When selling business assets, understanding the tax implications is crucial. One area to focus on is Section 1231 of the Internal Revenue Code, which governs the treatment of gains and losses from the sale or exchange of certain business property.

Business Gain & Loss Tax Basics

The federal income tax character of gains and losses from selling business assets can fall into three categories:

• Capital Gains & Losses. These result from selling capital assets, which are generally defined as property other than 1) inventory and property primarily held for sale to customers, 2) business receivables, 3) real and depreciable business property including rental real estate, and 4) certain intangible assets such as copyrights, musical works, and art works created by the taxpayer. Operating businesses typically don’t own capital assets, but they might from time to time.
• Section 1231 Gains & Losses. These result from selling Section 1231 assets which generally include 1) business real property (including land) that’s held for more than one year, 2) other depreciable business property that’s held for more than one year, 3) intangible assets that are amortizable and held for more than one year, and 4) certain livestock, timber, coal, domestic iron ore, and unharvested crops.
• Ordinary Gains & Losses. These result from selling all assets other than capital assets and Section 1231 assets. Other assets include 1) inventory, 2) receivables, and 3) real and depreciable business assets that would be Section 1231 assets if held for over one year. Ordinary gains can also result from various recapture provisions, the most common of which is depreciation recapture.

Favorable Tax Treatment

Gains and losses from selling Section 1231 assets receive favorable federal income tax treatment.

Net Section 1231 Gains. If a taxpayer’s Section 1231 gains for the year exceed the Section 1231 losses for that year, all the gains and losses are treated as long-term capital gains and losses — assuming the nonrecaptured Section 1231 loss rule explained later doesn’t apply.

An individual taxpayer’s net Section 1231 gain — including gains passed through from a partnership, LLC, or S corporation — qualifies for the lower long-term capital gain tax rates.

Net Section 1231 Losses. If a taxpayer’s Section 1231 losses for the year exceed the Section 1231 gains for that year, all the gains and losses are treated as ordinary gains and losses. That means the net Section 1231 loss for the year is fully deductible as an ordinary loss, which is the optimal tax outcome.

Unfavorable Nonrecaptured Section 1231 Loss Rule

Now for a warning: Taxpayers must watch out for the nonrecaptured Section 1231 loss rule. This provision is intended to prevent taxpayers from manipulating the timing of Section 1231 gains and losses to receive favorable ordinary loss treatment for a net Section 1231 loss, followed by receiving favorable long-term capital gain treatment for a net Section 1231 gain recognized in a later year.

The nonrecaptured Section 1231 loss for the current tax year equals the total net Section 1231 losses that were deducted in the preceding five tax years, reduced by any amounts that have already been recaptured. A nonrecaptured Section 1231 loss is recaptured by treating an equal amount of current-year net Section 1231 gain as higher-taxed ordinary gain rather than lower-taxed long-term capital gain.

For losses passed through to an individual taxpayer from a partnership, LLC, or S corporation, the nonrecaptured Section 1231 loss rule is enforced at the owner level rather than at the entity level.

Tax-Smart Timing Considerations

Because the unfavorable nonrecaptured Section 1231 loss rule cannot affect years before the year when a net Section 1231 gain is recognized, the tax-smart strategy is to try to recognize net Section 1231 gains in years before the years when net Section 1231 losses are recognized.

Conclusion

Achieving the best tax treatment for Section 1231 gains and losses can be a challenge. Contact us and we can help you plan the timing of gains and losses for tax planning.