How is the 1231 section gain or loss taxed?

1231 section gain or loss happens when you sell or transfer any asset used in business and on which depreciation is claimed. One should always distinguish the sale of an investment asset not used for business purposes. It also means that a section 1231 property is always used for business and on which you claimed depreciation expense.

Section 1231 of the Internal Revenue Code applies to assets used in a trade or business. IRC 1231 also applies to a capital asset connected with a transaction entered into for profit and held for over one year.The Section 1231 property sale or exchange results in either of two

1. Long-term capital gain (LTCG), which is taxed at LTCG rate and depreciation recapture income
2. Ordinary loss that can be adjusted with income of the year.

What are examples of section 1231 properties?

Section 1231 IRC applies to tangible properties held for more than 1 year and used in the trade or business and on which allowance for depreciation is claimed or claimable. However, certain types of properties are not covered under section 1231. Section 1231 properties are assets used in a business that is eligible for depreciation as per IRS rules that prescribe that to qualify as a depreciable asset, the asset/properties must meet the following requirements:

• You must be the owner.
• The property is used in business or income-producing activities.
• The property must have a useful life of at least 12 months.

Examples of section 1231 properties are:

1. Manufacturing machinery
2. All kinds of vehicles-cars, cranes, trucks, buses etc
3. Office buildings
4. The house -residential or commercial structure employed for earning rental income 

• Any equipment, including office computers
• Timber, coal, and iron ore, to which section 631 applies.
• Cattle and horses, held for more than 24 months and used in his business.
• Other livestock is used in businesses and is held for 12 months or more.

What are not Section 1231 properties?

Section 1231(b)(1) provides a list of properties not covered under section 1231 are :

1. Inventories of business or 
2. stock in trade of business
3. Patent, invention, model or design (whether or not patented), a secret formula or process, a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property held by a taxpayer described in paragraph (3) of section 1221(a),
4. a publication of the United States Government [, please refer. R.C. § 1231(b)(1)(D) ]
5. Poultry

Section 1231 vs. 1245 

1. Every depreciable asset comes under section 1231, but section 1245 applies to only certain kinds of properties.
2. Section 1231, enacted in 1940, is primarily concerned with the gains and losses of a depreciable asset. But section 1245 is concerned with the depreciation recapture on all kinds of depreciable assets except real estate properties covered under section 1250.
3. If there is a loss on the sale or transfer of 1231 properties, the loss is adjustable with other ordinary income, but the provision of section 1245 does not apply to such loss cases.

Section 1231 vs. 1250

1. Every depreciable asset comes under section 1231, but section 1250 applies to real estate depreciable properties.
2. Section 1231, enacted in 1940, is primarily concerned with the gains and losses of a depreciable asset. But section 1245 is concerned with the depreciation recapture on all kinds of depreciable assets except real estate properties covered under section 1250.
3. If there is a loss on the sale or transfer of 1231 properties, the loss is adjustable with other ordinary income, but the provision of section 1245 does not apply to such loss cases.

How is the 1231 section loss help you save taxes?

Suppose the result of the sale or exchange of section 1231 property is a loss. In that case, it is not considered capital loss but an ordinary loss adjustable to the taxpayer’s regular income. This is quite a relief because ordinarily, property losses are treated as capital losses, limiting the adjustment to merely $3,000. But in case of loss on sale or exchange of depreciable assets under section 1231, you get 100 percent of the loss adjusted with your ordinary income in the same year. This considerably reduces your taxable income.

How to calculate section 1231 properties gain and loss?

As stated earlier, a section 1231 property falls under either section 1245 asset or section 1250. Both these provisions are related, or depreciation recaptures on the disposition of 1231 properties. So, compute the depreciation recapture income as per section 1245 or as per section 1250.

The formula to compute the section 1231 gain or loss is quite easy to understand.  

(i) Sales consideration /Exchange value

Less

(ii) Basis of the assets – accumulated depreciation claimed

If (i) minus (ii) is positive, it is 1231 gains. 

In the case of 1231 gains, you determine long-term capital gains that are taxable on long-term capital gains tax rate and recapture depreciation income as per section 1245 or section 1250, which is added to ordinary income.

If (i) minus (ii) is negative,

It is a loss; there is no recapture income. The entire loss is adjusted with other ordinary income.

Since , every time you compute gains or loss on 1231 section property , you will need to understand the depreciation recapture , we have posted a detailed article on depreciation recapture with a calculator.