Business assets are not capital assets but the sale my result in long-term capital gain if the asset has been held for more than one year. Under Code Section 1231, the net gain from sale of all Section 1231 assets is long-term capital gain, but there are two are two exceptions for depreciable property. (1) For personal property, under Section 1245, gain is ordinary income to the extent of any depreciation allowed or allowable (depreciation recapture). Allowable means that if the taxpayer could have taken depreciation on the asset but did not do so, then this amount must reduce the basis of the asset and is considered as ordinary income when the property is sold for a gain. (2) Under Section 1250, real property depreciated under an accelerated method is also treated as ordinary income. The amount of recapture depends on when the asset was placed in service and what depreciation method (ACRS or pre ACRS) was used. These areas will be discussed in more detail below. If the net of all Section 1231 transactions is a loss, it is treated as an ordinary loss. Unlike capital losses, there is no limitation on the amount of ordinary loss that can be deductible.
Prior year net Section 1231 losses are recaptured in future years as ordinary income (see discussion and example below). Gains on sales of depreciable or amortizable property sold to Arelated@ parties, is ordinary, regardless of the type of asset, depreciation method, or how long it was held [TC Memo. 2013-270]. Sales of business assets is reported on Form 4797. The remainder of this article will discuss sales of assets and the interaction of Sections 1245, 1250, and 1231 and provide an illustration of completing Form 4797 and recapture of Section 1231 losses.
Since land is not depreciable, recapture does not apply. If the land was held for more than one year, any gain or loss is Section 1231. If it is held one year or less, the gain or loss is ordinary.
Non-Residential Buildings (Section 1250)
The depreciation method allowed depends on when the asset was placed in service. Any gain subject to depreciation recapture depends on the method used and whether the taxpayer is an individual or a corporation.
For buildings placed in service after 1986, MACRS straight line depreciation was required to be used. If it was held for more than one year and sold for a gain or loss, there is no depreciation recapture and all the gain or loss is Section 1231. If it is held one year or less, the gain or loss is ordinary.
For buildings placed in service before 1987 and after 1980, ACRS (accelerated cost recovery system) was allowed over 35 years but an election could be made to use straight line over 35 or 45 years. Under Section 1250, all gain on the sale of property depreciated using ACRS is treated as ordinary income. If straight line depreciation was used, there is no recapture and all the gain is Section 1231. If held one year or less, the gain or loss is ordinary.
For buildings placed in service before 1980, the depreciation methods used were the same as used for book purpose (straight line and declining balance-accelerated). The life used was based on the IRS asset depreciation guidelines. If the asset was sold for a gain and accelerated depreciation was used, the excess of accelerated depreciation over what straight line would have been is ordinary income under Section 1250. The remaining gain is Section 1231. If straight line depreciation was used, all the gain is Section 1231. If held more than one year, any loss is Section 1231. If held one year or less, the gain or loss is ordinary.
The rules regarding depreciation and the character of the gain on sale of buildings is the same as individuals except for depreciation recapture for straight-line depreciation under Section 291. This amount is 20% of the excess, if any, of the amount that would be treated as ordinary income if such property were Sec 1245 property over the amount treated as ordinary income under Section 1250 (this applies only to buildings in service before 1987). Any remaining gain after depreciation recapture is Section 1231. If held more than one year, any loss is Section 1231. If held one year or less, the gain or loss is ordinary.
Personal Property (Section 1245)
Examples of personal property are machinery, equipment, personal computers, trucks, autos, and furniture. If these assets are sold the treatment of the gain or loss depends on how long they were held., depreciation allowed or allowable, and whether i9t was sold for a gain or loss. If the assets were held one year or less, all the gain or loss is ordinary. If the assets were held for more than one year, under Section 1245, the gain is treated as ordinary income to the extent of any depreciation allowed or allowable (depreciation recapture). Any remaining gain is 1231. A loss will be Section 1231.
Illustration of Sale of Corporation Business Assets
Millenium Gadgets Manufacturing Corp. sold the following assets during 2013. Sect 179 expensing and additional first year depreciation was not elected for personal property.
Gains and losses on sale of above assets:
(1) Non depreciable held more than one year. All the gain or loss is Section 1231.
(2) All the gain is ordinary income. Under Sect.1245, the lesser of the depreciation allowed or allowable or the gain is ordinary income.
(3) The gain will be treated as follows:
Total gain 187,500
Less Sect 1245 depreciation recapture (ordinary income) 112,500
Sect 1231 Gain = 75,000
(4 ) Total gain 363,250
Sect. 291 depreciation recapture (20% of deprec) 17,750
Sect 1231 gain = 345,500
(5) 100% of loss is ordinary because it was held one year or less
Asset sales are reported on form 4797 and Schedule D (for the long-term capital gain from Section 1231). See completed forms for this illustration in my tax library on TaxConnections.com.
Explanation of Form 4797 Illustration
Part 1 Section 1231
The parcels of land are entered in this section and were the only Section 1231 assets sold. The net gain from both parcels is $30,500. Line 6 is the $420,500 Section 1231gain from sale of the truck, machinery, and building (from part 111, line 32). This is combined with the net gain from the land giving a total Section 1231 gain. of $450,500 entered on lines 7 and 9. This amount is long-term capital gain and is entered on line 11 of Schedule D. The net long-term capital gain from Schedule D is entered on form 1120, line 8.
Part II Ordinary Income
The computer is listed in this section because it was held one year or less. [Note: I wrote this information because the tax program did not have the final version of form 4797 and I could not type the information on the form). On line 13, the $157,738 depreciation recapture from sale of the Section 1245 and 1250 assets is entered (from Part III, line 31). Total ordinary income is $154,163 (line 17, part II) and is entered on Form 1120, Line 9.
Part III Sale of Section 1245 and 1250 property
The name, purchase date, and date sold is entered on lines A, B, and C. On lines 20-24, columns A, B, and C the sales price, cost, depreciation allowed or allowable, adjusted basis, and gain is entered. Line 25(a) is the depreciation allowed or allowable, and line 25(b) is the lesser of the gain or depreciation recaptured.
Line 26, column C, is used for the building (Section 1250). Since the building was depreciated using straight-line, there is no additional depreciation; thus, lines 26(a) and (b) are not applicable, so the gain is then entered on line 8. Line 26(d) and (e) are also not applicable because there is no additional depreciation. The $17,750 on lines (e) and (f) is the depreciation recapture under Section 291 for corporations.
Summary of Part III Gains
Line 30 is the total gain from the sale of all assets in Part 111. Line 31 represents the depreciation recapture on the Section 1245 and 1250 assets (from lines 26(g).
This is entered in Part 11 on line 13. Line 32 is the remaining gain treated as Section 1231 which is entered in Part 1 on line 6.
Recapture of Net Section 1231 Prior Years Losses
Net Section 1231 l losses deducted against ordinary income for the five prior years that have not yet been applied against any net Section 1231gain will be treated as ordinary income to the extent of future net Section gains.
Example. A taxpayer had net Section 1231 gains (losses) as follows:
The result is as follows:
@@ In 2013, there is sufficient net 1231 gain to offset the remaining unrecaptured loss
## reported on Form 4797 Part 1I, line 12.
** reported on Form 4797 Part 1, line 8
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