Capital Gains and Losses, Section 1231, and Depreciation Recapture
Capital asset treatment
IRC §1221 defines a capital asset as property held by the taxpayer, excluding inventory, depreciable business property, real property used in a trade or business, and certain self-created intangibles. Capital gains and losses are classified by holding period: short-term if held one year or less, long-term if held more than one year. Net capital losses are deductible against ordinary income only up to $3,000 ($1,500 married filing separately); excess carries forward indefinitely. Capital losses cannot offset ordinary income beyond the limit.
§1231 and recapture
Section 1231 property includes depreciable property and real property used in a trade or business and held more than one year. Net §1231 gains are treated as long-term capital gains; net §1231 losses are ordinary. The §1231 lookback recaptures net gains as ordinary to the extent of nonrecaptured §1231 losses in the prior five years.
Depreciation recapture overrides §1231:
- §1245 recaptures ordinary income on personal property to the extent of depreciation, limited to gain.
- §1250 recaptures additional depreciation on real property; for post-1986 straight-line property, unrecaptured §1250 gain is taxed at 25%, with the remainder §1231.
- §291 applies a 20% recapture rule to corporations.
Worked example
A machine costs $100,000, has $60,000 of depreciation, and is sold for $90,000. Realized gain is $50,000. Section 1245 recaptures the lesser of depreciation ($60,000) or gain ($50,000), so the entire $50,000 is ordinary income; no §1231 gain remains. If the sale price were $170,000, gain would be $130,000: $60,000 ordinary under §1245 and $70,000 §1231 gain.
Traps
- Treating a net §1231 loss as capital.
- Applying §1231 before recapture.
- Missing the five-year lookback for prior §1231 losses.
- Using the wrong holding period for capital assets.
- Forgetting the $3,000 capital loss limit and carryforward.
- Treating inventory or self-created goodwill as a capital asset.