Section 1231 Gains and Losses
How the gains and losses from these transactions are treated (whether as ordinary or capital gain or loss) will depend on whether you have a net gain or a net loss from all section 1231 transactions.
- If you have a net overall loss from section 1231 transactions, the loss is treated as an ordinary loss for tax purposes.
- If you have a net overall section 1231 gain, the gain is considered ordinary income up to the amount of any section 1231 losses from the previous 5 years that have not been recaptured as ordinary income. The rest of the gain would be treated as a long-term capital gain.
- You had a net section 1231 loss of $12,000 in year 1, a net gain of $5,000 in year 2, a net gain of $4,000 in year 4, and a net gain of $8,000 in year 6.
- The net gain of $8,000 in year 6 would be ordinary income of $3,000 for the un-recaptured loss from year 1 ($12,000 loss from year 1 less $5,000 recaptured in year 2 and $4,000 recaptured in year 4).
- The rest of the gain in year 6, ($8,000 minus $3,000 = $5,000) would be long-term capital gain.
Where To Report
Section 1231 gains and losses are reported in Part I of Form 4797, Sales of Business Property. Each transaction for the current year is reported individually, and there is a separate line for reporting the un-recaptured section 1231 loss from prior years.
Recapture of Depreciation
When property that is subject to depreciation or amortization is sold or disposed of at a gain, part or all of the gain may have to be reported as ordinary income. The part of the gain that represents depreciation or amortization that was taken as a deduction, or could have been taken as a deduction, up until the time of the sale or disposal is the amount that must be recaptured as ordinary income.
Gains or losses from these sales or dispositions are reported in Part III of Form 4797, and include different types of property referred to according to the Internal Revenue Code sections that define their tax treatment.
Section 1245 Property
This is the case with property referred to as Section 1245 property. This type of property includes tangible personal property, such as furniture and equipment, that is subject to depreciation, or intangible personal property, such as a patent or license, that is subject to amortization.
Section 1245 property also includes certain other tangible property that is an integral part of a manufacturing, production, or extraction facility, certain infrastructure, and related research and storage facilities. Other capitalized costs subject to amortization, such as pollution control facilities, childcare facilities, the removal of barriers to disabled and elderly persons, and reforestation costs are also included in section 1245 property. But section 1245 property does not include buildings and structural components.
When section 1245 property is sold or disposed of at a gain, the part of the gain that represents recaptured depreciation or amortization is treated as ordinary income. Then, any gain remaining after that is treated as section 1231 property, for purposes of determining whether the remaining part of the gain is ordinary or capital gain. If the amount of recaptured depreciation or amortization is more than the
gain on the sale or disposition, the entire amount of the gain is reported as ordinary income.
What Depreciation and Amortization Must Be Recaptured
The amounts that must be recaptured as ordinary income include the following, among others:
- Ordinary depreciation deductions, and the special 30% and 50% depreciation allowances, that can be taken the first year property is placed in service,
- Amortization of the costs of acquiring a lease, improvements you make on property you lease, pollution control facilities, and reforestation expenses,
- Amortization of section 197 intangibles, which include goodwill, patents, copyrights, formulas, licenses, permits, franchises, and trademarks,
- Section 179 deduction, for the election to recover all or part of the cost of an asset in the year it is placed in service,
- Tax deductions taken for the costs of removing barriers to disabled or elderly persons, and
- Reductions in the basis of assets for the investment tax credit.
Section 1250 Property
Depreciation may also have to be recaptured on Section 1250 property - depreciable real property, including leaseholds if they are subject to depreciation. The amount that has to be recaptured as ordinary income is the additional depreciation allowed or allowable. Additional depreciation includes accelerated depreciation and the special 30% or 50% depreciation allowance that can be taken the year the property is place in service.
If you hold the property longer than one year, additional depreciation is the amount by which the actual depreciation you deducted, or could have deducted, exceeded the amount of depreciation calculated under the straight-line method. If you hold the property for 1 year or less, all the depreciation is additional depreciation.
Depreciation deductions taken by another person are included in the carryover basis when that person transfers the property to you. So your additional depreciation on section 1250 property that would have to be recaptured as ordinary income would be the additional depreciation taken by the previous owner and by you as the current owner, if you sell or exchange the property and have a gain.
Other types of property subject to the recapture rules, that are included on Form 4797 are:
- Section 1252 property, which is farmland held less than 10 years, on which soil, water, or land-clearing expenses were deducted,
- Section 1254 property, including intangible drilling and development costs, exploration costs, and costs for developing mining operations, and
- Section 1255 property, which is cost-sharing payment property described in section 126 of the Internal Revenue Code.
Traders in Securities
If you are a trader in securities and you made a mark-to-market election, your gains and losses from securities and commodities trading activities are reported on Form 4797, rather than on Schedule D. When you make the mark-to-market election, each security you hold at year-end is considered to be sold and reacquired at its fair market value on that date.
All gains and losses from your securities trading are ordinary income and losses, instead of capital gains and losses. So the lower capital gain rates do not apply, but at the same time, you are not subject to the limitations on capital losses. And the wash sale rule does not apply, so as a trader, you could deduct a loss on a wash sale, instead of having to add a disallowed loss to the basis of the securities you purchase.