Section 1231 gains and losses

Your section 1231 treatment depends on the relationship between your section 1231 gains and your section 1231 losses for the taxable year. When your gains exceed your losses, section 1231 generally treats those gains and losses as long term capital gains and long term capital losses, respectively. Your net gain is also subject to the rule for nonrecaptured net section 1231 losses from the 5 most recent preceding taxable years.

When your section 1231 gains do not exceed your section 1231 losses, those gains and losses are not treated as gains and losses from sales or exchanges of capital assets. When your annual calculation ends below zero, Form 4797 moves that deficit from its first part into its second part for ordinary loss treatment.

Your net section 1231 gain is the amount by which your section 1231 gains exceed your section 1231 losses. To calculate your loss balance under section 1231, subtract the year's total gains from its total losses when losses are larger. In determining either amount, the special rules in section 1231(a)(4) apply.

Your net section 1231 gain is ordinary income to the extent it does not exceed your nonrecaptured net section 1231 losses. You carry any net gain remaining after that reduction to Schedule D as a long term capital gain. This means your current net gain can include both an ordinary income portion and a long term capital gain portion.

You look back five taxable years immediately before the current year to identify losses eligible for recapture. You total the net section 1231 losses for those years. You then subtract the portion of those losses already taken into account under this ordinary income rule in those preceding years.

You therefore use the remaining nonrecaptured amount when determining how much of your current net gain becomes ordinary income. The calculation accounts for both your net losses within the specified period and the portions already used against gains in preceding years.

When you apply prior losses against your current net section 1231 gain, you begin with the earliest loss in the 5 year period. Your current gain is ordinary gain to the extent of the applicable prior losses. After you account for those prior losses, Schedule D receives only the balance eligible for long term capital treatment.

If you dispose of section 1245 property, your gain generally is ordinary income to the extent of depreciation allowed or allowable, but if section 1031 or 1033 provides full or partial nonrecognition, your section 1245 ordinary income cannot exceed the gain recognized without applying section 1245 plus the fair market value of acquired property that is not section 1245 property and is not already counted in that recognized gain. Any recognized gain exceeding that ordinary income portion is a section 1231 gain.

For section 1245, you determine recomputed basis by adding to adjusted basis all reflected adjustments for depreciation or amortization allowed or allowable to you or any other person for that property or other property, except that you add only the amount allowed for a period if adequate records or other sufficient evidence establish it was less than the amount allowable, and you treat deductions allowable under sections 179, 179B, 179C, 179D, 179E, 181, 190, 193, or 194 as amortization deductions. Your section 1231 gain is the recognized gain remaining after the ordinary income portion attributable to that depreciation. The recognized gain and the section 1231 portion therefore can be different amounts.

Your remaining section 1231 gain then enters the annual section 1231 calculation. If that calculation produces a net gain, your nonrecaptured net section 1231 losses can cause some or all of that net gain to be ordinary income.

You can consequently have ordinary income attributable to depreciation on your section 1245 property and ordinary income attributable to prior section 1231 losses. The first rule determines the section 1231 portion of your recognized disposition gain. The second determines the treatment of your annual net section 1231 gain.

Your unrecaptured section 1250 gain generally is the part of your capital gain from selling section 1250 property, which is real property, that is due to depreciation. That amount cannot exceed your net section 1231 gain and is reduced by any net loss in the 28% group.

You must use the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions for Form 1040 to figure your unrecaptured section 1250 gain. The calculation includes the limit tied to your net section 1231 gain and the reduction for any net loss in the 28% group.

Under the statutory definition, the starting amount is your long term capital gain that is not otherwise treated as ordinary income but would be ordinary income if section 1250(b)(1) included all depreciation and the applicable percentage under section 1250(a) were 100 percent. From that amount, you subtract the excess, if any, of the amount in section 1(h)(4)(B) over the amount in section 1(h)(4)(A). Your unrecaptured section 1250 gain is the excess, if any, remaining after that subtraction.

For your sales, exchanges, and conversions described in section 1231(a)(3)(A), the starting amount in that statutory calculation cannot exceed your net section 1231 gain for the taxable year. You can find further information about section 1250 property and section 1231 gain in chapter 3 of the IRS publication identified in the sources.

You must treat the disposal of standing timber under a cutting contract as a section 1231 transaction if you meet all three conditions below. You must own the timber, have held it longer than 1 year before its disposal, and have kept an economic interest in it.

You show your section 1231 gains and losses in Part I of Form 4797. Your annual net result determines the next reporting step. For a negative balance, you use the ordinary loss classification in the second part of that form.

If you have a net gain, you carry it to Schedule D as a long term capital gain, subject to the adjustment for nonrecaptured net section 1231 losses. If you have those losses from the preceding 5 tax years, you reduce your net gain by the applicable losses and report the reduction as ordinary gain in Part II.

Your reporting therefore follows the same division used to characterize your net gain. You report the portion attributable to nonrecaptured prior losses as ordinary gain in Part II. For your Schedule D entry, carry only the amount by which your net section 1231 gain exceeds your nonrecaptured net section 1231 losses from the preceding 5 tax years, carrying none of that gain if those losses equal or exceed it.