Selling a building, equipment or breeding livestock used in a business produces gain or loss under section 1231, a provision that gives the taxpayer the best of both worlds: net gains are taxed as long-term capital gains and net losses are ordinary. The catch is the five-year lookback, which re-characterizes a later gain as ordinary to the extent of recent net losses. A client who sells assets in alternating good and bad years needs a running schedule, which most files do not have.
What qualifies
Section 1231(b)(1) defines property used in the trade or business as depreciable property used in the trade or business and held for more than one year, and real property used in the trade or business held for more than one year. Excluded are inventory-type property, property held primarily for sale to customers, certain self-created intangibles such as patents, copyrights and similar property held by their creator, and certain government publications.
Livestock qualifies under section 1231(b)(3) if it is held for draft, breeding, dairy or sporting purposes:
- cattle and horses, regardless of age, held 24 months or more from acquisition; and
- other livestock, regardless of age, held 12 months or more from acquisition.
Poultry is excluded. Timber, coal and iron ore under section 631 are included, and an unharvested crop sold, exchanged or converted together with the land to the same person is treated as property used in the trade or business under section 1231(b)(4), with the land held more than one year.
The netting rule
Under section 1231(a)(1), if section 1231 gains for the year exceed section 1231 losses, the gains and losses are treated as long-term capital gains and losses. Under section 1231(a)(2), if gains do not exceed losses, they are not treated as gains and losses from the sale of capital assets, so the net loss is ordinary. Section 1231 gain also includes recognized gain from compulsory or involuntary conversions, and losses from destruction, theft, seizure or condemnation of business property are treated as losses from involuntary conversions.
Casualty and theft items have their own gate. Under section 1231(a)(4)(C), if recognized losses from involuntary conversions of business property, and of capital assets held more than one year, exceed the recognized gains from those conversions for the year, section 1231 does not apply to those items, and none of them enter the netting. Gains count only to the extent included in gross income, and losses only to the extent taken into account in computing taxable income, without the capital loss limitation of section 1211.
Depreciation recapture comes first. Gain that is ordinary income under section 1245 or 1250 is removed before netting, so only the remaining gain participates. See depreciation recapture.
The five-year lookback
Under section 1231(c)(1), net section 1231 gain for a year is treated as ordinary income to the extent it does not exceed the non-recaptured net section 1231 losses. Non-recaptured net section 1231 losses are the excess of the aggregate net section 1231 losses for the 5 most recent preceding taxable years over the portion of those losses already taken into account under this rule in prior years.
Worked example. A farmer's section 1231 results are:
- Year 1: net loss of $80,000 (ordinary).
- Year 2: net gain of $30,000.
- Year 3: net gain of $120,000.
Year 2: the non-recaptured loss is $80,000. The $30,000 gain is all ordinary, because it does not exceed $80,000. Non-recaptured loss remaining: $80,000 minus $30,000, or $50,000.
Year 3: the non-recaptured loss is $50,000. Of the $120,000 gain, $50,000 is ordinary income, and the remaining $70,000 is long-term capital gain. Non-recaptured loss remaining: zero.
Second example: the window closes. A client has a $40,000 net section 1231 loss in year 1, a $20,000 net loss in year 2, nothing in years 3 through 6, and a $100,000 net gain in year 7.
- The five most recent preceding years for year 7 are years 2 through 6. The year 1 loss is outside the window.
- Non-recaptured net section 1231 losses: $20,000.
- Ordinary income: $20,000. Long-term capital gain: $100,000 minus $20,000, or $80,000.
The year 1 loss was an ordinary deduction that never gets recaptured, so the schedule has to date each loss, not just total them.
Without the rule, the farmer would have taken an $80,000 ordinary deduction in year one and $150,000 of capital gain later. With the rule, $80,000 of the later gain is ordinary.
Interaction with other provisions
- Unrecaptured section 1250 gain within net section 1231 gain is limited to the net section 1231 gain, per section 1(h)(6)(B).
- Installment sales are subject to recapture in the year of sale. See section 453.
- Involuntary conversions may defer gain under section 1033.
Common questions
Is a net section 1231 loss capital or ordinary?
Ordinary. Under section 1231(a)(2), when gains do not exceed losses, none of them are treated as gains or losses from the sale of capital assets, so the net loss is deductible against ordinary income.
Does a year with no section 1231 transactions count in the five years?
Yes. The look-back is the 5 most recent preceding taxable years, measured by calendar position, so a gap year uses up a year of the window.
Are cattle held 18 months section 1231 property?
Not if held for breeding, dairy, draft or sporting purposes for less than 24 months from acquisition. Cattle and horses need 24 months or more. Other livestock, except poultry, need 12 months or more.
File checklist
- Form 4797 for each of the last five years. The instructions send a Part I line 7 gain to line 8 when nonrecaptured section 1231 losses exist from the 5 preceding tax years, and to Schedule D as long-term capital gain when none exist.
- A section 1231 carryforward schedule showing net losses, amounts recaptured and the remainder.
- Asset-level disposal schedule with holding periods, for livestock and real property in particular.
- The ordering of recapture, netting and capital gain on the current return.
Sources
- Legal Information Institute, 26 U.S.C. 1231, Property used in the trade or business and involuntary conversions: https://www.law.cornell.edu/uscode/text/26/1231
- Internal Revenue Service, Instructions for Form 4797, Part I lines 7 and 8: https://www.irs.gov/instructions/i4797
- Legal Information Institute, 26 U.S.C. 1, Tax imposed (subsection (h)(6)): https://www.law.cornell.edu/uscode/text/26/1
- Internal Revenue Service, About Form 4797, Sales of Business Property: https://www.irs.gov/forms-pubs/about-form-4797
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Part of CORAA University · Tax and compliance for CPA firms: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error