3. Ordinary or Capital Gain or Loss for Business Property
Introduction
When you dispose of business property, your taxable gain or loss is usually a section 1231 gain or loss. Its treatment as ordinary or capital is determined under rules for section 1231 transactions.
When you dispose of depreciable property (section 1245 property or section 1250 property) at a gain, you may have to recognize all or part of the gain as ordinary income under the depreciation recapture rules. Any remaining gain is a section 1231 gain.
Topics
This chapter discusses:
- Section 1231 gains and losses
- Depreciation recapture
Useful Items You may want to see:
Publication
- 534 Depreciating Property Placed in Service Before 1987
- 537 Installment Sales
- 551 Basis of Assets
- 946 How To Depreciate Property
- 954 Tax Incentives for Empowerment Zones and Other Distressed Communities
Form (and Instructions)
- 4797 Sales of Business Property
See chapter 5 for information about getting publications and forms.
Section 1231 Gains and 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 purposes 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 purposes 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.
Copyrights. The sale of a copyright, a literary, musical, or artistic composition, or similar property is not a section 1231 transaction if your personal efforts created the property, or if you acquired the property in a way that entitled you to the basis of the previous owner whose personal efforts created it (for example, if you receive the property as a gift). The sale of such property results in ordinary income and generally is reported in Part II of Form 4797.
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 1999, it had a net section 1231 loss of $8,000. For tax years 2001 and 2002, the company has net section 1231 gains of $5,250 and $4,600, respectively. In figuring taxable income for 2001, 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 from 1999. In 2002 it applies its remaining net section 1231 loss, $2,750 ($8,000 - $5,250) against its net section 1231 gain, $4,600. For 2002, 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 2002 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 2002 is determined by including the $1,850 long-term capital gain in the 20% group.
Depreciation Recapture
If you dispose of depreciable or amortizable property at a gain, you may have to treat all or part of the gain (even if otherwise nontaxable) as ordinary income.
To figure any gain that must be reported as ordinary income, you must keep permanent records of the facts necessary to figure the depreciation or amortization allowed or allowable on your property. This includes the date and manner of acquisition, cost or other basis, depreciation or amortization, and all other adjustments that affect basis.
On property you acquired in a nontaxable exchange or as a gift, your records also must indicate the following information.
- Whether the adjusted basis was figured using depreciation or amortization you claimed on other property.
- Whether the adjusted basis was figured using depreciation or amortization another person claimed.
Corporate distributions. For information on property distributed by corporations, see Distributions to Shareholders in Publication 542, Corporations.
General asset accounts. Different rules apply to dispositions of property you depreciated using a general asset account. For information on these rules, see section 1.168(i)-1(e) of the regulations.
Section 1245 Property
A gain on the disposition of section 1245 property is treated as ordinary income to the extent of depreciation allowed or allowable on the property. See Gain Treated as Ordinary Income, later.
Any gain recognized that is more than the part that is ordinary income from depreciation is a section 1231 gain. See Treatment as ordinary or capital under Section 1231 Gains and Losses, earlier.
Section 1245 property. Section 1245 property includes any property that is or has been subject to an allowance for depreciation or amortization and that is any of the following types of property.
- Personal property (either tangible or intangible).
- Other tangible property (except buildings and their structural components) used as any of the following.
- An integral part of manufacturing, production, or extraction, or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services.
- A research facility in any of the activities in (a).
- A facility in any of the activities in (a) for the bulk storage of fungible commodities.
- That part of real property (not included in (2)) with an adjusted basis that was reduced by certain amortization deductions (including those for certified pollution control facilities, child-care facilities, removal of architectural barriers to persons with disabilities and the elderly, or reforestation expenses) or a section 179 deduction.
- Single purpose agricultural (livestock) or horticultural structures.
- Storage facilities (except buildings and their structural components) used in distributing petroleum or any primary product of petroleum.
Buildings and structural components. Section 1245 property does not include buildings and structural components. Do not treat structures that are essentially items of machinery or equipment as buildings and structural components. Also, do not treat as buildings structures that house property used as an integral part of an activity if the structures' use is so closely related to the property's use that the structures can be expected to be replaced when the property they initially house is replaced. The fact that the structures are specially designed to withstand the stress and other demands of the property and the fact that the structures cannot be used economically for other purposes indicate that they are closely related to the use of the property they house. Structures such as oil and gas storage tanks, grain storage bins, silos, fractionating towers, blast furnaces, basic oxygen furnaces, coke ovens, brick kilns, and coal tipples are not treated as buildings.
