Section 1231 gains and losses are the taxable gains and losses from
section 1231 transactions. Their treatment as ordinary or capital
depends on whether you have a net gain or a net loss from all your
section 1231 transactions.
If you have a gain from a section 1231 transaction, first determine
whether any of the gain is ordinary income under the depreciation
recapture rules (explained later). Do not take that gain into account
as section 1231 gain.
Section 1231 transactions.
The following transactions result in gain or loss subject to
section 1231 treatment.
- Sales or exchanges of real property or depreciable
personal property. This property must be used in a trade or
business and held longer than 1 year. Generally, property held for the
production of rents or royalties is considered to be used in a trade
or business. Depreciable personal property includes amortizable
section 197 intangibles (described in chapter 2 under Other
- Sales or exchanges of leaseholds. The leasehold
must be used in a trade or business and held longer than 1 year.
- Sales or exchanges of cattle and horses. The
cattle and horses must be held for draft, breeding, dairy, or sporting
and held for 2 years or longer.
- Sales or exchanges of other livestock. This
livestock does not include poultry. It must be held for draft,
breeding, dairy, or sporting and held for 1 year or longer.
- Sales or exchanges of
unharvested crops. The
crop and land must be sold, exchanged, or involuntarily converted at
the same time and to the same person and the land must be held longer
than 1 year. The taxpayer cannot keep any right or option to directly
or indirectly reacquire the land (other than a right customarily
incident to a mortgage or other security transaction). Growing crops
sold with a lease on the land, though sold to the same person in the
same transaction, are not included.
- Cutting of timber or disposal of timber, coal, or iron
The cutting or disposal must be
treated as a sale, as described in chapter 2 under Timber
and Coal and Iron Ore.
The condemned property must
have been held longer than 1 year. It must be business property or a
capital asset held in connection with a trade or business or a
transaction entered into for profit, such as investment property. It
cannot be property held for personal use.
- Casualties and thefts.
The casualty or theft must have affected
business property, property held for the production of rents and
royalties, or investment property (such as notes and bonds). You must
have held the property longer than 1 year. However, if your casualty
or theft losses are more than your casualty or theft gains, neither
the gains nor the losses are taken into account in the section 1231
computation. For more information on casualties and thefts, see
Casualties, Disasters, and Thefts.
Property for sale to customers.
A sale, exchange, or involuntary conversion of property held mainly
for sale to customers is not a section 1231 transaction. If you will
get back all, or nearly 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.
You manufacture and sell steel cable, which you deliver on
returnable reels that are depreciable property. Customers make
deposits on the reels, which you refund if the reels are returned
within a year. If they are not returned, you keep each deposit as the
agreed-upon sales price. Most reels are returned within the 1-year
period. You keep adequate records showing depreciation and other
charges to the capitalized cost of the reels. Under these conditions,
the reels are not property held for sale to customers in the ordinary
course of your business. Any gain or loss resulting from their not
being returned may be capital or ordinary, depending on your section
Treatment as ordinary or capital.
To determine the treatment of section 1231 gains and losses,
combine all your section 1231 gains and losses for the year.
- If you have a net section 1231 loss, it is
- If you have a net section 1231 gain, it is
ordinary income up to the amount of your nonrecaptured section 1231
losses from previous years. The rest, if any, is long-term capital
Nonrecaptured section 1231 losses.
Your nonrecaptured section 1231 losses are your net section 1231
losses for the previous 5 years that have not been applied against a
net section 1231 gain by treating the gain as ordinary income. These
losses are applied against your net section 1231 gain beginning with
the earliest loss in the 5-year period.
Ashley, Inc., a graphic arts company, is a calendar year
corporation. In 1998, it had a net section 1231 loss of $8,000. For
tax years 2000 and 2001, the company has net section 1231 gains of
$5,250 and $4,600, respectively. In figuring taxable income for 2000,
Ashley treated its net section 1231 gain of $5,250 as ordinary income
by recapturing $5,250 of its $8,000 net section 1231 loss. In 2001 it
applies its remaining net section 1231 loss, $2,750 ($8,000 -
$5,250) against its net section 1231 gain, $4,600. For 2001, the
company reports $2,750 as ordinary income and $1,850 ($4,600 -
$2,750) as long-term capital gain.
Tax rate on capital gain.
The tax rate on the net capital gain of an individual, estate, or
trust is determined by treating any ordinary income from a net section
1231 gain as consisting of, first, any net section 1231 gain in the
28% group, then any net section 1231 gain in the 25% group, and
finally any net section 1231 gain in the 20% group. Any long-term
capital gain is treated as consisting of any remaining net section
1231 gain in each group. See Capital Gain Tax Rates in
The facts are the same as in the previous example, except that the
company is operated by an individual as a sole proprietorship. The
$4,600 net section 1231 gain for 2001 is the total of a $1,000 net
section 1231 gain in the 28% group and a $3,600 net section 1231 gain
in the 20% group. The $2,750 treated as ordinary income consists of
the $1,000 gain in the 28% group and $1,750 of the gain in the 20%
group. The tax rate on the individual's net capital gain for 2001 is
determined by including the $1,850 long-term capital gain in the 20%