Introduction

When you dispose of business property, your taxable gain or loss is usually a section 1231 gain or loss. Its treatment as ordinary or capital is determined under rules for section 1231 transactions.

When you dispose of depreciable property (section 1245 property or section 1250 property) at a gain, you may have to recognize all or part of the gain as ordinary income under the depreciation recapture rules. Any remaining gain is a section 1231 gain.

Topics

This chapter discusses:

• Section 1231 gains and losses
• Depreciation recapture

Useful Items

You may want to see:

Publication

• 534   Depreciating Property Placed in Service Before 1987
• 537   Installment Sales
• 551   Basis of Assets
• 946   How To Depreciate Property
• 954   Tax Incentives for Empowerment Zones and Other Distressed Communities

Form (and Instructions)

• 4797   Sales of Business Property

See chapter 5 for information about getting publications and forms.

Section 1231
Gains and Losses

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 Dispositions).
• 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 purposes 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 purposes 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 ore. The cutting or disposal must be treated as a sale, as described in chapter 2 under Timber and Coal and Iron Ore.
• Condemnations. 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 Publication 547, 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.

Example.   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 1231 transactions.

Copyrights.    The sale of a copyright, a literary, musical, or artistic composition, or similar property is not a section 1231 transaction if your personal efforts created the property, or if you acquired the property in a way that entitled you to the basis of the previous owner whose personal efforts created it (for example, if you receive the property as a gift). The sale of such property results in ordinary income and generally is reported in Part II of Form 4797.

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 ordinary loss.
• 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 gain.

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.

Example.   Ashley, Inc., a graphic arts company, is a calendar year corporation. In 1999, it had a net section 1231 loss of $8,000. For tax years 2001 and 2002, the company has net section 1231 gains of $5,250 and $4,600, respectively. In figuring taxable income for 2001, 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 from 1999. In 2002 it applies its remaining net section 1231 loss, $2,750 ($8,000 - $5,250) against its net section 1231 gain, $4,600. For 2002, 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 chapter 4.

Example.   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 2002 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 2002 is determined by including the $1,850 long-term capital gain in the 20% group.

Depreciation Recapture

If you dispose of depreciable or amortizable property at a gain, you may have to treat all or part of the gain (even if otherwise nontaxable) as ordinary income.

To figure any gain that must be reported as ordinary income, you must keep permanent records of the facts necessary to figure the depreciation or amortization allowed or allowable on your property. This includes the date and manner of acquisition, cost or other basis, depreciation or amortization, and all other adjustments that affect basis.

On property you acquired in a nontaxable exchange or as a gift, your records also must indicate the following information.

• Whether the adjusted basis was figured using depreciation or amortization you claimed on other property.
• Whether the adjusted basis was figured using depreciation or amortization another person claimed.

Corporate distributions.   For information on property distributed by corporations, see Distributions to Shareholders in Publication 542, Corporations.

General asset accounts.   Different rules apply to dispositions of property you depreciated using a general asset account. For information on these rules, see section 1.168(i)-1(e) of the regulations.

Section 1245 Property

A gain on the disposition of section 1245 property is treated as ordinary income to the extent of depreciation allowed or allowable on the property. See Gain Treated as Ordinary Income, later.

Any gain recognized that is more than the part that is ordinary income from depreciation is a section 1231 gain. See Treatment as ordinary or capital under Section 1231 Gains and Losses, earlier.

Section 1245 property.   Section 1245 property includes any property that is or has been subject to an allowance for depreciation or amortization and that is any of the following types of property.

1. Personal property (either tangible or intangible).
2. Other tangible property (except buildings and their structural components) used as any of the following.
   1. An integral part of manufacturing, production, or extraction, or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services.
   2. A research facility in any of the activities in (a).
   3. A facility in any of the activities in (a) for the bulk storage of fungible commodities.
3. That part of real property (not included in (2)) with an adjusted basis that was reduced by certain amortization deductions (including those for certified pollution control facilities, child-care facilities, removal of architectural barriers to persons with disabilities and the elderly, or reforestation expenses) or a section 179 deduction.
4. Single purpose agricultural (livestock) or horticultural structures.
5. Storage facilities (except buildings and their structural components) used in distributing petroleum or any primary product of petroleum.

