Question

If your company has a qualified Sec. 1231 asset held one year or less, will you be able to treat net gains from the sale of such business property as capital gains and net losses as ordinary losses? If there are any exceptions, please explain your position.

Answer 1

Many Taxpayers are unaware of the tax consequences that can potentially apply to the sale of business property. It's not as simple as just selling an asset. You can think of selling business property as having many different layers. Each of these different layers can potentially be taxed at different tax rates and be treated differently on a Taxpayer's tax return.

When you sell a business asset you can potentially have different types of gains and losses, even within the same transaction. The gains and losses can be: short term capital gains, short term capital losses, long term capital gains, long term capital losses, section 1245 depreciation recapture, section 1250 depreciation recapture, unrecaptured 1250 gain, and 28% gain (relating to the sale of certain collectibles). Each of these categories of gains and losses are treated differently and taxed at different rates.

When determining what character of gain you will have when you sell a business asset it is first important to determine what kind of asset you are selling and also what type of entity the asset is being held in. The three categories of assets that are most commonly sold are (1) Section 1231 property, (2) Section 1245 property, and (3) Section 1250 property. If the asset that is sold is being held in a C-Corporation the gain is taxed at ordinary tax rates despite what kind of property the asset is. If the asset that is being sold is held in an entity other than a C-Corporation then you can potentially have different layers of gain, depending on the type of asset that is sold.

Section 1231 property are assets that are used in your trade or business and are held by the Taxpayer for more than one year. A gain on the sale of Section 1231 business property is treated as long-term capital gain and is taxed at a maximum rate of 15%, at least through December 31, 2012. A loss on the sale of Section 1231 business property is treated as ordinary loss and can reduce ordinary income on the Taxpayer's return and is not subject to the capital loss limitations ($3,000 limitation for individuals or capital gain limitation for corporations).   However there is a Section 1231 recapture rule that if you sell business property at a gain and you have deducted ordinary losses due to the sale of Section 1231 property in that past five years then the Section 1231 gain that you recognize will be taxed as ordinary income, using the Taxpayer's ordinary income rate, and not the preferential 15% maximum capital gain rate.

Section 1245 property is (1) all depreciable personal property, whether tangible or intangible, and (2) certain depreciable real property (usually, real property that performs specific functions, for example, a storage tank, but not buildings or structural components of building). If you sell Section 1245 property, you must recapture your gain as ordinary income to the extent of your earlier depreciation deductions on the asset that was sold. Any gain up to the amount of the previously taken depreciation will be taxed at ordinary income rates. The amount of gain that exceeds the depreciation previously taken is then treated as Section 1231 gain (subject to the Section 1231 rules mentioned above). The Section 1245 recapture rules do not apply if the asset is sold at a loss. If a section 1245 asset is sold at a loss, the loss is treated as a Section 1231 loss and is deducted as an ordinary loss which can reduce ordinary income.

Section 1250 property consists of real property that is not Section 1245 property (as defined above), generally buildings and their structural components. When you sell Section 1250 property you will have to be aware of possible Section 1250 depreciation recapture as well as "unrecaptured Section 1250 gain". If you sell Section 1250 property that is placed in service after 1986, none of the long-term capital gain attributable to depreciation deductions will be subject to Section 1250 depreciation recapture. If you depreciated nonresidential real property which was placed in service before 1987 and you depreciated the property placed in service using just straight-line depreciation, there would be no Section 1250 depreciation recapture. However, if at any time an accelerated depreciation method was used, the gain on the sale will be taxed as ordinary income to the extent that the amount of accelerated depreciation taken exceeded depreciation that would have been allowed if you used the straight line depreciation method. This Section 1250 depreciation recapture is taxed at ordinary income rates.

Any gain in excess of the amount treated as ordinary income because of Section 1250 recapture, but not exceeding the total depreciation claimed, is "unrecaptured Section 1250 gain".   Unrecaptured Section 1250 gain will be taxed at a maximum rate of 25%.  

Any remaining gain in excess of both the Section 1250 depreciation recapture and unrecaptured Section 1250 gains will be treated as Section 1231 gain (long term capital gain), which will be taxed at a maximum rate of 15%, through December 31, 2012. The sale of Section 1250 property at a loss produces a Section 1231 loss and is deducted as ordinary loss which can reduce ordinary income. The Section 1250 recapture provisions only apply to gains, not losses.

As I'm sure you can see it is not as simple as just selling a business asset. Every sale of business assets can have many possible tax treatments, producing various tax results. The tax treatment of the sale of business assets can be quite complex and if you are unsure of the possible tax consequences you should contact your Dermody, Burke, and Brown tax advisor to explain how the sale should be treated.