Section 1231 Gains & Losses

Section 1231 gains and losses are the taxable gains and losses from section 1231 transactions. Their treatment as ordinary or capital depends on whether you have a net gain or a net loss from all your section 1231 transactions.

If you have a gain from a section 1231 transaction, first determine whether any of the gain is ordinary income under the depreciation recapture rules (explained later). Do not take that gain into account as section 1231 gain.

Section 1231 transactions. The following transactions result in gain or loss subject to section 1231 treatment.

• Sales or exchanges of real property or depreciable personal property. This property must be used in a trade or business and held longer than 1 year. Generally, property held for the production of rents or royalties is considered to be used in a trade or business. Depreciable personal property includes amortizable section 197 intangibles (described in chapter 2 under Other Dispositions).
• Sales or exchanges of leaseholds. The leasehold must be used in a trade or business and held longer than 1 year.
• Sales or exchanges of cattle and horses. The cattle and horses must be held for draft, breeding, dairy, or sporting and held for 2 years or longer.
• Sales or exchanges of other livestock. This livestock does not include poultry. It must be held for draft, breeding, dairy, or sporting and held for 1 year or longer.
• Sales or exchanges of unharvested crops. The crop and land must be sold, exchanged, or involuntarily converted at the same time and to the same person and the land must be held longer than 1 year. The taxpayer cannot keep any right or option to directly or indirectly reacquire the land (other than a right customarily incident to a mortgage or other security transaction). Growing crops sold with a lease on the land, though sold to the same person in the same transaction, are not included.
• Cutting of timber or disposal of timber, coal, or iron ore. The cutting or disposal must be treated as a sale, as described in chapter 2 under Timber and Coal and Iron Ore.
• Condemnations. The condemned property must have been held longer than 1 year. It must be business property or a capital asset held in connection with a trade or business or a transaction entered into for profit, such as investment property. It cannot be property held for personal use.
• Casualties and thefts. The casualty or theft must have affected business property, property held for the production of rents and royalties, or investment property (such as notes and bonds). You must have held the property longer than 1 year. However, if your casualty or theft losses are more than your casualty or theft gains, neither the gains nor the losses are taken into account in the section 1231 computation. For more information on casualties and thefts, see Publication 547, Casualties, Disasters, and Thefts.

Property for sale to customers. A sale, exchange, or involuntary conversion of property held mainly for sale to customers is not a section 1231 transaction. If you will get back all, or nearly all, of your investment in the property by selling it rather than by using it up in your business, it is property held mainly for sale to customers.

Example. You manufacture and sell steel cable, which you deliver on returnable reels that are depreciable property. Customers make deposits on the reels, which you refund if the reels are returned within a year. If they are not returned, you keep each deposit as the agreed-upon sales price. Most reels are returned within the 1-year period. You keep adequate records showing depreciation and other charges to the capitalized cost of the reels. Under these conditions, the reels are not property held for sale to customers in the ordinary course of your business. Any gain or loss resulting from their not being returned may be capital or ordinary, depending on your section 1231 transactions.

Treatment as ordinary or capital. To determine the treatment of section 1231 gains and losses, combine all your section 1231 gains and losses for the year.

• If you have a net section 1231 loss, it is ordinary loss.
• If you have a net section 1231 gain, it is ordinary income up to the amount of your nonrecaptured section 1231 losses from previous years. The rest, if any, is long-term capital gain.

Nonrecaptured section 1231 losses. Your nonrecaptured section 1231 losses are your net section 1231 losses for the previous 5 years that have not been applied against a net section 1231 gain by treating the gain as ordinary income. These losses are applied against your net section 1231 gain beginning with the earliest loss in the 5-year period.

Example. Ashley, Inc., a graphic arts company, is a calendar year corporation. In 1998, it had a net section 1231 loss of $8,000. For tax years 2000 and 2001, the company has net section 1231 gains of $5,250 and $4,600, respectively. In figuring taxable income for 2000, Ashley treated its net section 1231 gain of $5,250 as ordinary income by recapturing $5,250 of its $8,000 net section 1231 loss. In 2001 it applies its remaining net section 1231 loss, $2,750 ($8,000 - $5,250) against its net section 1231 gain, $4,600. For 2001, the company reports $2,750 as ordinary income and $1,850 ($4,600 - $2,750) as long-term capital gain.

Tax rate on capital gain. The tax rate on the net capital gain of an individual, estate, or trust is determined by treating any ordinary income from a net section 1231 gain as consisting of, first, any net section 1231 gain in the 28% group, then any net section 1231 gain in the 25% group, and finally any net section 1231 gain in the 20% group. Any long-term capital gain is treated as consisting of any remaining net section 1231 gain in each group. See Capital Gain Tax Rates in chapter 4.

Example. The facts are the same as in the previous example, except that the company is operated by an individual as a sole proprietorship. The $4,600 net section 1231 gain for 2001 is the total of a $1,000 net section 1231 gain in the 28% group and a $3,600 net section 1231 gain in the 20% group. The $2,750 treated as ordinary income consists of the $1,000 gain in the 28% group and $1,750 of the gain in the 20% group. The tax rate on the individual's net capital gain for 2001 is determined by including the $1,850 long-term capital gain in the 20% group.

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