IRC Section 1231: It’s the Best of Both Worlds

Most owners and developers know that the sale of a business asset, including real estate, can have significant tax implications. The tax effects generally arise when the sale results in a gain or a loss. Ideally, gains would be treated as long-term capital gains, subject to lower tax rates, and losses would be considered ordinary losses, which could be applied to offset ordinary income. Section 1231 of the Internal Revenue Code (IRC) permits such advantageous treatment — the best of both worlds.

Eligible Property

Sec. 1231 generally applies to depreciable property used in a trade or business that’s held for more than one year. A sale or exchange of property held mainly for sale to customers isn’t a Sec. 1231 transaction, especially if you get back all, or almost all, of your investment in the property by selling it, rather than by using it in your business. On the other hand, property used to generate rents is used in a trade or business and is 1231 property.

Notably, the IRS has taken the position that real property purchased or constructed for use in a trade or business qualifies for Sec. 1231 treatment even if it was never placed in service but instead was sold — as long as the property was held for more than a year. In other words, property doesn’t have to be placed in service to be considered property used in a trade or business.

Treatment of Sec. 1231 Gains and Losses

When determining the treatment of Sec. 1231 gains and losses, all of the Sec. 1231 gains and losses for the year should be combined. If you have a net Sec. 1231 loss, it’s treated as an ordinary loss. Not only can this loss be used to offset your ordinary income, but the loss is not subject to the capital loss limitation of $3,000 and can be used against other ordinary income. Plus, the loss could give rise to a net operating loss that can be carried back or forward.

If you have a net gain, it’s considered ordinary income up to the amount of your nonrecaptured Sec. 1231 losses from previous years. The remainder, if any, is long-term capital gain that can offset other capital losses from sales of non-Sec. 1231 property.

The Recapture Issue

As suggested above, the benefits of long-term capital gains treatment might not be available if you had a non-recaptured Sec. 1231 loss in the prior five years. That means that, for every year in the last five in which you have a net Sec.1231 gain, you must “look back” to determine whether you had an aggregate net Sec. 1231 loss. You have a non-recaptured loss if the total net Sec. 1231 losses exceed the total Sec. 1231 gains for the prior five years. Real property may also be subject to depreciation recapture under Sec. 1250.

A Complicated Matter

While the benefits of Sec. 1231 transactions are straightforward and clear, the applicable rules and their potential interaction with other provisions of the tax code are anything but. Your financial advisor can help you decipher the proper timing and planning to get the best of both worlds.

For more information, contact Doug Collins, our real estate partner at (973) 298-8500.