What Is Section 1231 Gain?

What Is Section 1231 Gain?

Section 1231 property is a type of property, defined by section 1231 of the U.S. Internal Revenue Code. Section 1231 property is real or depreciable business property held for more than one year.

A section 1231 gain from the sale of a property is taxed at the lower capital gains tax rate versus the rate for ordinary income. If the sold property was held for less than one year, the 1231 gain does not apply.

Examples of section 1231 properties include buildings, machinery, land, timber, and other natural resources, unharvested crops, cattle, livestock, and leaseholds that are at least one year old. However, section 1231 property does not include poultry and certain other animals, patents, inventions, and inventory–such as goods held for sale to customers.

Key Takeaways

  • Section 1231 property is a type of property, defined by section 1231 of the U.S. Internal Revenue Code.
  • Section 1231 property is real or depreciable business property held for more than one year.
  • A section 1231 gain from the sale of a property is taxed at the lower capital gains tax rate versus the rate for ordinary income.
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Section 1231 Property

Understanding Section 1231 Gain

Broadly speaking, if gains on property fitting Section 1231's definition are more than the adjusted basis and amount of depreciation, the income is counted as capital gains, and as a result, it is taxed at a lower rate than ordinary income.

However, when losses are recorded on section 1231 property whereby the loss is classified as an ordinary loss, it's 100% deductible against their income. Ordinarily, if income was qualified as capital gains, so would any losses, which can only be deductible up to $3,000 for the tax year, and any losses in excess of that figure would be arrived at in the following year. The section 1231 law makes it, so taxpayers and business owners get the best of both worlds.

Types of Section 1231 Transactions

The following are considered 1231 transactions under IRS regulations

  • Casualties and thefts – If you have held a property for more than one year and it is adversely affected by theft or casualty (loss or damage from an unexpected or rare event).
  • Condemnations – If a property was held for more than a year, and held as a capital asset relating to trade or business.
  • Sale or exchange of real property, personal property that is depreciable – If the property was held for more than a year and was used in trade or in a business (usually generating revenue via rent or royalties). 
  • Leaseholds either sold or exchanged – If held for a year and used in trade or business.
  • Cattle and horses sold or exchanged – If held for two years and used for dairy, draft, breeding, or sporting purposes.
  • Unharvested crops sold or exchanged – If held for one year and then sold, exchanged, or converted involuntarily and then not reacquired through any means. 
  • Disposal or Cutting of timber, coal, or iron ore – If treated as a sale. 

Section 1231 property is related to section 1245 property and section 1250 property. Section 1231 defines the tax treatment that the gains and losses of property fitting the definitions of sections 1245 and 1250 on form 4797.

Section 1231 vs. Section 1245 Property

Section 1245 property cannot include buildings or structural components unless the structure is designed specifically to handle the stresses and demands of a specific use, and can’t be used for any other use, in which case it can be considered closely related to the property it houses. Section 1245 property is any asset that is depreciable or subject to amortization and meets any of the following descriptions in Publication 544 (2018), Sales and Other Dispositions of Assets:

  • Personal property - Generally defined as property other than real estate
  • Other tangible property - This would include machinery or facility that play a key role in production, extraction, or furnishing of services, as well as certain research facilities, or a facility for the bulk storage of fungible commodities. This does not include buildings that are included as storage for equipment but would conceivably include a facility that stored goods temporarily before they were packaged and moved.
  • Single-purpose structures built for the sole purpose of agricultural or horticultural use - This does not include a barn but would include silos or grain storage bins.
  • Facilities used to store and distribute petroleum or primary products of petroleum except for buildings and those buildings structural components.

Tax Treatment on Section 1245 Property Gains

If the sale of section 1245 property is less than the depreciation or amortization on the property, or if the gains on the disposition of the property are less than the original cost, gains are recorded as normal income and are taxed as such. If the gain on the disposition of the section 1245 property is greater than that original cost, then those gains are taxed as capital gains.

If the section 1245 property was acquired through a like-kind exchange, the amounts you claimed on the property you used in the exchange are included in the depreciation or amortization amount, as would be the amounts a previous owner of section 1245 property claimed if the adjusted basis was used as a reference to your own.

Section 1250 Property

The IRS defines section 1250 property as all real property, such as land and buildings, that are subject to allowance for depreciation, as well as a leasehold of land or section 1250 property.

Tax Treatment on Section 1250 Property Gains

Much like with section 1245 property, gains on section 1250 property qualify as ordinary income if they are less than or equal to the amount the property has depreciated, and the gains exceed the depreciation then the income is treated as capital gains. During the year of the sale, depreciation recapture is taxable as ordinary income if the sale of the property is executed in an installment method. 

While section 1231 was introduced in the 1954 IRS Code, the content of the tax code referring to gains received upon deposition of depreciable and real property was introduced in 1939 in section 117(j).

Section 1231 Gains and Capital Gains

The IRS handles the taxation of a section 1231 gain as a "regular" capital gain when there is income, but not when there is a loss. Capital gains tax is a tax on the profit when you sell something that’s increased in value. It’s the gain you make that’s taxed, not the amount of money you receive.

Example of Section 1231 Property

Let's say a building is bought at $2 million and then has another $2 million put into it in the form of refurbishment (updating A/C units, windows, and a new roof) with an amortization rate of 50% over 10 years. So, let's say then that 10 years after the building had $2 million put into it, it is sold at a price of $6 million. The recorded gains on that sale would be $4 million, not $2 because the cost of refurbishment would be capitalized on the books. That $4 million sale would be taxed as capital gains because the property was sold for more than the amount that it had depreciated.

Where Does Section 1231 Gain Get Reported?

IRS Form 4797, Sales of Business Property, is used to report the section 1231 gains on a sold property.

What Is the Difference Between 1231 and 1250 Property?

Section 1231 applies to all depreciable business assets owned for more than one year, while section 1250 (and also 1245) provides guidance on how different asset categories are taxed when sold at a gain or loss. All property used in a trade or business is considered section 1231 property and, for taxation purposes, either section 1245 or 1250 applies, depending on the property’s characteristics.

What Is the Difference Between 1231 Gain and Capital Gain?

When it comes to taxation there is no difference under certain circumstances. if gains on property fitting Section 1231's definition are more than the adjusted basis and amount of depreciation, the income is counted as capital gains, and as a result, it is taxed at a lower rate than ordinary income.

The Bottom Line

Section 1231 gains are gains from depreciable property and real property used in a business and held for more than one year. Such gains are considered "tax-friendly" as they have traditionally enjoyed a favored status in the tax code. Net Section 1231 gains for the taxable year are treated as long-term capital gains, but a net Section 1231 loss is considered an ordinary loss.

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  1. TaxAudit. "What is the difference between 1245, 1231, and 1250 properties?"