Understanding Section 1231 Property: Definition, Examples, and Tax Benefits

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Understanding Section 1231 Property: Definition, Examples, and Tax Benefits

What is Section 1231 property?

Section 1231 of the Internal Revenue Code covers depreciable business property and real property held for more than one year. When such property is sold, gains and losses receive special tax treatment:

  • Net gains are treated as long-term capital gains (subject to lower capital gains rates).
  • Net losses are treated as ordinary losses (fully deductible against ordinary income).

This mixed treatment can provide a tax advantage: favorable capital gains rates for gains, and full ordinary-loss deductions when losses exceed gains.

Key points

  • Applies to depreciable tangible property and real property used in a trade or business and held over one year.
  • Net Section 1231 gain = long-term capital gain; net Section 1231 loss = ordinary loss.
  • Certain asset categories (Sections 1245 and 1250) have additional depreciation-recapture rules that can convert some gain to ordinary income.

How Section 1231 affects taxes

  • If sale proceeds exceed adjusted basis (after depreciation), the excess generally qualifies as capital gain.
  • If losses exceed gains for the year, the net loss is treated as an ordinary loss and fully deductible.
  • Depreciation taken on an asset can be “recaptured” under Sections 1245 or 1250, causing part (or all) of a gain to be taxed as ordinary income rather than as capital gain.

Common Section 1231 transactions

Section 1231 treatment commonly applies to:
* Sales or exchanges of business real estate and depreciable personal property held over one year.
* Involuntary conversions (casualty, theft, condemnation) of business property held over one year.
* Certain timber, coal, or mineral disposals treated as sales.
* Leaseholds and some livestock or crops if holding-period and use rules are met.

Check specific holding-period exceptions (for example, certain livestock require a two-year holding period).

Section 1245 vs. Section 1250 (how recapture differs)

Both Sections 1245 and 1250 describe depreciation recapture rules that interact with Section 1231:

  • Section 1245 (mostly personal property and some special-purpose structures):
  • Recaptures depreciation/amortization up to the amount of gain as ordinary income.

  • Any remaining gain above recaptured depreciation may be treated as capital gain.

  • Section 1250 (depreciable real property):

  • Generally recapture rules for real property are more limited.
  • For individuals, a portion of gain attributable to prior depreciation (unrecaptured Section 1250 gain) may be taxed at a higher capital gain rate (up to 25%) rather than ordinary income; rules vary with the type and amount of depreciation.
  • Net gain in excess of recapture treatment is treated as capital gain.

In short: depreciation can convert part of a Section 1231 gain into ordinary income under Sections 1245/1250; any excess may be capital gain.

Example (simplified)

You buy a commercial building for $2,000,000, spend $2,000,000 on capital improvements that are depreciated, and hold the property more than one year. If you sell the property later for $6,000,000 and the adjusted basis after depreciation is $2,000,000, your realized gain is $4,000,000. That gain would generally be treated as a long-term capital gain under Section 1231, except to the extent depreciation must be recaptured under Sections 1245/1250.

Reporting

Report Section 1231 gains and losses on IRS Form 4797 (Sales of Business Property). Depreciation recapture amounts are also reported on Form 4797 and carried through to Schedule D and Form 8949 if applicable.

Frequently asked questions

Bottom line

Section 1231 blends capital-gain treatment for net gains with ordinary-loss treatment for net losses, often creating a tax advantage for business property dispositions. However, depreciation recapture under Sections 1245 and 1250 can convert some gains to ordinary income, so careful tracking of basis and depreciation is essential when selling business assets.

Primary references

  • IRS Publication 544, Sales and Other Dispositions of Assets
  • Instructions for IRS Form 4797