Section 1231 Gain: Definition and Example Explained

A section 1231 gain is defined as the difference between a section 1231 property’s tax basis and its selling price, if it’s sold for more than its depreciated value. This amount is taxable at a lower capital gains rate rather than at the ordinary gains rate.

To be considered for the capital gain treatment under section 1231 of the Internal Revenue Code (IRC), an asset must be considered real or depreciable property that was purchased or constructed for business or trade. To qualify for tax treatment under section 21, the company must hold the asset for a minimum of one year, counting from the purchase date to the sale date. Personal property, commercial real estate, residential properties held for investment purposes, and vacant land that’s used for business may all qualify as section 1231 properties if they meet the aforementioned criteria, even if they were never put into service.

Additional capital assets and types of property that may qualify for section 1231 treatment include:

• Buildings
• Leaseholds
• Machinery and other equipment
• Vehicles
• Furniture
• Unharvested crops
• Rental properties
• Livestock raised or purchased for breeding, dairy, draft, or sporting purposes

Properties that have been condemned or adversely impacted by theft or damage may also qualify for section 1231 treatment if there is a recognized gain from the involuntary conversion of the property. However, section 1231 doesn’t apply to properties purchased specifically to resell to customers. If you can recoup your investment by selling such property instead of using it in your business, it's considered investment property that is held primarily for sale to customers.

Section 1231 gains discount the tax rate on a portion of a section 1231 property’s selling price when the property sells for a price that’s higher than its current tax basis. Essentially, as a business property depreciates in value, its tax basis decreases. If the business sells the property, and the buyer pays a price that’s higher than the tax basis, it results in a capital gain. The Internal Revenue Service (IRS) taxes the amount of the gain at a lower capital gains tax rate, rather than at the standard income rate.

For many businesses, the tax treatment under IRC section 1231 is the best of both worlds because if they have an aggregate section 1231 gain, it incurs lower capital gain rates, but if they have an aggregate section 1231 loss, it's considered an ordinary loss, which is 100% deductible. This differs from an ordinary capital loss, for which a business may claim a maximum $3,000 deduction in any tax year, with the excess carried over to the following year.

Calculating section 1231 gains involves determining the current tax basis, which you can arrive at by subtracting the amount the property has depreciated from the cost of the original purchase. Then, subtract the tax basis from the resale price to calculate the section 1231 gain. If, however, the resale price is lower than the tax basis, subtract the lower number. The result, in the latter case, is a capital loss.

For example, imagine that a construction company purchases a specialty bulldozer for a short-term project at a cost of $100,000. The following year, they decided to sell it. In the year they’ve had the bulldozer, its value has depreciated by $20,000, giving the bulldozer a current tax basis of $80,000. The company then sells the bulldozer for $90,000.

To determine the capital gain on the sale of the bulldozer, subtract the tax basis from the sales price. In this example, we’ll subtract the $80,000 tax basis from the sales price of $90,000 to arrive at a capital gain of $10,000. The IRS taxes this amount at the lower capital gains tax rate rather than at ordinary income rates, as long as the company holds the equipment for at least one year.

Under IRS tax law, section 1231 gains incur taxes at the lower capital gains rate rather than the rate assessed to ordinary income, but other provisions in the income tax code may also factor in. Always consult a CPA for tax advice specific to your situation as they will be most familiar with special rules.

In broad terms, if a company’s yearly combined 1231 gains and losses result in a net loss, it’s considered an ordinary loss, which companies can use to offset their ordinary income for the current year. If the result is a net gain, the income incurs taxes at the lower rate. This amount may also be used as a long-term capital gain to offset capital losses during the relevant taxable year resulting from the sale of non–section 1231 property.

However, limitations apply. For example, taxpayers that have had a, unrecaptured section 1231 loss within the previous five tax years may not be able to reap these benefits. Essentially, you have a nonrecaptured loss if your aggregate net section 1231 losses exceed your aggregate section 1231 gains over the previous five tax years. If your section 1231 gains involve real property, the assets may also be subject to depreciation recapture rules under IRC section 1250.

All investments, including real estate investments, come with inherent risks which may involve the depreciation of assets, financial losses, or legal ramifications. The information presented in this article is for educational, informational, and referential purposes only. Consult a licensed real estate or financial professional before making any legal or financial commitments.

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