1231 Property - Application

Application

A taxpayer may net all 1231 gains and losses. Such gains and losses are often referred to as the hotchpot. If the result is a loss, then it is an ordinary loss. If the result is a gain, then the gains and losses will be treated as long term capital gains and losses. The caveat to this is that if the gain is less than any “non-recaptured losses” from the preceding 5 years, it is recharacterized as ordinary income. It gets reported on Form 4797.

“Non-recaptured loss” is covered by 1231(c). It refers to a situation when a taxpayer claims a 1231 loss in year one, but seeks a 1231 gain in any of years two through six. Any gain which is less than or equal to the loss in year one will be characterized as ordinary income, rather than long term capital gain (which has preferred tax rates). For example, A takes a $20,000 1231 loss in year one, and in year two takes a $10,000 1231 gain. All of the gain will be ordinary income. If in year three A takes another $25,000 1231 gain, $10,000 would be ordinary income (to “recapture” the remaining $10,000 in loss from year one) and $15,000 would be long term capital gain.

1231 gains and losses due to casualty or theft are set aside in what is often referred to as the firepot (tax). These gains and losses do not enter the hotchpot unless the gains exceed the losses. If the result is gain, both the gain and loss enter the hotchpot and are calculated with any other 1231 gains and losses. If there are more casualty losses than gains, the excess is treated as an ordinary loss. For example, B has a $50,000 casualty/involuntary conversion loss and a $100,000 gain from her trade or business. Without the firepot mechanism, which prevents the $50,000 loss from being included in the hotchpot, B would have to offset this $100,000 gain with the $50,000 loss. Ultimately, B would have a $50,000 1231 gain, taxed at capital gain rates. With the firepot mechanism, B has a $50,000 ordinary loss, which can be deducted from ordinary income, and a $100,000 capital gain, taxed at preferable rates. Depending on B's tax rate, this provision could lower B's tax burden by up to $10,000.