Section 1231 Property
Congress has provided capital gain relief for certain long-lived business assets. The rationale for this treatment is that long-lived assets sold at a gain have characteristics common to capital assets and deserve the same treatment in order to negate inflationary gains and to promote capital investment in long-lived business assets. The assets accorded this special relief are referred to a Section 1231 property. The basic intention of Section 1231 is to provide long-term capital gain status to net Section 1231 gains for a tax year while preserving the ordinary loss deductions for years in which a business has net Section 1231 losses. So this provision is providing both preferential capital gains treatment for net gains and ordinary loss deductions for net losses.
Definition of Section 1231 Property - Assets eligible for the preferential treatment under Section 1231 include:
- Depreciable or real property used in a trade or business that is held for more than one year.
- Timber, coal, and domestic iron ore.
- Cattle and horses held for draft, breeding, dairy and sporting purposes that are held for 24 months or more.
- Other livestock held for draft, breeding, dairy, and sporting purposes that are held for 12 months or more.
- Unharvested crops.
The assets qualifying for Section 1231 treatment must be held for more than 1 year, consistent with the holding period requirement for long-term capital gains. Assets that are held one year or less are never given Section 1231 treatment and always produce ordinary income.
Section 1231 Netting Procedure - As with capital gains and losses, the tax treatment accorded Section 1231 property applies to the net gains or losses on all Section 1231 transactions occurring during the tax year. The netting procedure involves two separate netting's of transactions occurring during the current tax year and a separate netting of any net Section 1231 gains in the current year against net 1231 loss deductions taken during the previous five years.
Step 1: The first step is to net together all casualty gains and losses on Section 1231 property to produce a single net casualty gain or loss for the year.
If the result of the first netting is a loss, all casualty gains and losses for the year are considered ordinary losses. This results in a net ordinary casualty loss deduction for the year. If the result of the first netting is a gain, the net casualty gain is carried into the second netting (step 2).
Step 2: In the second netting, all other Section 1231 gains and losses occurring during the year are netted together with any net casualty gain from the first netting. As in the first netting, if the result of the second netting is a loss, all gains and loses for the year are considered ordinary. This results in a net ordinary loss deduction for Section 1231 transactions for the year.
Step 3: When the second netting results in a gain another netting must be done. This netting is required by the "lookback recapture rule", which nets the current-year net Section 1231 gain against any Section 1231 ordinary loss deductions taken in the previous five years. Any current-year net Section 1231 gain in excess of ordinary losses deducted in the previous five years is treated as long-term capital gain. After applying the lookback rule's netting, the Section 1231 gain is added to other long-term capital gains and combined with other capital gains and losses in the capital gain-and-loss netting. Once ordinary Section 1231 loss deductions have been recaptured as ordinary income, they do not have to be recaptured again.