The Tax Treatment of a Section 1250 Loss
Understand the tax treatment when selling depreciable real property at a loss. A Section 1250 loss is governed by Section 1231, not recapture rules.
When a business disposes of depreciable real property, the resulting gain or loss has specific tax implications. A loss from the sale of this type of asset is known as a Section 1250 loss. While Internal Revenue Code Section 1250 is associated with rules for recapturing depreciation on gains, the tax treatment for losses follows a distinct pathway. The characterization of the loss ultimately determines how it can be deducted.
What Is Section 1250 Property
Section 1250 property is any real property that is subject to a depreciation allowance and is used in a trade or business. This category primarily includes buildings and their structural components. Common examples are office buildings, warehouses, factories, and residential rental properties. Essentially, if a building can be depreciated for tax purposes, it falls under this classification.
The primary exclusion is land, as it is not a depreciable asset. When a property consisting of a building and land is sold, only the building portion is considered Section 1250 property. For these rules to apply upon disposition, the property must have been held by the taxpayer for more than one year.
Calculating the Loss on Disposition
The calculation of a loss from the sale of business property begins with the formula: selling price minus the property’s adjusted basis. The selling price is the gross sale price reduced by any expenses incurred during the sale. These selling expenses include real estate commissions, legal fees, and other closing costs.
The adjusted basis starts with the original cost of the property, which is then increased by the cost of any capital improvements made during ownership. From this amount, the total accumulated depreciation that has been claimed over the holding period is subtracted. The resulting figure is the adjusted basis, which reflects the property’s value for tax purposes.
For example, consider a business that purchased a warehouse for $800,000. Over the years, it invested $100,000 in a new roof and other structural improvements, bringing the total cost to $900,000. During its ownership, the business claimed $250,000 in depreciation deductions. The adjusted basis is $650,000 ($900,000 minus $250,000).
If this warehouse is then sold for a gross price of $600,000, and the business incurs $30,000 in commissions and legal fees, the net selling price is $570,000. The loss on the disposition is calculated by subtracting the adjusted basis from the net selling price. In this case, $570,000 minus $650,000 results in an $80,000 loss on the sale.
Tax Treatment of a Section 1250 Loss
The tax treatment of a loss on Section 1250 property is different from the treatment of a gain. The depreciation recapture rules in Section 1250 apply to gains, not losses. When a loss occurs on property held for more than a year, the transaction falls under Section 1231 and is classified as a Section 1231 loss.
The tax treatment hinges on a process of netting all Section 1231 transactions for the year, sometimes called the “hotchpot” calculation. All of a taxpayer’s Section 1231 gains and losses from various asset sales during the tax year are combined. The outcome of this netting process determines the character of the gains and losses.
If the result of the Section 1231 hotchpot is a net loss, the outcome is favorable for the taxpayer. The net loss is treated as an ordinary loss, which is fully deductible against other forms of ordinary income, such as wages or business income, without the limitations that apply to capital losses. Conversely, if the netting results in a net gain, all the individual gains and losses are treated as long-term capital gains and losses.
A final consideration is the Section 1231 five-year “look-back” rule. This rule requires that if a taxpayer has a net Section 1231 gain in the current year, they must look back at the previous five tax years. If there were any non-recaptured net Section 1231 losses in that period, the current year’s net gain is recharacterized as ordinary income to the extent of those prior losses.
Reporting the Loss on Form 4797
The transaction must be correctly reported to the IRS on Form 4797, Sales of Business Property. This form is used to report the sale or exchange of property used in a trade or business.
The details of the sale are first entered in Part III of Form 4797. This is where the taxpayer provides a description of the property, the dates it was acquired and sold, the gross sales price, and the calculation of the adjusted basis and depreciation. The resulting loss is calculated on this part of the form.
From Part III, the calculated loss is then carried to Part I of Form 4797. Part I is where all Section 1231 gains and losses for the tax year are aggregated and netted to determine the overall net gain or loss.
If the netting process in Part I results in a net ordinary loss, this final amount is transferred from Form 4797 to the taxpayer’s main income tax return. For individual taxpayers, this means reporting the ordinary loss on Schedule 1 of Form 1040. This allows the loss to be deducted against other sources of income.