Once taxpayers determine the amount and character of gain or loss they recognize on each
§1231 asset they sell during the year, they still have work to do to determine whether the gains or losses will be treated as ordinary or capital. After recharacterizing §1231 gain as ordinary income under the §1245 and §291 (if applicable) depreciation recapture rules and the §1239 related-person rules, the remaining §1231 gains and losses are netted together.21 Recall that a portion of the §1231 gains may include unrecaptured §1250 gains that are taxed at a maximum of 25 percent. When netting the §1231 losses against §1231 gains,
LO 11-5
Yes
No Sale of Assets Used in a Business
Ordinary Gain
Loss Gainor loss?
Gainor loss?
deductibleNot Was the asset held
more than one year?
Realized gain Loss
Sold to a related person (as defined in §267)
Sold to a related person (as defined in §267)
Sold to a related person (as defined in §1239)
Personal property
Gain is ordinary income (§1245).
*This treatment assumes the asset was initially purchased by the taxpayer.
Excess of the amount realized over the initial basis is §1231 gain.
Remaining gain is ordinary income (§1245).
§1231 netting (see in Exhibit 11-8) propertyReal Individual or
C corporation?
No
No Personal or
real property?
Sold for more than initial basis?*
Yes
Yes
Yes No
No Yes
20% of lesser of (1) gain or (2) accumulated depreciation is ordinary Income (§291).
Remaining gain is
§1231.
Gain is §1231. But lesser of (1) gain or (2) accumulated depreciation is unrecaptured §1250 gain (25% maximum tax rate.)
Remaining gain is taxed at 0/15/20%.
Individual C corporation
Yes
Loss
Gain No
deductibleNot Ordinary
loss §1231
loss Ordinary
income (§1239)
Depreciable property to
buyer?
Amount realized Adjusted basis –
2
EXHIBIT 11-7
the losses first offset regular §1231 gains before offsetting unrecaptured §1250 gains. If the gains exceed the losses, the net gain becomes a long-term capital gain (a portion of which may be taxed at the maximum rate of 25 percent). If the losses exceed the gains, the net loss is treated as an ordinary loss.
A taxpayer could obtain significant tax benefits by discovering a way to have all §1231 gains treated as long-term capital gains and all §1231 losses treated as ordinary losses.
The annual netting process makes this task impossible for a particular year. However, a taxpayer who owns multiple §1231 assets could sell the §1231 loss assets at the end of year 1 and the §1231 gain assets at the beginning of year 2. The taxpayer could benefit
from this strategy in three ways: (1) accelerating losses into year 1, (2) deferring gains until year 2, and (3) characterizing the gains and losses due to the §1231 netting process.
The §1231 look-back rule prevents this strategy.
§1231 Look-Back Rule
The §1231 look-back rule is a nondepreciation recapture rule that applies in situations like the one we just described to turn what would otherwise be §1231 gain into ordinary income. That is, the rule affects the character but not the amount of gains on which a taxpayer is taxed. In general terms, the §1231 look-back rule is designed to require tax- payers who recognize net §1231 gains in the current year to recapture (recharacterize) current-year gains as ordinary to the extent the taxpayer deducted ordinary net §1231 losses in prior years. Without the look-back rule, taxpayers could carefully time the year in which the §1231 assets are sold to maximize the tax benefits.
In specific terms, the §1231 look-back rule indicates that when a taxpayer recognizes a net §1231 gain for a year, the taxpayer must “look-back” to the five-year period preceding the current tax year to determine whether, during that period, the taxpayer recognized any nonrecaptured net §1231 losses, which are losses that were deducted as ordinary losses that have not caused subsequent §1231 gains to be recharacterized as ordinary income. The taxpayer starts the process by looking back to the year five years prior to the beginning of the current year. If the taxpayer has recognized a net §1231 loss in that period and has not previously recaptured the loss (by causing a subsequent §1231 gain to be recharacterized as ordinary) in a subse- quent year (but prior to the current year), the taxpayer must recharacterize the current-year net §1231 gain as ordinary income to the extent of that prior-year nonre- captured net §1231 loss. If the current year net §1231 gain includes nonrecaptured
§1250 gains, the lookback rule requires that the unrecaptured §1250 gains are rechar- acterized as ordinary before other §1231 gains. The prior-year loss is then considered
“recaptured,” to the extent it caused the current-year gain to be treated as ordinary income.
