What Is Section 1231 Property?

Section 1231 property, as defined by the U.S. Internal Revenue Code, includes real property or depreciable business property that has been held for over one year. These assets can also encompass certain noncapital assets held for more than a year and business and investment properties disposed of involuntarily. Let’s dive into what constitutes Section 1231 assets and the tax benefits they offer.

What Qualifies as Section 1231 Assets?

Section 1231 assets include:

(a) Depreciable Business Assets: Assets that have been held for more than one year.

(b) Real Estate: Buildings or farmland used in a business.

(c) Natural Resources: Such as timber, coal, and domestic iron ore.

(d) Livestock: Most livestock held for draft, breeding, dairy, or sporting purposes. This includes animals like a stallion used for horseracing or a pedigree bull held for breeding.

(e) Unharvested Crops: Crops of a farming business that remain unharvested.

Tax Benefits of Section 1231 Assets

The tax code provides favorable treatment for transactions involving Section 1231 assets. Here’s how it works:

Net Loss: If a taxpayer experiences a net loss from all Section 1231 transactions, the loss is treated as an ordinary loss. This means it can offset other ordinary income, which is beneficial as ordinary income tax rates are typically higher than capital gains rates.

Net Gain: If there is a net gain from Section 1231 transactions, the gain is generally treated as a long-term capital gain. This offers more favorable tax treatment since capital gains tax rates are typically lower than ordinary income tax rates and ordinary losses are not limited.

However, it’s important to note that this favorable treatment does not apply to depreciation recapture or any unrecaptured Section 1231 losses claimed in the previous five years. These are taxed as ordinary income.

Real-World Example

Consider Barclay, who owns several assets:

1. Antique Vase: Purchased at an auction two years ago. This is a capital asset because it is a collectible and Barclay is not a dealer.

2. Residential Rental Property: Purchased eight years ago and qualifies as a Section 1231 asset.

3. Pizza Delivery Van: Exclusively used in his pizza business, bought several years ago. This is a Section 1231 asset because it’s business property held for over one year.

4. SUV: Used for personal use and errands. This is a personal-use capital asset.

Qualifying Transactions for Section 1231 Treatment

1. Sale of Cattle and Horses

(A) Criteria: These animals must be used for draft, breeding, dairy, or sporting purposes and held for 24 months or longer.

(B) Example: Selling a dairy cow after two years of use on the farm qualifies for Section 1231 treatment, potentially reducing the tax burden on the gain.

2. Sale of Other Livestock

(A) Criteria: This includes hogs, mules, sheep, goats, donkeys, and other fur-bearing animals used for draft, breeding, dairy, or sporting purposes and held for 12 months or longer. Poultry is not included.

(B) Example: Selling sheep that have been used for wool production for over a year can result in a favorable tax treatment on any gain.

3. Sale of Depreciable or Amortizable Property

(A) Criteria: Business property and equipment held for more than one year, including machinery, trucks, and amortizable section 197 intangibles like patents or copyrights.

(B) Example: Disposing of a piece of machinery that has been used in your business for several years falls under Section 1231, allowing for potential capital gain treatment.

4. Sale or Exchange of Business Real Estate

(A) Criteria: Property used in a business activity and held for more than one year, such as barns, factory buildings, and office buildings.

(B) Example: Selling an office building that has been part of your business operations for over a year can lead to capital gains treatment, which is typically more favorable than ordinary income tax rates.

5. Sale of Unharvested Crops

(A) Criteria: Both the crops and the land must be sold or involuntarily converted, with the land held for more than one year. Growing crops sold with a leasehold on the land do not qualify.

(B) Example: If you sell a farm including unharvested crops and the land has been owned for over a year, this transaction qualifies for Section 1231 treatment.

Benefits of Section 1231 Treatment

The key advantage of Section 1231 treatment is the potential to convert what would typically be ordinary income into long-term capital gains, which are taxed at lower rates. Additionally, any net loss from Section 1231 transactions can be deducted as an ordinary loss, providing a valuable offset against other income.

A Qualifying Section 1231 Property

Once again, examples of Section 1231 property include:

(a) Buildings

(b) Depreciable business machinery and equipment

(c) Land

(d) Depletable natural resources (such as timber, coal, and domestic iron ore)

(e) Unharvested crops

(f) Livestock held for draft, breeding, or dairy purposes (excluding poultry)

The property must be held and used in a trade or business for more than one year.

Note on Market Livestock: Animals held for sale in the ordinary course of business are treated as regular inventory. However, once livestock is used for breeding, dairy, or draft purposes, it is considered a Section 1231 asset.

