Most owners and developers know that the sale of a business asset, including real estate, can have significant tax implications. The tax effects generally come down to whether 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 just such advantageous treatment — the best of both worlds — for certain types of property in certain circumstances.
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. On the other hand, property used to generate rents is considered to be used in a trade or business.
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, running from the purchase date to the sale date. 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
To determine the treatment of Sec. 1231 gains and losses, you combine all of your Sec. 1231 gains and losses for the year. If you have a net Sec. 1231 loss, it’s an ordinary loss. Not only can such a loss be used to offset your ordinary income, but you’re also not subject to the normal $3,000 limit per year limitation on how much of the loss can be used against 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 nonrecaptured 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 nonrecaptured 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.