-
- 1250.
No, I am not talking about events from the Middle Ages, but how the IRS wants us to consider assets that we’ve sold. This question also comes up when folks do their own taxes and sold an asset. All those tax computer programs ask…. “Is the asset Section 1231 property, Section 1245 property, or Section 1250 property?” Like the taxpayer understands these concepts. Or- that they are not mutually exclusive.
The basic fact is that we are required (under Section 1001) to pay tax on the capital gains- the difference between the tax basis of the asset sold and the amount (gain) realized. And, to do so, we must know whether that profit is a capital gain or ordinary income?
Now, let’s consider Sections 1245 and 1250. 1245 refers to the type of gain that is bifurcarted (split) between ordinary income and capital gains. Section 1250 (only the IRS can do this, since cogent people never are allowed to use the word in its definition) involves those gains that are split between capital gains and “unrecaptured Section 1250 gains”.
Moreover, properties that we hold (in a trade or business) are considered to be a Section 1231 asset- and ALSO either a Section 1245 or Section 1250 asset. To make things perfectly clear (NOT), Section 1231 is considered a categorization provision; Sections 1245 and 1250 recharacterize those exact provisions. These sections ultimately determine if our profits are to be taxed at ordinary or capital gains- or something in-between. (And that means real money!)
Here’s the kicker. if we sell an asset and we generate a gain (this is what happens in a business or trade), then the gains are capital, according to Section 1231. If we lost money, then the losses (under Section 1231) are ordinary. An easy way to remember this is that we have always ordinary losses and capital gains.
And, another fact. We had to have these assets in our possession for more than 1 year- and they must be depreciable. Oh, and all REAL (as in real estate) property is Section 1231, if we owned it for more than a year’s time.
Oh, but wait. We also have to consider this. Let’s say we purchased some land, expecting to develop it (no, not into a McMansion) and fail to do so over a few years- because of the market, because the site would not merit the multiple we desired- basically, for any reason at all. Even so, the odds are that the sale price will probably be higher than we paid for the property. So, now that we want to sell the property and buy a different asset, we need to determine what our tax position will be for that sale.
Raw land (it’s called ‘raw’ because we did nothing with it) is normally considered inventory and not a capital asset. So, the sale of the property will involve ordinary income- and any profits will be taxed at the ordinary income rates. (Yes, many of my clients SCREAM at me with this position. Unfortunately, this is the position of the IRS- and the IRS will win in the end.) (One wrinkle- if we rented out the land for farm or grazing use- or for special events. Then, it wouldn’t be inventory.)
On the other hand, good will- which is considered to be a self-created ‘intangible’- is always (ok, almost always) a capital asset. But, it is NEVER considered to be Section 1231 property, since we can neither depreciate it nor is it real property. Unless we bought an entity or item from another party and portion of that purchase price was specifically denoted as goodwill- then, the acquired goodwill is considered Section 1231.
Other rules of thumb? Cash (and who cares, since it doesn’t appreciate in value), accounts receivable, inventory, and publicly traded stock (it is a capital asset, but under a completely different rule- Section 1221) are never considered Section 1231 assets. So the question about Sections 1245 and 1250 never come into play. Machinery, furniture, automobiles, buildings, land that is NOT raw- those are all Section 1231 assets.
As I said above, 1245 and 1250 are recharacterization provisions. And, 1245 covers depreciable personal property that is regulated under Section 1231. So, that provision omits buildings, land (that is associated with buildings), and self-generated goodwill.
Now, that these topics are slightly cleared than mud, consider that Section 1245 demands we bifurcate the gain between ordinary and capital income. Why? Because assets that were depreciated (or amortized) incurred an ordinary deduction on our tax returns. The IRS considers this deduction to be worth more than a capital loss (since you can only deduct $ 3000 of capital losses a year), and wants to recover those ordinary deductions as ordinary income to be taxed at your prevailing rates (roughly 39.6% at a maximum, versus a 20% maximum for capital gains).
This really means when we sell a Section 1231/1245 Asset, we can only take the lesser of the sales price or the original cost of the asset (you’ll love this: “recomputed basis”, under the verbiage of Section 1245) – which also means all depreciation (bonus, under section 168(k) and rapid depreciation, under section 179) and deduct this from the adjusted tax basis (that means the value of the asset AFTER depreciation) to determine what gains exist. If this is positive, then that portion of the gain is termed “ordinary” and taxed at the prevailing rate for the taxpayer.
But, what about Section 1250? This covers real property, even if it is depreciable. But, its effects are mitigated due to current practice (per the IRS tax code) and definition within the IRS. Because the only recharacterization that we must compute is the the difference between the depreciation we took and what straight line depreciation would have yielded us. Since 1986, we have been able to depreciate our real property under MACRS (Modified Accelerated Cost Recovery System) rules (Section 168)- and that means straight line over 27.5 (residential) or 39 (commercial) years. Given that, there would be ZERO difference between the depreciation taken and the straight line depreciation of Section 1250, unless we’ve owned the property since before 1986. (If we’ve owned the property that long, then there is a 25% tax on this portion of the gain.)
And, now, we really muddle the puddle. (What? You didn’t think that was possible?) Those Section 1231 gains? They can be taxed as a long-term capital gain ONLY if, after we look back five (5) tax years and ensure that there were no ordinary losses for a net Section 1231 loss during those tax years. If there were, we must recharacterize (yet again) those amounts of the gains to counter those five years of losses as ordinary income- leaving the rest of the gains to be taxed as capital gains.
Now, all this is perfectly clear to me. But, then again, I am a tax professional.