Real-World Examples

Example 1: Isaiah’s Goat Farm

Isaiah owns a small farm where he raises goats. In 2018, he sells a prized pedigree goat for $7,900, reporting the sale on Form 4797, “Sales of Business Property,” since it’s a Section 1231 asset held for breeding. Additionally, he sells 15 other goats from his herd, raised for sale and eventual slaughter, for a total of $3,750. These goats are considered inventory, so the sale is reported on Schedule F as ordinary income.

Example 2: Sports Town Hobbies

Sports Town Hobbies, a retail shop selling sports memorabilia, usually treats its inventory as noncapital assets. In 2018, the shop sells a piece of older display furniture, used for more than a year, for $1,000. The display furniture, being a depreciable asset, is classified as a Section 1231 asset. Thus, the sale is reported as a Section 1231 gain or loss, benefiting from favorable tax treatment.

Example 3: Shred-X Corporation

Shred-X Corporation purchased an industrial shredder for $10,000, which depreciated down to $1,000 by 2018. The shredder was sold for $700, resulting in a $300 loss. Since the shredder is a Section 1231 asset, this loss is treated as an ordinary loss, reported as such in their tax filings.

What is the Five-Year Lookback Rule for Sec 1231 transactions?

Generally, net gains on Section 1231 transactions are treated as long-term capital gains, benefiting from lower tax rates. However, if there have been net Section 1231 losses in the prior five years, these losses can recapture and reclassify current year gains as ordinary income. This “lookback rule” ensures that businesses don’t benefit from long-term capital gain treatment if they have previously claimed substantial ordinary losses.

Extended Example: Prairieland Dairy Farms, Inc.

To illustrate how the Five-Year Lookback Rule works, let’s consider Prairieland Dairy Farms, Inc.:

(A) 2018 Sale: Prairieland Dairy Farms sold farm machinery and reported $45,000 of Section 1231 gains.

(B) Prior Losses: In the five years preceding 2018, the corporation experienced net Section 1231 losses. Specifically, in 2015, the company had a $12,000 net Section 1231 loss from the sale of a farm building. This loss was deducted as an ordinary loss for that tax year.

Given that the $12,000 net Section 1231 loss in 2015 falls within the five-year lookback period before 2018, it impacts the gains reported in 2018. As a result:

(A) 2018 Tax Treatment: Out of the $45,000 Section 1231 gain in 2018, $12,000 will be treated as ordinary income under the Five-Year Lookback Rule. The remaining $33,000 will be classified as long-term capital gain.

Important Notes

(A) Full Recapture: Because all of the $12,000 net Section 1231 losses from 2015 were recaptured as ordinary income in 2018, none of these losses need to be considered in the lookback analysis for 2019 or 2020.

(B) Partial Recapture: If the 2015 net Section 1231 losses had been $60,000 instead of $12,000, only $45,000 would have been recharacterized in 2018, with the remaining $15,000 carried over to the 2019 lookback analysis.

Example #2

Using the same initial conditions but adjusting the 2015 losses to $60,000, here’s what happens:

(A) 2018 Impact: The entire $45,000 Section 1231 gain in 2018 would be recharacterized from long-term capital gain to ordinary income due to the higher prior losses.

(B) 2019 Impact: The remaining $15,000 of unrecovered 2015 losses would still influence the 2019 lookback analysis.

The Five-Year Lookback Rule for Section 1231 assets ensures that gains and losses are appropriately taxed, preventing businesses from disproportionately benefiting from long-term capital gain treatment when significant ordinary losses have been claimed in the recent past. By understanding and applying this rule, businesses can better manage their tax liabilities and ensure compliance with IRS regulations. 

Exclusions from Section 1231 Assets

1. Inventory: are Items held for sale in the normal course of business.

Example: Products on the shelves of a retail store.

2. Copyrighted Works

(a) Definition: Literary, musical, and artistic compositions held by their creator.

(b) Example: A novel held by its author or a song held by its composer.

3. Accounts Receivable: It refers to the money that customers owe a business for goods or services that have been provided.

Example: Invoices awaiting payment from clients.

4. U.S. Government Publications

Definition: Publications produced by the U.S. government.

Example: Official government reports or documents.

Special Note on Livestock

Poultry Exclusion

Definition: Only poultry is specifically excluded from being classified as a Section 1231 asset.

Reason: Poultry is typically short-lived (does not live longer than a year), which does not meet the holding period requirement for Section 1231 assets.