Facility for bulk storage of fungible commodities. This term includes oil or gas storage tanks and grain storage bins. Bulk storage means the storage of a commodity in a large mass before it is used. For example, if a facility is used to store oranges that have been sorted and boxed, it is not used for bulk storage. To be fungible, a commodity must be such that one part may be used in place of another.
Stored materials that vary in composition, size, and weight are not fungible. Materials are not fungible if one part cannot be used in place of another part and the materials cannot be estimated and replaced by simple reference to weight, measure, and number. For example, the storage of different grades and forms of aluminum scrap is not storage of fungible commodities.
Gain Treated as Ordinary Income
The gain treated as ordinary income on the sale, exchange, or involuntary conversion of section 1245 property, including a sale and leaseback transaction, is the lesser of the following amounts.
- The depreciation and amortization allowed or allowable on the property.
- The gain realized on the disposition (the amount realized from the disposition minus the adjusted basis of the property).
A limit on this amount for gain on like-kind exchanges and involuntary conversions is explained later.
For any other disposition of section 1245 property, ordinary income is the lesser of (1) earlier or the amount by which its fair market value is more than its adjusted basis. See Gifts and Transfers at Death, later.
Use Part III of Form 4797 to figure the ordinary income part of the gain.
Depreciation taken on other property or taken by other taxpayers. Depreciation and amortization include the amounts you claimed on the section 1245 property as well as the following depreciation and amortization amounts.
- Amounts you claimed on property you exchanged for, or converted to, your section 1245 property in a like-kind exchange or involuntary conversion.
- Amounts a previous owner of the section 1245 property claimed if your basis is determined with reference to that person's adjusted basis (for example, the donor's depreciation deductions on property you received as a gift).
Depreciation and amortization. Depreciation and amortization that must be recaptured as ordinary income include (but are not limited to) the following items.
- Ordinary depreciation deductions.
- The 30% special depreciation allowance for property acquired after September 10, 2001.
- Amortization deductions for all the following costs.
- Acquiring a lease.
- Lessee improvements.
- Pollution control facilities.
- Reforestation expenses.
- Section 197 intangibles.
- Child care facility expenses made before 1982.
- Franchises, trademarks, and trade names acquired before August 11, 1993.
- The section 179 deduction.
- Deductions for all the following costs.
- Removing barriers to the disabled and the elderly.
- Tertiary injectant expenses.
- Depreciable clean-fuel vehicles and refueling property (minus the amount of any recaptured deduction).
- Environmental cleanup costs.
- Any basis reduction for the investment credit (minus any basis increase for credit recapture).
- Any basis reduction for the qualified electric vehicle credit (minus any basis increase for credit recapture).
Example. You file your returns on a calendar year basis. In February 2000, you bought and placed in service for 100% use in your business a light-duty truck (5-year property) that cost $10,000. You used the half-year convention and your MACRS deductions for the truck were $2,000 in 2000 and $3,200 in 2001. You did not take the section 179 deduction on it. You sold the truck in May 2002 for $7,000. The MACRS deduction in 2002, the year of sale, is $960 (1/2 of $1,920). Figure the gain treated as ordinary income as follows.
| 1) | Amount realized |
$7,000 |
| 2) |
Cost (February 2000) |
$10,000 |
|
| 3) |
Depreciation allowed or allowable (MACRS deductions: $2,000 + $3,200 + $960) |
6,160 |
|
| 4) | Adjusted basis (subtract line 3 from line 2) |
$3,840 |
| 5) | Gain realized (subtract line 4 from line 1) |
$3,160 |
| 6) | Gain treated as ordinary income (lesser of line 3 or line 5) |
$3,160 |
Depreciation on other tangible property. You must take into account depreciation during periods when the property was not used as an integral part of an activity or did not constitute a research or storage facility, as described earlier under Section 1245 property.
For example, if depreciation deductions taken on certain storage facilities amounted to $10,000, of which $6,000 is from the periods before their use in a prescribed business activity, you must use the entire $10,000 in determining ordinary income from depreciation.
Depreciation allowed or allowable. The greater of the depreciation allowed or allowable is generally the amount to use in figuring the part of gain to report as ordinary income. If, in prior years, you have consistently taken proper deductions under one method, the amount allowed for your prior years will not be increased even though a greater amount would have been allowed under another proper method. If you did not take any deduction at all for depreciation, your adjustments to basis for depreciation allowable are figured by using the straight line method.
This treatment applies only when figuring what part of gain is treated as ordinary income under the rules for section 1245 depreciation recapture.
Multiple asset accounts. In figuring ordinary income from depreciation, you can treat any number of units of section 1245 property in a single depreciation account as one item if the total ordinary income from depreciation figured by using this method is not less than it would be if depreciation on each unit were figured separately.
