Section 1231 Categorizes Gains and Losses From
The Sale of Trade or Business Assets
and From Involuntary Conversions
Written by: Steven J. Fromm, J.D., LL.M. (Taxation)
Section 1231 of the Internal Revenue Code applies to and categorizes gains and losses from property used in the trade or business and from involuntary conversions.
When disposing of an asset, you have to determine whether property is a capital asset or is ordinary income property. Property generally can’t be both. However, Code Sec. 1231 is a special categorization provision that allows you to “have it” both ways:
- Any gains are taxed at low capital gains rates (generally 15 percent for 2012), and
- Any losses are treated as ordinary losses, taxable at more favorable ordinary loss rates, and available (without limit) to offset other ordinary income.
What Qualifies For This Head I Win and Tails I Win Treatment?
Code Sec. 1231 gains include:
- Recognized gains on the sale or exchange of property used in the trade or business; and
- Recognized gains from the involuntary or compulsory conversion (into money or other property) of property used in a trade or business, or of property held for more than one year and either used in the trade or business or used in a transaction entered into for profit.
Property used in a trade or business is property that is subject to depreciation and held by the taxpayer for more than one year.
Code Sec. 1231 losses are any recognized loss from a sale, exchange, or conversion of the same categories of property.
A Win-Win Equation
Gains and losses from these transactions are referred to as Code Sec. 1231 gains and Code Sec. 1231 losses.
The character of the gain or loss depends on whether Code Sec. 1231 gains exceed Code Sec. 1231 losses for the tax year. If the Code Sec. 1231 gains exceed the Code Sec. 1231 losses, then all of the Code Sec. 1231 gains and losses are treated as long-term capital gains and losses. The result is a net long-term capital gain. This amount can then be netted with other capital gains and losses.
If, however, the Code Sec. 1231 losses equal or exceed the Code Sec. 1231 gains, then all of the Code Sec. 1231 gains and losses are treated as ordinary income and losses. The net result is an ordinary loss, which can offset other ordinary income.
Depreciation Recapture: Not Covered by Section 1231
Code Sec. 1231 does not apply to depreciation that must be recaptured as ordinary income under either Code Sec. 1245 (depreciable personal property and certain real property) or Code Sec. 1250 (depreciable real property that is not Code Sec. 1245 property).
If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.