Business Capital Gains

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May 22, 2013

Business Capital Gains

backhoeBy DJ Berry

To understand how capital gains are treated from a business perspective, consider the three major code sections that deal with business capital gains-§1231 and its related cousins, §1245 & §1250.

§1231 deals with gains that are taxed at capital rates, and losses that are ordinary and offset ordinary income. §1231 is specifically listed as depreciable property used in a trade or business. So, in the discussion of §1231, one must realize it only applies to property used in a business and consequently sold for a gain or loss. As mentioned, the best aspect of §1231 property is the way it is treated. All §1231 gains and losses are combined together, into one big “pot.” If the result is a net gain, the gain is treated as capital gain (and taxed at favorable rates). If the result is a net loss, the losses are treated as ordinary losses which can be offset against ordinary income, such as wages on individual returns and sales on business returns.

§1245 property refers to fixed asset personal property, such as cars, machinery, etc. §1250 refers to real property, such as buildings. Both code sections relate strictly to depreciable property that is sold after being used in a trade or business, and the only time they are subject to depreciation recapture is when they are disposed of at a gain. If the property is sold for at a loss, the loss is generally going to be a §1231 loss.

Depreciation recapture can be confusing and difficult to understand. For real (§1250) property, recapture is generally only used if the property was not depreciated on the straight-line method. Since all real property acquired after 1986 is required to be on the straight-line method, it is rare that any building put into service after that date will have much in the way of recapture, unless the building was put into service and sold in the same year. It is important to note that depreciation recapture on §1250 property will be taxed at a maximum rate of 25% (unlike the general rule of capital gains being taxed at a maximum rate of 15%).

Personal property (§1245), on the other hand, deals with depreciation recapture on a more frequent basis. Still, the recapture for this section really only hinges on one fact: does the gain on the sale equal or exceed the depreciation taken during the life of the asset? In general terms, if the gain is equal to or less than the accumulated depreciation, the gain will be taxed as ordinary income. If the gain is more than the accumulated depreciation, the amount of accumulated depreciation will still be taxed as ordinary income, but the excess will be treated as §1231 gain and taxed at capital gain rates.

Considering the preferential treatment often associated with the business-related asset sections of §§1231, 1245 & 1250, it is easy to see why Congress has tweaked the manner in which assets are treated. In view of the fact that §1231 has been around since the beginning of World War II, taxpayers need to understand how these sections can affect their tax returns; the code sections are here to stay.

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