Example. In one transaction you sold 50 machines, 25 trucks, and certain other property that is not section 1245 property. All of the depreciation was recorded in a single depreciation account. After dividing the total received among the various assets sold, you figured that each unit of section 1245 property was sold at a gain. You can figure the ordinary income from depreciation as if the 50 machines and 25 trucks were one item.
However, if 5 of the trucks had been sold at a loss, only the 50 machines and 20 of the trucks could be treated as one item in determining the ordinary income from depreciation.
Normal retirement. The normal retirement of section 1245 property in multiple asset accounts does not require recognition of gain as ordinary income from depreciation if your method of accounting for asset retirements does not require recognition of that gain.
Section 1250 Property
Gain on the disposition of section 1250 property is treated as ordinary income to the extent of additional depreciation allowed or allowable on the property. To determine the additional depreciation on section 1250 property, see Additional Depreciation, later.
You will not have additional depreciation if any of the following conditions apply to the property disposed of.
- You figured depreciation for the property using the straight line method or any other method that does not result in depreciation that is more than the amount figured by the straight line method; you held the property longer than 1 year; and, if the property was qualified New York Liberty Zone property, you made a timely election not to claim the 30% special depreciation allowance. (In addition, if the property was in a renewal community, you must not have elected to claim a commercial revitalization deduction as figured under section 1400I of the Internal Revenue Code.)
- The property was residential low-income rental property you held for 162/3 years or longer. (For low-income rental housing on which the special 60-month depreciation for rehabilitation expenses was allowed, the 162/3 years start when the rehabilitated property is placed in service).
- You chose the alternate ACRS method for the property, which was a type of 15-, 18-, or 19-year real property covered by the section 1250 rules.
- The property was residential rental property or nonresidential real property placed in service after 1986 (or after July 31, 1986, if the choice to use MACRS was made); you held it longer than 1 year; and, if the property was qualified New York Liberty Zone property, you made a timely election not to claim the 30% special depreciation allowance. These properties are depreciated using the straight line method. (In addition, if the property was in a renewal community, you must not have elected to claim a commercial revitalization deduction as figured under section 1400I of the Internal Revenue Code.)
Section 1250 property. This includes all real property that is subject to an allowance for depreciation and that is not and never has been section 1245 property. It includes a leasehold of land or section 1250 property subject to an allowance for depreciation. A fee simple interest in land is not included because it is not depreciable.
If your section 1250 property becomes section 1245 property because you change its use, you can never again treat it as section 1250 property.
Gain Treated as Ordinary Income
To find what part of the gain from the disposition of section 1250 property is treated as ordinary income, follow these steps.
- In a sale, exchange, or involuntary conversion of the property, figure the amount realized that is more than the adjusted basis of the property. In any other disposition of the property, figure the fair market value that is more than the adjusted basis.
- Figure the additional depreciation for the periods after 1975.
- Multiply the lesser of (1) or (2) by the applicable percentage, discussed later. Stop here if this is residential rental property or if (2) is equal to or more than (1). This is the gain treated as ordinary income because of additional depreciation.
- Subtract (2) from (1).
- Figure the additional depreciation for periods after 1969 but before 1976.
- Add the lesser of (4) or (5) to the result in (3). This is the gain treated as ordinary income because of additional depreciation.
A limit on the amount treated as ordinary income for gain on like-kind exchanges and involuntary conversions is explained later.
Use Part III, Form 4797, to figure the ordinary income part of the gain.
Corporations. Corporations, other than S corporations, have an additional amount to recognize as ordinary income on the sale or other disposition of section 1250 property. The additional amount treated as ordinary income is 20% of the excess of the amount that would have been ordinary income if the property were section 1245 property over the amount treated as ordinary income under section 1250. Report this additional ordinary income on line 26(f) of Form 4797, Part III.
Additional Depreciation
If you hold section 1250 property longer than 1 year, the additional depreciation is the actual depreciation adjustments that are more than the depreciation figured using the straight line method. For a list of items treated as depreciation adjustments, see Depreciation and amortization under Gain Treated as Ordinary Income, earlier.
If you hold section 1250 property for 1 year or less, all the depreciation is additional depreciation.
You will have additional depreciation if any of the following statements are true.
- You use the regular ACRS method, the declining balance method, the sum-of-the-years-digits method, the units-of-production method, or any other method of rapid depreciation.
- You claimed the 30% special depreciation allowance for property acquired after September 10, 2001.
- You claimed the commercial revitalization deduction.
