44.8 Property Used in a Business (Section 1231 Assets)

Form 4797 is used to report the sale or exchange of Section 1231 assets. The following properties used in a business are considered “Section 1231 assets”:

• Depreciable assets such as buildings, machinery, and other equipment held more than one year. Depreciable rental property and royalty property fits in this category if held more than one year.
• Land (including growing crops and water rights underlying farmland) held more than one year.
• Timber, coal, or domestic iron ore subject to special capital gain treatment.
• Leaseholds held more than one year.
• An unharvested crop on farmlands, if the crop and land are sold, exchanged, or involuntarily converted at the same time and to the same person and the land has been held more than one year. Such property is not included here if you retain an option to reacquire the land.
• Cattle and horses held for draft, breeding, dairy, or sporting purposes for at least 24 months.
• Livestock (other than cattle and horses) held for draft, breeding, dairy, or sporting purposes for at least 12 months. Poultry is not treated as livestock for purposes of Section 1231.

Section 1231 netting.

On Form 4797, you combine all losses and gains, except gains allocated to depreciation recapture, from:

• The sale of Section 1231 assets (from the list at the beginning of this section).
• The involuntary conversion of Section 1231 assets and capital assets held for more than one year for business or investment purposes. You include casualty and theft losses incurred on business or investment property held for more than one year. However, there is an exception if losses exceed gains from casualties or thefts in one taxable year.
• Involuntary conversions of capital assets held for personal purposes are not subject to a Section 1231 computation but are subject to a separate computation; see 18.25.

Caution

Capital Gain or Ordinary Loss

Profitable sales and involuntary conversions of Section 1231 assets are generally treated as capital gain, except for profits on equipment (44.1) and real estate allocated to recaptured depreciation (44.2), and losses are deducted as ordinary loss. However, the exact tax result depends on the net profit and loss realized for all sales of such property made during the tax year. Under the netting rules (44.8), the net result of these sales determines the tax treatment of each individual sale. In making the computation on Form 4797, you must also consider losses and gains from casualty, theft, and other involuntary conversions involving business and investment property held more than one year. Follow the Form 4797 instructions.

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Result of netting.

A net gain on Section 1231 assets from Form 4797 is entered on Schedule D as a long-term capital gain unless the recapture rule (see the second Caution on this page) for net ordinary losses applies. A net loss on Section 1231 assets is combined on Form 4797 with ordinary income from depreciation recapture (44.1) and with ordinary gains and losses from the sale of business property that does not qualify for Section 1231 netting.

Installment sale.

Gain realized on the installment sale of business or income-producing property held for more than a year may be capital gain one year and ordinary income another year. Actual treatment in each year depends on the net result of all sales, including installment payments received in that year (44.6).

Losses exceed gains from casualties or thefts.

On Form 4684, you must compute the net financial result from all involuntary conversions arising from fire, storm, or other casualty or theft of assets used in your business and capital assets held for business or income-producing purposes and held more than one year. The purpose of the computation is to determine whether these involuntary conversions enter into the above Section 1231 computation. If the net result is a gain, all of the assets enter into the Section 1231 computation. If the net result is a loss, then these assets do not enter into the computation; the losses are deducted separately as casualty losses, and the gains reported separately as ordinary income. If you incur only losses, the losses similarly do not enter into the Section 1231 computation.

Caution

Recapture of Net Ordinary Losses

Net Section 1231 gain is not treated as capital gain but as ordinary income to the extent of net Section 1231 losses realized in the five most recent prior taxable years. Losses in the five preceding years that have not yet been applied against net Section 1231 gains are recaptured in chronological order on Line 8 of Form 4797. Losses that have already been “recaptured” under this rule in prior years are not taken into account.

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