Times change, and sometimes the tax law must change with them. A law that was fair and equitable 20 years ago may not work in today’s business environment. From time to time, it becomes necessary to alter the Internal Revenue Code. It was one such alteration that gave us section 1231 of the tax law — a law that can benefit you greatly if you plan well.

What is Section 1231?

During World War II, American businesses faced two potentially large tax problems. One was that the sale of used business equipment became an expensive proposition. Because the war caused inflation, used business assets were worth much more money than they previously had been. This meant that selling an old asset could result in a large gain and a big chunk of taxable income.

Another issue was condemnation. To fund the war effort, a new law allowed the government to seize real estate and other property by any means necessary, including condemnation. This meant that business owners unexpectedly suffered a potentially substantial loss but could only claim part of it on their taxes.

To solve this unfair problem for businesses, Congress created Section 1231 of the tax code in 1942. The goal was to provide a more equitable way to handle taxation when businesses sold or lost assets.

Tax Advantages

The tax advantages gained under section 1231 apply to both gains and losses. Under this special rule, the IRS taxes section 123 gains at the lower capital gains tax rate rather than the higher ordinary income tax rate. This provides a tax break when businesses sell big-ticket items like buildings or cars.

The IRS handles the taxation of a section 1231 asset as a capital gain when there is income, but not when there is a loss. Normally, when a business experiences a capital loss, they’re limited to a deduction of $3,000 per year. Under section 1231, however, businesses can claim the loss as an ordinary loss, meaning the entire amount can be claimed in the current tax year.

Section 1231 Gain Explained

When calculating section 1231 gain, it’s important to understand that your basis in a property may not be the same as what you bought it for. Although certainly not a technical definition, your basis in a property is what you have invested in it. Your gain is the income you received for the property minus your basis.

In many cases, this is a pretty simple formula. Let’s say that you bought a collectible baseball card for $50 at an auction. When he sees it, your brother just has to have it. You sell it to him for $75. You’re an honest taxpayer who understands that even simple transactions like this one are taxable, so you report the sale on your income taxes. In this example, your basis in the baseball card is the $50 you paid and your gain is $25.

Your basis in a property under section 1231 is a little bit different because section 1231 assets (which we’ll explain shortly), are usually depreciable. In this example, we’ll pretend you own a building that you purchased for $500,000. You sell the building for $600,000, but you’ve already claimed $50,000 worth of depreciation.

In this case, your basis in the property is only $450,000.(The purchase price of the building minus depreciation.) Your gain is then $150,000.

What is a Section 1231 or 1250 property?

So just what gets classified as section 1231 property? It’s any property that:

  • you’ve owned for more than one year.
  • was used in a trade or business.
  • is depreciable or real property.

“Real property” refers to a tangible or physical piece of property. Intellectual property, such as patents, is not considered real property.

Commercial real estate, residential investment properties, buildings and land used for business are all section 1231 properties. Equipment, automobiles and furniture may also fall under section 1231, as can unharvested crops. Livestock too can be section 1231 property, but only if it is intended for dairy, breeding, draft or sporting activities.

Any piece of real estate that’s classified as a 1231 property is also a section 1250 property. So what the heck does that mean? It means that the federal government giveth, and the federal government taketh away. Section 1250 of the Internal Revenue Code deals with depreciation on section 1231 property. A second look at our earlier example will explain best.

Let’s again say that you bought a building for $500,000, claimed depreciation of $50,000, and sold the property for $600,000. As we discussed earlier, your basis in the property is $450,000, which makes your gain $150,000. But some of your gains came not from the sale itself but from the depreciation you already claimed. 

The government is kind and will tax $100,000 of your gain at the lower capital gain tax rate under section 1231. But the government’s kindness only goes so far — they will perform a depreciation recapture under section 1250 by taxing the depreciated portion of your gain ($50,000) at the higher ordinary income tax rate.

Section 1231 Loss Explained

Sometimes, businesses must sell property or old equipment at a loss. These losses may simply be the result of market conditions, but there are other reasons a business may experience a loss. Sometimes property is stolen, for instance, or condemned as it was during World War II.

Ordinarily, losses of property are treated as capital losses, limiting the amount of the loss the business can claim in a year. Under section 1231, however, the business can deduct the entire loss.

Pretend you own a construction company, and one of your workers forgot to lock the door at a job site one night. The next morning, your crew discovers that $5,000 worth of tools were stolen overnight. You’ve previously claimed $1,000 of depreciation on said tools. This makes your basis in them $4,000. Your loss is also $4,000.

If the IRS treated your loss as a capital loss, you could only deduct $3,000 on your taxes. You could carry the remaining $1,000 over into next year, but that wouldn’t help you this year.

Under section 1231, your loss is instead treated as an ordinary loss. This means you can claim the entire $4,000 loss on your taxes this year. This reduces your tax burden and hopefully makes it easier to replace the stolen tools.

Calculating 1231 Gain and Loss

The formula for calculating section 1231 gains and losses is fairly simple. Begin by calculating your basis in the object. The formula for calculating your basis is the purchase price minus claimed depreciation.

Next, subtract your basis from the sale price of the item. If this number is positive, you have a gain. If it’s a negative number you’ve incurred a loss. If you’ve incurred a loss due to theft, casualty or condemnation, your loss equals your basis.

Form 4562

As you now know, you must first determine your basis when calculating the gain or loss from a section 1231 asset. This means taking your depreciation into account. To make sure that you’ve properly depreciated your asset, the IRS requires you to file Form 4562 along with your taxes every year that you claim depreciation. This allows both you and the IRS to track the amount of depreciation you’ve claimed on a given asset.

Form 4797

When you do sell or otherwise dispose of a business asset, the IRS requires you to file a Form 4797. This form lists the asset you sold or lost, your purchase price and the amount of depreciation you’ve previously claimed on Forms 4562. You’ll then use this information to calculate your basis in the property as well as your gain or loss. 

This form also lists any depreciation recapture, if applicable, under section 1250. It also clearly spells out where to report your specific gains or losses.

At Picnic Tax, we do our best to clearly explain the tax rules and make them easier to digest. If you’re still not sure exactly what to do with your section 1232 assets or find yourself staring blankly at a Form 4797, don’t hesitate to reach out to us for help. We’re happy to answer your questions and take the stress out of the tax equation.