If the current-year net §1231 gain exceeds the nonrecaptured net §1231 loss from the year five years prior, the taxpayer repeats the process for the year four years prior, and then three years prior, and so on. A prior year’s nonrecaptured net losses are not netted against the current year’s gains (they don’t offset the current-year gains); rather, they cause the taxpayer to recharacterize a net §1231 gain or a portion of that gain (that would otherwise be characterized as a long-term capital gain) as ordinary income.
THE KEY FACTS Netting and Look-Back
Rule
• §1231 gains and losses from individual asset dispo- sitions are annually netted together.
• Net §1231 gains may be recharacterized as ordinary income under the §1231 look-back rule.
What if: Suppose that Teton began business in year 1 and that it recognized a $7,000 net §1231 loss in year 1. Assume that the current year is year 6 and that Teton reports a net §1231 gain of $25,000 for the year. Teton did not recognize any §1231 gains or losses in years 2–5. For year 6, what would be the ultimate character of the $25,000 net §1231 gain?
Answer: $7,000 ordinary income and $18,000 long-term capital gain. Because it recognized a net
§1231 loss in year 1, it must recharacterize $7,000 of its net §1231 gain in year 6 as ordinary income.
The remaining $18,000 §1231 gain is taxed as long-term capital gain.
What if: Assume the same facts as above, except that Teton also recognized a $2,000 net §1231 loss in year 5. For year 6, what would be the ultimate character of the $25,000 net §1231 gain?
Answer: $9,000 ordinary income and $16,000 long-term capital gain. Note that the overall gain is still
$25,000, but to the extent of the $7,000 loss in year 1 and the $2,000 loss in year 5, the §1231 gain is recharacterized as ordinary income under the §1231 look-back rule.
Example 11-13
As we’ve mentioned before, ultimately, all of a taxpayer’s §1231 gains and losses must be characterized as ordinary or capital for purposes of determining the taxpayer’s tax liability. Exhibit 11-8 summarizes the process of characterizing §1231 gains and losses as ordinary or capital.
ETHICS
Emma Bean operates a yoga studio and wants to sell some of her business equipment and a piece of land that is used as a parking lot. She expects to realize a $10,000 loss on the equip- ment and a $15,000 gain on the land. Emma has talked to her accountant and has learned
about the look-back rule for §1231 property. To avoid any negative effects, she has decided to game the system and sell the land this year and then sell the equipment early next year. What do you think about her strategy to avoid the look- back rule?
EXHIBIT 11-8 §1231 Netting Process
§1231 Gain Property
Net §1231 Loss
Ordinary Income or Loss
Long-Term Capital Gain
Net §1231 Gain
§1231 Loss Property
Apply
Depreciation Recapture 1
Net Remaining §1231 Gain with §1231 Losses, if any
2
Apply §1231 Look-Back Rule 3
The following provides details on Steps 1–3 from Exhibit 11-8:
Step 1: Apply the depreciation recapture rules (and the §1239 recapture rules) to
§1231 assets sold at a gain (any recaptured amounts become ordinary).
Step 2: Net the remaining §1231 gains with the §1231 losses. The §1231 losses off- set regular §1231 gains before the unrecaptured §1250 gains. If the netting process yields a §1231 loss, the net §1231 loss becomes an ordinary loss.
Step 3: If the netting process produces a net §1231 gain, the taxpayer applies the
§1231 look-back rule to determine if any of the remaining §1231 gain should be recharacterized as ordinary gain. Under the lookback rule, the unrecap- tured §1250 gains will be recharacterized before the regular §1231 gains.
Any gain remaining after applying the look-back rule is treated as long-term capital gain (including unrecaptured §1250 gain). This gain is included in the capital gains netting process, which is discussed in the Investments chapter.