Section 1231 and Section 1250 Recapture Codes in Taxes

Tax Code 1231, 1245, 1250, 291

A Section 1231 asset is an asset that is non-capital, that it may receive capital gain treatment. To be a Section 1231 asset, the asset must be personal or real property used in a trade/business that has been owned for a year -- for example, a piece of equipment like a tractor. Equipment is treated the same whether it is owned by a sole proprietor or a corporation. So if it were purchased for $20,000, sold for $50,000, with a depreciation of $4,000, with a $16,000 basis, the gain would be $34,000. If the tractor were held as a 1231 asset, the gain would be the same regardless of whether you were a sole proprietor or a corporation. The gain would be counted as an ordinary income -- and the $4,000 depreciation portion of the $34,000 could be counted as Section 1245 gain (ordinary income). The long-term capital gain (or the Section 1231 gain) would be the remaining $30,000.

If one were applying these codes to real estate, the case would go like this: if a building were purchased and owned for at least a year and used for a business/trade, it could count as a Sec 1231 asset. A difference can here be applied if the owner of the building is a sole proprietor rather than a corporation. Using the same prices for purchasing, depreciation, and selling, in this case all $34,000 would count as Sec 1231 gains for the sole proprietor. However, if the real estate is owned by a corporation, the corporation is obliged to recapture some of the gain as ordinary income. This is Sec 291 gain. The corporation must take 20% of the depreciation ($800 in this case), which will then be counted as ordinary income under Sec 291. The balance of the gain is then treated as long-term capital gain (Sec 1231 gain), which would be $33,200. Thus, there is a difference in the way a sole proprietor vs. a corporation must treat real estate.

These rules, of course, apply only to depreciation that took place after 1987. If it took place before 1987 and the asset is only just now being sold the rules are different. So, for example, a building that was put in service before 1987 could be treated differently. Say, the building was $350,000 and the basis was $200,000. If it was sold there would be a gain of $150,000. This would be treated under Section 1250: real estate put into service before 1987 when accelerated depreciation could be utilized. If the company that owned the building had taken accelerated depreciation of $100,000, it now goes back to do straight line depreciation and calculates it to be $70,000. The difference between these two rates of depreciation ($30,000) is counted as ordinary income, or Section 1250 gain. The balance of the gain would then be $120,000 -- Section 1231 gain, or long-term capital gain.