Business Assets: Section 1231, 1245, and 1250

Jessica I. Marschall, CPA, ISA AM

January 23^rd, 2024

Section 1231, Section 1245, and Section 1250 are provisions of the United States Internal Revenue Code that deal with the taxation of certain types of assets.

1. Section 1231:
   1. Section 1231 of the Internal Revenue Code deals with the tax treatment of gains and losses on the sale or exchange of certain business or investment property.
   1. It applies to property used in a trade or business and includes real property (like land and buildings) and depreciable personal property (like machinery and equipment).
   1. Net gains from the sale of Section 1231 assets are generally treated as long-term capital gains, while net losses are treated as ordinary losses. This classification can have tax implications for the taxpayer.

• Section 1245:
  • Section 1245 specifically addresses the tax treatment of gains on the sale of certain depreciable property, such as machinery, equipment, and other tangible personal property.
  • If a taxpayer sells or disposes of Section 1245 property at a gain, the gain is treated as ordinary income rather than capital gain. This is because these types of assets are subject to depreciation deductions during their useful life, and the gain is considered as recapture of previously claimed depreciation. (See Depreciation Recapture below)

• Section 1250:
  • Section 1250 pertains to the tax treatment of gains on the sale of certain depreciable real property, such as buildings and structural components.
  • Similar to Section 1245, if a taxpayer sells or disposes of Section 1250 property at a gain, part of the gain may be treated as ordinary income (recapture of depreciation) while the remaining portion may be treated as a long-term capital gain.

What About Depreciation Recapture?

Depreciation recapture under Section 1245 and Section 1250 refers to the process by which the IRS recovers some of the tax benefits that a taxpayer has claimed through depreciation deductions on certain types of assets. When a taxpayer sells or disposes of such assets, any gain realized on the sale may be subject to depreciation recapture rules. Here’s a breakdown of each section:

1. Section 1245 Depreciation Recapture:
   1. Section 1245 applies to the recapture of depreciation on certain depreciable personal property, such as machinery, equipment, and other tangible personal property used in a trade or business.
   1. When a taxpayer sells or disposes of Section 1245 property at a gain, part of that gain is treated as ordinary income, not as a capital gain. This is because the gain is considered as recapture of the depreciation deductions previously claimed by the taxpayer during the asset’s useful life.
   1. The ordinary income recapture is limited to the amount of depreciation claimed or allowable.

• Section 1250 Depreciation Recapture:
  • Section 1250 deals with the recapture of depreciation on certain depreciable real property, such as buildings and structural components.
  • When a taxpayer sells or disposes of Section 1250 property at a gain, a portion of the gain may be subject to depreciation recapture. The recaptured amount is taxed at a 25% rate while the remaining gain is treated as a long-term capital gain in the current 0%/15%/20% rates.
  • The recapture amount is generally limited to the lesser of the depreciation claimed or the gain realized on the sale.

In both cases, the concept of depreciation recapture is designed to prevent taxpayers from indefinitely deferring tax on the depreciation deductions they have taken over the years. Instead, when the property is sold, a portion of the gain is recognized as ordinary income to recapture the tax benefits previously received.

It is important for taxpayers to be aware of these rules when selling depreciable assets, as they can impact the overall tax implications of the transaction. Consulting with a tax professional is advisable to ensure compliance with these depreciation recapture provisions and to accurately calculate the tax consequences of asset sales.