1231 Property - Impact

Impact

Section 1231 allows businesses to get the "best of both worlds" in regards to the tax treatment of property that falls within the section. It allows the taxpayer to have capital gains treatment if they realize a gain on Section 1231 property, but at the same time allows the taxpayer to treat any loss on such property as ordinary loss.

Section 1231 treatment allows taxpayers to enjoy tax favored treatment for 1231 property gains that are greater than losses on such property. This means that if the asset could be sold for a value greater than its basis then it would be taxed at a capital gains rate which is lower than an ordinary income rate. However, if the 1231 property resulted in a loss, then the taxpayer can treat it as an ordinary loss and such a loss may reduce the taxpayer's taxable income.

The reason Section 1231 is said to give a taxpayer the "best of both worlds" is that it allows the favorable capital gains tax rate on section 1231 property, while avoiding the negative implications of capital loss treatment. Ordinary losses are 100% deductible while capital losses are subject to an annual deduction limitation of $3,000. So, if capital losses exceed capital gains by more than $3,000 in any given tax year, only a maximum of $3,000 may be deducted; the excess loss over $3,000 must be carried over to the following year.

For example, assume in YEAR 1 a taxpayer has a capital gain of $2,000 and a capital loss of $6,000. The $2,000 gain will be wiped out by the $6,000 loss. Since the $6,000 loss exceeds the $2,000 gain by $4,000, only $3,000 of the $4,000 excess loss may be deducted in YEAR 1. The remaining $1,000 must be carried over to YEAR 2. The loss retains its character as short-term or long-term when it is carried over.

C corporations are not allowed to deduct capital losses against ordinary income. C corporations must deduct capital losses against capital gains. If capital losses exceed capital gains in any given tax year, the excess loss may be carried back three years and carried forward five years where it is offset against capital gains of those years. When carrying a C corporation's capital loss back or forward, the loss does not retain its character as short-term or long-term. In other words, the loss is treated as a short-term capital loss even if it was originally a long-term capital loss.

It is important to remember that Section 1231 does not reclassify property as a capital asset. What it does is even better, allowing the taxpayer to treat net gains on 1231 property as capital gains but to treat net losses on such property as ordinary losses. However, there are important limitations.

Congress has decided not to let this "best of both worlds" treatment give taxpayers undesired benefits beyond its purpose. This treatment would compel a taxpayer to sell a §1231 loss asset at the end of a year to get an ordinary loss and hold a §1231 gain until the next taxable year to receive capital gains treatment. In order to control this undesired result, Congress included 1231(c).

This is one of controversial topics in U.S. taxation. Care should be exercised to make calculations Under 1231(c), the 1231 gain that was deferred until the second year in the example above will be recharacterized as ordinary income. This is done because the taxpayer has already received the benefit of having the loss in year one treated as an ordinary loss. Thus, if the 1231 gain is disposed of after year one, but before what becomes the seventh year under 1231(c)(2)(A), it will receive ordinary income treatment. If held onto and disposed of after the seventh year, it may be treated as a capital gain.