Understanding Gains from the Sale of Property Used in Trade or Business

When selling property used in a trade or business, taxpayers must navigate the complex rules surrounding capital gains and losses. The IRS classifies such sales under IRC Sec. 1231, offering unique tax benefits. However, recharacterization rules under Sections 1245 and 1250 can impact how the gains are taxed.  

Key Takeaways  

• Selling property used in trade or business may result in capital gains or losses under Sec. 1231 rules   
• Net Section 1231 gains benefit from long-term capital gain tax rates, while net Section 1231 losses are treated as ordinary losses, offering better tax advantages 
• Certain tax rules recharacterize Section 1231 gains into Section 1245 or Section 1250 gains, altering how they are taxed 
• Understanding these tax classifications can help business owners and investors optimize their tax planning  

Tax Advantages and Recharacterization of Section 1231 Gains  

Taxpayers get the best of both worlds when they sell Section 1231 assets. A sale of Sec. 1231 property (a capital asset used for business) can result in either a capital gain or a capital loss, depending on whether the selling price exceeds the asset’s adjusted tax basis. Taxpayers benefit in two ways:  

• Net Section 1231 gains qualify for favorable long-term capital gain tax rates 
• Net Section 1231 losses are treated as ordinary losses, reducing taxable income more effectively than capital losses  

However, as is often the case with tax law, there are some provisions of the tax code that require recharacterization of a Sec. 1231 gain into a Sec. 1245 or Sec. 1250, altering these benefits.  

Section 1245: Recharacterizing Personal Property Gains

Section 1245 applies to personal property (business equipment, machinery, etc.) that is subject to depreciation. If a taxpayer sells a Sec. 1231 asset that is classified as personal property/Sec. 1245, a portion (or all) of the gain may be recharacterized as ordinary income.  

The amount of the gain treated as ordinary income is the lesser of:  

• The total gain realized or  
• The amount of depreciation allowed or allowable with respect to such property 

Section 1250: Real Property and Depreciation Recapture  

Section 1250 property includes real estate (buildings, structures) subject to depreciation. For pre-1987 real property, 1250 recapture requires that accelerated depreciation exceeding straight-line depreciation be taxed as ordinary income.  

More commonly, sellers encounter unrecaptured Sec. 1250 gain, where the portion of gain attributable to depreciation is taxed at a maximum rate of 25%, instead of the lower long-term capital gain rate.  

Section 1231(c): Recapturing Previous Losses  

The Sec. 1231(c) recapture rule states that if a taxpayer had net Section 1231 losses in the past five taxable years, then current-year gains must be treated as ordinary income – offsetting previous deductions.

Tax Planning Strategies for Minimizing Capital Gains on Property Sales  

There are tax planning opportunities that taxpayers can undertake to minimize tax liabilities on capital gains, but it requires working closely with tax advisors during the year to formulate and execute strategies in a tax efficient manner.  

These tax planning strategies include:  

• Timing asset sales to optimize tax rates 
• Managing depreciation deductions strategically  
• Leveraging like-kind exchanges for deferral benefits  

By understanding Sec. 1231, Sec. 1245, and Sec. 1250, real estate owners can navigate property sales more efficiently and maximize their tax benefits.  

Get Personalized Tax Guidance  

At EisnerAmper, our experienced real estate tax professionals help businesses and investors implement strategic tax planning that aligns with their financial goals. Connect with our team using the form below to explore tax strategies and get specialized insights into your specific situation.