§1231 Netting, Recapture, and an Installment Sale
Quantrell is a sole proprietor who sold three assets in 2024. Asset A is a warehouse used in his business since 2010. He bought the building for $360,000 and the land for $90,000, claimed $180,000 of straight-line depreciation on the building, and sold the property for $620,000, allocated $520,000 to the building and $100,000 to the land. Asset B is a packaging machine bought for $150,000; Quantrell claimed $130,000 of depreciation and sold it for $85,000. Asset C is 40 acres of investment land bought for $40,000 and sold in 2024 for $75,000: $15,000 cash at closing and a $60,000 note payable in four equal annual installments of $15,000 plus market-rate interest, beginning in 2025. Quantrell had no other property sales in 2024 and no capital loss carryforwards. His taxable income before these transactions is $280,000, all ordinary. He is single and files Form 1040 with Schedule C and Schedule D.
1. Compute the amount and character of gain on each asset, including any depreciation recapture.
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Asset A building: amount realized $520,000; adjusted basis $360,000 - $180,000 = $180,000; realized gain $340,000. Because the depreciation was straight-line, there is no ordinary §1250 recapture. The $180,000 of depreciation is unrecaptured §1250 gain, taxed at a maximum 25% rate. The remaining $160,000 is §1231 gain. Asset A land: $100,000 - $90,000 = $10,000 §1231 gain. Total Asset A §1231 gain is $350,000, of which $180,000 is unrecaptured §1250 gain.
Asset B: $85,000 - $20,000 = $65,000 gain. Section 1245 recaptures the lesser of gain ($65,000) or depreciation ($130,000), so the entire $65,000 is ordinary income; no §1231 gain remains.
Asset C: $75,000 - $40,000 = $35,000 capital gain. It is investment land, a capital asset, not §1231 property. Under the installment method, gross profit ratio is $35,000/$75,000 = 46.667%; 2024 gain is $15,000 × 46.667% = $7,000 long-term capital gain.
2. How does the §1231 netting work, and what rates apply to the resulting gains?
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Section 1231 nets all gains and losses from sales of property used in a trade or business held more than one year. The building and land produce $350,000 of §1231 gain. The machine's $65,000 is excluded from §1231 netting because §1245 recharacterizes it as ordinary income first. With no §1231 losses, the net §1231 gain is $350,000 and is treated as long-term capital gain. But the character within that gain matters: $180,000 is unrecaptured §1250 gain taxed at a maximum 25%; the remaining $170,000 is adjusted net capital gain taxed at 0%, 15%, or 20%. With $280,000 of ordinary taxable income, the 20% rate likely applies to the $170,000, while the $180,000 is capped at 25%. Add the $7,000 installment gain from Asset C, for total net capital gain of $357,000. If there had been a net §1231 loss, it would be ordinary, and §1231(c) would recapture prior nonrecaptured §1231 losses as ordinary income.
3. How does the installment sale of Asset C affect 2024 and later years, and what if Quantrell had instead sold it for $75,000 cash?
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Section 453 requires the installment method for a sale with at least one payment after the year of sale unless the taxpayer elects out under §453(d). The $60,000 note is not payment; the $15,000 cash is. Gross profit is $35,000; contract price is $75,000; gross profit ratio is 46.667%. 2024 recognizes $7,000; each of the four $15,000 payments in 2025-2028 recognizes $7,000, for total $35,000. Interest is ordinary income. If Quantrell had sold for $75,000 cash, the entire $35,000 would be recognized in 2024 as long-term capital gain. If the sale had involved §1250 property, §453(i) would require the depreciation recapture to be recognized in the year of sale rather than deferred; that rule does not apply to this land. The installment method is mandatory unless Quantrell elects out by the due date, including extensions, of the 2024 return.