Buildings and structural components.   Section 1245 property does not include buildings and structural components. Do not treat structures that are essentially items of machinery or equipment as buildings and structural components. Also, do not treat as buildings structures that house property used as an integral part of an activity if the structures' use is so closely related to the property's use that the structures can be expected to be replaced when the property they initially house is replaced. The fact that the structures are specially designed to withstand the stress and other demands of the property and the fact that the structures cannot be used economically for other purposes indicate that they are closely related to the use of the property they house. Structures such as oil and gas storage tanks, grain storage bins, silos, fractionating towers, blast furnaces, basic oxygen furnaces, coke ovens, brick kilns, and coal tipples are not treated as buildings.

Facility for bulk storage of fungible commodities.   This term includes oil or gas storage tanks and grain storage bins. Bulk storage means the storage of a commodity in a large mass before it is used. For example, if a facility is used to store oranges that have been sorted and boxed, it is not used for bulk storage. To be fungible, a commodity must be such that one part may be used in place of another.

Stored materials that vary in composition, size, and weight are not fungible. Materials are not fungible if one part cannot be used in place of another part and the materials cannot be estimated and replaced by simple reference to weight, measure, and number. For example, the storage of different grades and forms of aluminum scrap is not storage of fungible commodities.

Gain Treated as Ordinary Income

The gain treated as ordinary income on the sale, exchange, or involuntary conversion of section 1245 property, including a sale and leaseback transaction, is the lesser of the following amounts.

1. The depreciation and amortization allowed or allowable on the property.
2. The gain realized on the disposition (the amount realized from the disposition minus the adjusted basis of the property).

A limit on this amount for gain on like-kind exchanges and involuntary conversions is explained later.

For any other disposition of section 1245 property, ordinary income is the lesser of (1) earlier or the amount by which its fair market value is more than its adjusted basis. See Gifts and Transfers at Death, later.

Use Part III of Form 4797 to figure the ordinary income part of the gain.

Depreciation taken on other property or taken by other taxpayers.   Depreciation and amortization include the amounts you claimed on the section 1245 property as well as the following depreciation and amortization amounts.

• Amounts you claimed on property you exchanged for, or converted to, your section 1245 property in a like-kind exchange or involuntary conversion.
• Amounts a previous owner of the section 1245 property claimed if your basis is determined with reference to that person's adjusted basis (for example, the donor's depreciation deductions on property you received as a gift).

Depreciation and amortization.   Depreciation and amortization that must be recaptured as ordinary income include (but are not limited to) the following items.

1. Ordinary depreciation deductions.
2. The 30% special depreciation allowance for property acquired after September 10, 2001.
3. Amortization deductions for all the following costs.
   1. Acquiring a lease.
   2. Lessee improvements.
   3. Pollution control facilities.
   4. Reforestation expenses.
   5. Section 197 intangibles.
   6. Child care facility expenses made before 1982.
   7. Franchises, trademarks, and trade names acquired before August 11, 1993.
4. The section 179 deduction.
5. Deductions for all the following costs.
   1. Removing barriers to the disabled and the elderly.
   2. Tertiary injectant expenses.
   3. Depreciable clean-fuel vehicles and refueling property (minus the amount of any recaptured deduction).
   4. Environmental cleanup costs.
6. Any basis reduction for the investment credit (minus any basis increase for credit recapture).
7. Any basis reduction for the qualified electric vehicle credit (minus any basis increase for credit recapture).

Example.   You file your returns on a calendar year basis. In February 2000, you bought and placed in service for 100% use in your business a light-duty truck (5-year property) that cost $10,000. You used the half-year convention and your MACRS deductions for the truck were $2,000 in 2000 and $3,200 in 2001. You did not take the section 179 deduction on it. You sold the truck in May 2002 for $7,000. The MACRS deduction in 2002, the year of sale, is $960 (1/2 of $1,920). Figure the gain treated as ordinary income as follows.