Many people are aware that the sale of a business asset, including real estate, can have significant tax implications. The tax effects generally boil down to whether the sale results in a gain or a loss. Ideally, gains would be treated as long-term capital gains, subject to lower tax rates, and losses would be considered ordinary losses, which could be applied to offset ordinary income. Section 1231 of the Internal Revenue Code (IRC) permits just such advantageous treatment — the best of both worlds — for certain types of property in certain circumstances.
Eligible Property
Sec. 1231 generally applies to depreciable property used
in a trade or business that is held for more than one year. Sale of
inventory or other property held mainly for sale to customers would
not qualify. If you are able to recover all, or almost 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. On the other hand, property used to generate rents is
considered to be used in a trade or business.
Notably, the IRS has taken the position that real property purchased or constructed for use in a trade or business qualifies for Sec. 1231 treatment even if it was never placed in service but instead was sold, as long as the property was held for more than a year, running from the purchase date to the sale date. In other words, property does not have to be placed in service to be considered property used in a trade or business.
Treatment of Sec. 1231 Gains and Losses
To determine the treatment of Sec. 1231 gains and losses,
you combine all of your Sec. 1231 gains and losses for the year. If
you have a net Sec. 1231 loss, it is an ordinary loss. Not only can
such a loss be used to offset your ordinary income, but you are
also not subject to the normal $3,000 capital loss per year
limitation on how much of the loss can be used against ordinary
income. Plus, the loss could generate a net operating loss that can
be carried back or forward and reduce ordinary taxable income.
If you have a net gain, it is considered ordinary income up to the amount of your non-recaptured Sec. 1231 losses from previous years. The remainder, if any, is long-term capital gain that can offset other capital losses from sales of non-Sec. 1231 property.
The Recapture Issue
As suggested above, the benefits of long-term capital
gains treatment might not be available if you had a non-recaptured
Sec. 1231 loss in the prior five years. That means that for every
year in the last five in which you have a net Sec.1231 gain, you
must "look back" to determine whether you had an
aggregate net Sec. 1231 loss. You have a non-recaptured loss if the
total net Sec. 1231 losses exceed the total Sec. 1231 gains for the
prior five years. Real property may also be subject to depreciation
recapture under Sec. 1250.
A Complicated Matter
While the benefits of Sec. 1231 transactions are
straightforward and clear, the applicable rules and their potential
interaction with other provisions of the tax code are anything but.
Your financial advisor can help you decipher the proper timing and
planning to get the best of both worlds.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
