Section 1231 Capital Gain Treatment of Assets Used in Trade or Business

1. Section 1231 Capital Gain Treatment of Assets Used in Trade or Business (Losses on Assets Used in Trade or Business Are Ordinary)

2. Section 1231 Assets & Recapture • Section 1231 Assets are fixed assets used in a trade or business for more than 1 year • If used less than one year, no capital gain treatment would apply • Gains on disposal of these assets receive capital gain treatment subject to recapture • Losses receive ordinary treatment • File Form 4797 for disposition of these assets.

3. 43. Which one of the following is not generally considered §1231 property? a. Land held thirteen months and used in a trade or business as a parking lot b. Crops growing on farm land held 20 years c. Cattle held 14 months and used in ranching d. Equipment used in a printing business and held 15 months What a hard question! Answer: a & d are clearly Sec. 1231 property. Crops generally are ordinary income property – but only after they’re harvested! They’re 1231 property if still growing. Livestock must normally be held only 12 months to qualify – but not cattle! They must be held 24 months. “C” is the correct answer.

4. Netting Process • Net Sec. 1231 gains & losses from casualty/theft • If net gain, add to other 1231 gains • If net loss, then treat each item separately: gains are ordinary and losses also ordinary • Net other Sec. 1231 gains & losses • If loss, all ordinary • If gain, capital gain treatment subject to depreciation recapture & lookback period

5. 44. G sold a file cabinet used in her business for $250. She had purchased it for $400 and deducted depreciation of $220. What is the amount and character of G's gain or loss recognized on this sale? a. $70 ordinary income b. $70 § 1231 gain c. $150 § 1231 loss d. $220 ordinary income and $150 § 1231 loss

6. Lookback • To avoid taxpayers taking gains in one year, losses in another to maximize their tax positions (rather than offsetting tax liabilities), *if* a Section 1231 netting results in a gain, that gain is offset against the non-recaptured Section 1231 losses from the previous 5 years. • That is, gains will be treated as ordinary (not capital) to the extent that there were ordinary losses on Sec. 1231 assets in the previous 5 yrs.

7. Depreciation Recapture • Applies to personal, depreciable (Sec. 1245) property. • Includes property that was Sec. 179’d. • Once the gain on the property is figured, the gain is treated as ordinary to the extent that it was deducted as (ordinary) depreciation/179. • Put another way, with recapture, there are only capital gains treatment where you sell the asset for more than you bought it for.

8. Example • An asset was purchased for $12,000, and $8,000 of depreciation was taken. The asset was sold for $5,000. What was the gain? • $5,000 - ($12,000 – 8,000) = $1,000 • How much of this gain gets capital treatment? • None (you did not sell it for more than you bought it for; all of the $1,000 (the lower of $1,000 gain or $8,000 depreciation) is recaptured as ordinary income

9. Example • An asset was purchased for $12,000, and $8,000 of depreciation was taken. The asset was sold for $15,000. What was the gain? • $15,000 - ($12,000 – 8,000) = $11,000 • How much of this gain gets capital treatment? • $3,000(which is how much more you sold it for than you bought it for; all of the $8,000 (the lower of $11,000 gain or $8,000 depreciation) is recaptured as ordinary income.

10. Section 1250 Depreciable Real Estate • Land not included, because it’s not depreciable. • Pre-1987 purchases have separate rules that may trigger recapture • Most recapture is “timed out” • Rather than recapture (at ordinary rates) the depreciation taken (up to the amount of gain), we tax it at a 25% rate. • That’s a tax break, but not as big as the 15% rate would have generated.

11. Special 1245 & 1250 Exceptions • Gifts: recapture carries over to donee • Death: recapture potential extinguished • Nontaxable exchange: recapture generally carries over to new property • Installment sales: recaptured gain must be recognized in year of sale(!) • Related party sales: gains treated as ordinary if purchaser will depreciate property • Special Sec. 291 recapture on Sec. 1250 real estate applies to regular corporations