A 1231 Capital Gain – But My Joy Didn’t Last – I Forgot My 1231 Losses Within The 5 Years Past

By Gerald Deutsch, Esq., Glen Head, NY

Section 1231 normally is a “taxpayer friendly” section in that any gain from the sale or disposition of a section 1231 asset is treated as a capital gain and if the sale or disposition results in loss, the loss is treated as an ordinary loss.

Section 1231 normally is a “taxpayer friendly” section in that any gain from the sale or disposition of a section 1231 asset is treated as a capital gain and if the sale or disposition results in loss, the loss is treated as an ordinary loss.

Property used in the trade or business is defined as property held for more than one year that is used in the taxpayer’s trade or business that is of a character subject to the allowance for depreciation, and real property used in the taxpayer’s trade or business.  It also includes certain timber, coal, and domestic iron ore, livestock, and unharvested crops.  It does not include property that would properly be included in inventory if on hand at the close of the taxable year; property held primarily for sale to customers; certain copyrights, literary, musical, or artistic compositions; and certain publications of the U.S. government.

It is easy to understand that the net of “section 1231 transactions” that is realized by the taxpayer must be combined with the net of such transaction that comes from taxpayer’s partnerships and S corporations (Form 4797 line 2 of Part I if a gain on line 10 of Part II if a loss) but line 8 may not be fully understood.  That line reads, “Nonrecaptured net 1231 losses from prior years.”

The instructions for line 8 reads:

“Your net section 1231 gain – is treated as ordinary income to the extent of your ‘nonrecaptured section 1231 losses.’  Your nonrecaptured 1231 losses are your net section 1231 losses deducted during the 5 preceding tax years---”

It is important, therefore, that taxpayers be aware of their five year history of section 1231 losses, if any, because failure to do so could cause faulty tax planning.  For example, assume that in 2004 a taxpayer had a section 1231 loss in the amount of $100,000 that reduced his income by that amount in that year.  Now, in 2009, taxpayer, as a result of the economy, has realized $100,000 in capital losses and wants sell real estate used in his business that will yield a capital gain which can be offset against that capital loss and result in no tax.

Unfortunately, what happened in 2004 – five years ago – will be expensive for taxpayer.  The real estate used in his business is not a capital asset but a “section 1231 asset” and will only be taxed as a capital gain if there are no “section 1231 losses” in that year – or the five most recent preceding taxable years.  In this case, since there was such a loss in the pertinent period the result here is that the $100,000 gain (i) can’t be offset against the capital loss, and (ii) will be taxed as ordinary income.

So while most taxpayers consider a three year statute of limitations, a longer period must be considered if a section 1231 loss has been claimed during that longer period.