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 real or 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 gain rates.
  • A net section 1231 loss is fully deductible as an ordinary loss. In contrast, a capital loss is only deductible up $3,000 in any tax year and any excess over $3,000 must be carried over to the next year.

Nonrecaptured Net section 1231 losses and Recaptured Depreciation

Nonrecaptured Net section 1231 Losses:

After you net all gains and losses from the sale of section 1231 assets, you'll end up with an overall net gain or loss. An overall net loss is reported as an ordinary loss and is fully deductible on Form 1040, line 14.

However, if you end up with an overall net section 1231 gain, you have a little more work to do before you know how much of the current year's gain should be reported as ordinary income and how much should be reported as long-term capital gain. This is where nonrecaptured net section 1231 losses and recaptured depreciation come in.

Determine your section 1231 gain:

If you sell section 1245 property that was held over one year, such as machinery, equipment, furniture, and fixtures at a gain, you need to know how much depreciation you have actually claimed on the property (referred to as allowed depreciation) or could have claimed even if you did not claim any at all (referred to as allowable depreciation).

The portion of the current year's gain that exceeds recaptured depreciation is section 1231 gain. Any net section 1231 loss from the previous five years is offset against the current year's section1231 gain. Any section 1231 gain remaining after subtracting the recaptured loss is long-term capital gain. The recaptured loss is reported as ordinary income.

To summerize, recaptured depreciation is reported as ordinary income, recaptured section 1231 losses are reported as ordinary income, and the current years net gain that exceeds both recaptured depreciation and recaptured section 1231 losses is reported as long-term capital gain.

A common question is: What's the difference between section 1231 property and section 1245 property.

First, both refer to different sections of the Internal Revenue Code. section 1245 contains the depreciation recapture rules that apply to gains from dispositions of certain depreciable property. For example, business equipment, furniture and fixtures.

Section 1231 simply governs the tax treatment of gains and losses of real and depreciable property used in a trade or business and held over one year. Such property would include not only personal property (Section 1245 property) but also real property such as a building (Section 1250 property).

As you can see, section 1245 property and Section 1250 property can also be referred to as section 1231 property if held more than one year when sold or exchanged since they are subject to the tax treatment of section 1231.

The rule for reporting recaptured depreciation as ordinary income is:

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

You must reduce the basis of property by the depreciation allowed or allowable, whichever is greater. Depreciation allowed is depreciation you actually deducted (from which you received a tax benefit). Depreciation allowable is depreciation you are entitled to deduct.

In other words, you are deemed to have claimed depreciation on depreciable property even if you have claimed no depreciation.

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