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What Is a Section 1231 Gain?

Knowing what a Section 1231 property is, and how the IRS treats the sale of that property, can save you a significant amount of money at tax time.

[Updated: Mar 02, 2021] Feb 18, 2020 by Kevin Vandenboss
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When the sale of a Section 1231 property results in a gain, that gain is taxed at the lower capital gains tax rate instead of the ordinary income tax rate.

To understand what a Section 1231 gain is, you first have to understand what a Section 1231 property is. According to Internal Revenue Code Section 1231, a Section 1231 property must meet all three of the following criteria:

  1. Has been held for at least one year.
  2. Is used for trade or business.
  3. Is either depreciable or real property.

This means that each of the following falls under Section 1231:

Further examples of Section 1231 properties include:

  • Buildings.
  • Land.
  • Equipment.
  • Automobiles.
  • Furniture.
  • Livestock held for draft, dairy, breeding, or sporting purposes.
  • Unharvested crops.

Section 1231 gain

When real property or depreciable business property is sold for more than its current tax basis, it is considered a capital gain. If that property was held for more than a year before it was sold, it falls under Section 1231 rules. In this case, the gain isn't taxed as ordinary income but at the lower capital gain rates.

Here's an example:

A business purchases equipment for $100,000.

This equipment is depreciated over five years at $20,000 each year.

After three years, a total of $60,000 has been depreciated, so the tax basis is now $40,000.

The business sells the equipment for $80,000.

The tax basis of $40,000 is subtracted from the $80,000 sale price, leaving a capital gain of $40,000.

This $40,000 gain is now taxed as a capital gain instead of ordinary income.

Section 1250 property

Real estate that's considered Section 1231 property is also considered Section 1250 property. Section 1250 lays out depreciation recapture rules when a capital gain is realized from the sale of Section 1231 real estate.

When real estate that falls under Section 1231 treatment is sold, the prior depreciation is taxed differently than any gain realized from the property being sold for more than it was purchased for.

Here's an example:

A real estate investor purchases a commercial property for $1 million.

After five years, a total of $102,564 has been depreciated. The tax basis is now $897,436.

The investor sells the property and nets $1.25 million.

There is a total taxable gain of $352,564.

However, the $102,564 of that gain that was from the prior depreciation is taxed at a higher special capital gain tax rate of 25%.

The other $250,000 is taxed at the long-term capital gain tax rate.

Section 1231 loss

A Section 1231 loss can be deducted against ordinary income instead of being limited to only being written off against capital gains. This gives taxpayers the best of both worlds, because outside of Section 1231, a business can only deduct capital losses of up to $3,000 against ordinary income.

A Section 1231 loss can be the result of a sale below the tax basis, casualty and theft after being held for one year, or condemnation after being held for one year.

Here's an example:

A business purchases equipment for $100,000.

The equipment is depreciated over five years at $20,000 per year.

After two years, $40,000 has been depreciated leaving a tax basis of $60,000.

The business sells the equipment for $45,000.

Since the sale price is less than the current tax basis, it was sold as a loss of $15,000.

This $15,000 loss can now be written off against ordinary income.

Calculating a Section 1231 gain or loss

Before calculating the gain or loss from a Section 1231 transaction, Form 4562 must first be completed to determine the allowable depreciation. From there, you can list the details from each Section 1231 transaction on Form 4797 to figure out the net gain or loss for the year.

Instructions for Form 4797 provides a list of other IRS tax forms that may be needed, depending on certain details of the transactions.

Real estate investing has many tax benefits, and paying a lower tax rate on a Section 1231 gain is one of them. Understanding these various tax rules can make a significant impact on the amount of your real estate profits you keep at tax time.

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