1250 Gain vs. 1231 Gain: What’s the Difference?

When selling property used for business or investment, the resulting gains are not treated the same as those from selling personal assets. The tax implications are governed by specific sections of the Internal Revenue Code that dictate how much tax will be owed on the profit.

Two concepts in this area are Section 1231 and Section 1250. These terms frequently appear when discussing the sale of business real estate or other depreciable assets. They work together to determine the character of the gain, which in turn determines the tax rate applied. A clear understanding of what each section covers is needed to navigate these rules.

Understanding Section 1231 Assets

Section 1231 of the U.S. Internal Revenue Code defines a category of property that includes real or depreciable business properties held for more than one year. Common examples include buildings, machinery, land, and equipment. Certain other assets like timber, coal, livestock, and unharvested crops can also qualify.

The asset must be owned for more than one year to receive Section 1231 treatment. Property held for one year or less is treated as an ordinary asset. Additionally, property held primarily for sale to customers, such as inventory, and intangible assets like copyrights are excluded from this classification.

The tax treatment of Section 1231 assets provides a unique advantage. When all Section 1231 transactions for the year result in a net gain, that gain is taxed at the lower long-term capital gains rates. Conversely, if the transactions result in a net loss, it is considered an ordinary loss, which is fully deductible against other forms of income without the limitations placed on capital losses. An ordinary loss is more valuable than a capital loss because it can offset higher-taxed income and is not subject to the annual $3,000 deduction limit for individuals.

Defining Section 1250 Gain

Section 1250 gain is a concept tied to the depreciation of real property. When you sell a depreciable real estate asset, such as an office building, for a profit, a portion of that gain may be classified as Section 1250 gain. This rule is a form of depreciation recapture, designed to “recapture” the tax benefit from depreciation deductions. The gain applies only to depreciable real property, not the land it sits on.

For most real property placed in service after 1986, the IRS mandates the use of the straight-line depreciation method. The portion of the gain attributable to the straight-line depreciation taken is categorized as “unrecaptured Section 1250 gain.” This type of gain is subject to a maximum federal income tax rate of 25%, which is higher than the top long-term capital gains rates of 15% or 20%.

This differs from Section 1245 recapture, which applies to personal property like equipment and machinery and recaptures all depreciation as ordinary income. Section 1250, in its modern application, primarily deals with the straight-line depreciation on real estate. Taxpayers use the Unrecaptured Section 1250 Gain Worksheet, found in the instructions for Schedule D (Capital Gains and Losses), to perform this calculation.

The Interaction and Calculation Process

To understand how these rules work together, consider an example of selling a commercial building. All calculations related to the sale of business property are reported on IRS Form 4797, Sales of Business Property.

First, the adjusted basis of the property must be determined. The adjusted basis is the original purchase price of the asset minus any accumulated depreciation. Imagine a business bought a warehouse for $500,000 and claimed $150,000 in straight-line depreciation. The adjusted basis would be $350,000 ($500,000 – $150,000).

Next, the total gain on the sale is calculated by subtracting the adjusted basis from the selling price. If the warehouse is sold for $600,000, the total gain is $250,000 ($600,000 – $350,000).

The third step is to identify the unrecaptured Section 1250 gain. This is the portion of the total gain attributable to depreciation, and it is the lesser of the total gain or the total accumulated depreciation. In this example, the unrecaptured Section 1250 gain is $150,000, the lesser of the $250,000 gain and $150,000 depreciation.

Finally, the remaining portion of the gain is classified as a Section 1231 gain. This is calculated by subtracting the unrecaptured Section 1250 gain from the total gain. Here, the remaining Section 1231 gain is $100,000 ($250,000 – $150,000).

The tax consequence is that the $250,000 total gain is split into two parts. The $150,000 of unrecaptured Section 1250 gain is taxed at a maximum rate of 25%. The remaining $100,000 of Section 1231 gain is taxed at the applicable long-term capital gains rate, which could be 0%, 15%, or 20%, depending on the taxpayer’s income.

The Section 1231 Look-Back Rule

After determining the amount of Section 1231 gain, a final test must be applied before it can be treated as a long-term capital gain. This is the Section 1231 look-back rule, as described in Internal Revenue Code Section 1231. This provision prevents taxpayers from strategically timing their sales to take losses as ordinary in one year and gains as capital in another. The rule requires a taxpayer with a net Section 1231 gain in the current year to “look back” over the previous five tax years.

The purpose of the look-back rule is to recharacterize current Section 1231 gains from capital to ordinary income, to the extent of any “non-recaptured” Section 1231 losses from that five-year period. A non-recaptured loss is a net Section 1231 loss that was deducted as an ordinary loss and has not yet been “paid back” by treating a subsequent gain as ordinary income. Any Section 1231 gain recharacterized under this rule is taxed at the taxpayer’s higher ordinary income tax rates.

For a practical illustration, assume a taxpayer has a net Section 1231 gain of $50,000 in the current year. To determine its character, the taxpayer must review their tax returns for the prior five years. If, two years ago, they had a net Section 1231 loss of $20,000 which they deducted as an ordinary loss, that loss must now be recaptured.

Under the look-back rule, the first $20,000 of the current year’s $50,000 gain is recharacterized as ordinary income. The remaining $30,000 of the gain retains its character as a Section 1231 long-term capital gain and is taxed at the lower capital gains rates. Once a prior year’s loss is fully recaptured, it does not affect the character of gains in future years. This rule ensures that the tax benefit of an ordinary Section 1231 loss is eventually offset before a taxpayer can take full advantage of a capital Section 1231 gain.