the sales of section 1231 assets is ordinary gain to the extent of your [unapplied] prior [year] losses. These losses are applied against your section 1231 gain beginning with the earliest loss in the 5-year period
The example below demonstrates how nonrecaptured section 1231 losses are applied.
What is a Section 1231 Gain?
IRS Publication 544, page 29 regarding a gain on section 1245 property (i.e. machinery, equipment, furniture, and fixtures) defines a section 1231 gain as follows:
Any gain recognized that is more than the part that is ordinary income from depreciation is a section 1231 gain.
In other words, you subtract recaptured depreciation from the current year's gain and the amount that remains is a section 1231 gain. The the following table shows how to figure a net Section 1231 gain.
Figuring a Net Section 1231 Gain
| Year 2020 gain from the sale of a machine. Note: The machine is Section 1245 property because it is property that is or has been subject to an allowance for depreciation. Section 1245 property that is held more than one year at the time of disposal is also referred to as Section 1231 property because the tax rules of Section 1231 apply when such property is disposed of. |
$7,000 |
| Less: Recaptured depreciation Note: Recaptured depreciation is reported as ordinary income. |
(2,000) |
|---|---|
| Section 1231 Gain for the current year reported as long-term capital gain on Schedule D. Note: Nonrecaptured net section 1231 losses of the previous five years, if any, would be subtracted from the current year's $5,000 section 1231 gain. Any balance remaining would be reported as long-term capital gain. (The example below shows you how to recapture net Section 1231 losses.) | $5,000 |
Section 1231 Losses of the Previous Five Years.
If you have section 1231 losses in the previous five years that total more than section 1231 gains during those same five years, the excess loss (the unapplied loss) is applied against (subtracted from) the current year's section 1231 gain.
The amount of the loss that is applied against the current year's section 1231 gain is reported as ordinary income.
The balance of the current year's section 1231 gain that exceeds the recaptured section 1231 loss from the previous five years is reported as long-term capital gain.
To apply section 1231 losses of the previous 5 years to the current year's section 1231 gain, you begin with the earliest year.
How to recapture nonrecaptured net section 1231 losses of the previous 5 years:
Example:
Current year: 2020
Section 1231 gain: $5,000.
Your records show the following section 1231 gains and losses for the previous five years:
- 2019: -0-
- 2018: -0-
- 2017: $1,600
- 2016: -0-
- 2015: ($2,500)
Your objective is to determine:
- What portion of the current year's section 1231 gain of $5,000 will be reported as ordinary income, and
- What portion of the current year's gain of $5,000 will be reported as long-term capital gain.
Reminder: In case you're wondering about recaptured depreciation, you'll notice that it is taken into account when figuring the amount of a net section 1231 gain. (See the previous table - Figuring a Net Section 1231 Gain.)
| Section 1231 gain for 2020 of $5,000 ($7,000 gain minus $2,000 recaptured depreciation. The $2,000 recaptured depreciation is reported as ordinary income). |
$5,000 | |
| Section 1231 loss (2015) | ($2,500) | |
| Section 1231 gain (2017) | 1,600 | |
| Unapplied section 1231 loss from the previous 5 years | ($ 900) | |
| Portion of 2020 gain reported as ordinary income | $900 | |
| Portion of 2020 gain reported as long-term capital gain | $4,100 | |
| Note: Of the $2,500 loss in 2015, $1,600 of that loss is first applied against the $1,600 gain in 2017. The remaining $900 ($2,500 minus $1,600) is reported as ordinary income. The $900 is subtracted from the $5,000 2020 gain, leaving $4,100 to be reported as long-term capital gain. The $2,500 section 1231 loss has therefore been fully recaptured against |