Depreciation taken by other taxpayers or on other property. Additional depreciation includes all depreciation adjustments to the basis of section 1250 property whether allowed to you or another person (as carryover basis property).
Example. Larry Johnson gives his son section 1250 property on which he took $2,000 in depreciation deductions, of which $500 is additional depreciation. Immediately after the gift, the son's adjusted basis in the property is the same as his father's and reflects the $500 additional depreciation. On January 1 of the next year, after taking depreciation deductions of $1,000 on the property, of which $200 is additional depreciation, the son sells the property. At the time of sale, the additional depreciation is $700 ($500 allowed the father plus $200 allowed the son).
Depreciation allowed or allowable. The greater of depreciation allowed or allowable (to any person who held the property if the depreciation was used in figuring its adjusted basis in your hands) generally is the amount to use in figuring the part of the gain to be reported as ordinary income. If you can show that the deduction allowed for any tax year was less than the amount allowable, the lesser figure will be the depreciation adjustment for figuring additional depreciation.
Retired or demolished property. The adjustments reflected in adjusted basis generally do not include deductions for depreciation on retired or demolished parts of section 1250 property unless these deductions are reflected in the basis of replacement property that is section 1250 property.
Example. A wing of your building is totally destroyed by fire. The depreciation adjustments figured in the adjusted basis of the building after the wing is destroyed do not include any deductions for depreciation on the destroyed wing unless it is replaced and the adjustments for depreciation on it are reflected in the basis of the replacement property.
Figuring straight line depreciation. The useful life and salvage value you would have used to figure straight line depreciation are the same as those used under the depreciation method you actually used. If you did not use a useful life under the depreciation method actually used (such as with the units-of-production method) or if you did not take salvage value into account (such as with the declining balance method), the useful life or salvage value for figuring what would have been the straight line depreciation is the useful life and salvage value you would have used under the straight line method.
Salvage value and useful life are not used for the ACRS method of depreciation. Figure straight line depreciation for ACRS real property by using its 15-, 18-, or 19-year recovery period as the property's useful life.
The straight line method is applied without any basis reduction for the investment credit.
Property held by lessee. If a lessee makes a leasehold improvement, the lease period for figuring what would have been the straight line depreciation adjustments includes all renewal periods. This inclusion of the renewal periods cannot extend the lease period taken into account to a period that is longer than the remaining useful life of the improvement. The same rule applies to the cost of acquiring a lease.
The term renewal period means any period for which the lease may be renewed, extended, or continued under an option exercisable by the lessee. However, the inclusion of renewal periods cannot extend the lease by more than two-thirds of the period that was the basis on which the actual depreciation adjustments were allowed.
Rehabilitation expenses. A part of the special 60-month depreciation adjustment allowed for rehabilitation expenses incurred before 1987 in connection with low-income rental housing is additional depreciation. The additional depreciation is the special depreciation adjustments that are more than the adjustments that would have resulted if the straight line method, normal useful life, and salvage value had been used.
Example. On January 7, 2002, Fred Plums, a calendar year taxpayer, sold real property in which the entire basis was from rehabilitation expenses of $40,000 incurred in 1985. The property was placed in service on January 3, 1986. Under the special depreciation provisions for rehabilitation expenses, the property was depreciated under the straight line method using a useful life of 60 months (5 years) and no salvage value. If Fred had used the regular straight line method, he would have used a salvage value of $4,000 and a useful life of 15 years, and would have had a depreciable basis of $36,000. Depreciation under the straight line method would have been $2,400 each year (1/15 × $36,000). On January 1, 2002, the additional depreciation for the property was $4,000, figured as follows.
| |
Depreciation |
Straight Line |
Additional |
| |
Claimed |
Depreciation |
Depreciation |
| 1986 |
8,000 |
2,400 |
5,600 |
| 1987 |
8,000 |
2,400 |
5,600 |
| 1988 |
8,000 |
2,400 |
5,600 |
| 1989 |
8,000 |
2,400 |
5,600 |
| 1990 |
8,000 |
2,400 |
5,600 |
| 1991 |
|
2,400 |
(2,400) |
| 1992 |
|
2,400 |
(2,400) |
| 1993 |
|
2,400 |
(2,400) |
| 1994 |
|
2,400 |
(2,400) |
| 1995 |
|
2,400 |
(2,400) |
| 1996 |
|
2,400 |
(2,400) |
| 1997 |
|
2,400 |
(2,400) |
| 1998 |
|
2,400 |
(2,400) |
| 1999 |
|
2,400 |
(2,400) |
| 2000 |
|
2,400 |
(2,400) |
| Total |
$40,000 |
$36,000 |
$ 4,000 |
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