Form 4797: Sales of Business Property

The §1231 Framework — Ordinary Loss, Capital Gain

Section 1231 property includes real property and depreciable personal property used in a trade or business and held for more than one year. The defining characteristic of §1231 is its asymmetric tax treatment: net §1231 losses are treated as ordinary losses (fully deductible against ordinary income), while net §1231 gains are treated as long-term capital gains (taxed at preferential rates).

This asymmetry is extraordinarily valuable for tax planning. A client who sells business equipment at a loss gets an ordinary deduction — not a capital loss limited to $3,000/year. A client who sells appreciated real estate gets long-term capital gain rates. The §1231 framework is the reason that selling a business or investment property is often more tax-efficient than selling publicly traded securities.

The §1231 lookback rule: if the taxpayer had net §1231 losses in any of the prior 5 years, current net §1231 gains are recharacterized as ordinary income to the extent of those prior losses. This prevents the strategy of taking ordinary losses in one year and capital gains in the next. Always check the client's prior 5-year §1231 history before projecting the tax impact of a current-year sale.

§1245 Recapture — Depreciable Personal Property

Section 1245 requires that gain on the sale of depreciable personal property (equipment, vehicles, furniture, computers, leasehold improvements) be recognized as ordinary income to the extent of all depreciation previously taken. This includes regular MACRS depreciation, bonus depreciation, and Section 179 expensing.

The §1245 recapture calculation: the amount of recapture is the lesser of (1) the gain realized, or (2) the total depreciation taken (including §179 and bonus). Any gain in excess of total depreciation is §1231 gain. Example: a client purchases equipment for $100,000, takes $80,000 in depreciation (including §179), and sells for $90,000. Adjusted basis is $20,000. Gain is $70,000. §1245 recapture is $70,000 (lesser of $70,000 gain or $80,000 depreciation). All $70,000 is ordinary income.

Bonus depreciation trap: clients who took 100% bonus depreciation on equipment in 2022 and 2023 have zero basis in that equipment. Any sale proceeds are fully recaptured as ordinary income under §1245. This is a critical planning consideration when advising clients who are selling or trading in business equipment.

§1250 Recapture — Real Property

Section 1250 recapture applies to depreciable real property (buildings, improvements). Unlike §1245, §1250 recapture only applies to the extent that depreciation taken exceeds straight-line depreciation. Since residential and commercial real property is depreciated on a straight-line basis under MACRS, there is typically no §1250 recapture in the traditional sense for property placed in service after 1986.

However, unrecaptured §1250 gain — a separate concept — applies to all straight-line depreciation taken on real property. This gain is taxed at a maximum rate of 25% (not the 0%/15%/20% LTCG rates). The unrecaptured §1250 gain is reported on the §1250 Gain Worksheet in the Schedule D instructions and flows to the Qualified Dividends and Capital Gain Tax Worksheet.

Cost segregation and §1250: when a cost segregation study reclassifies building components to 5-year or 15-year property, those components become §1245 property. The accelerated depreciation on those components is subject to full §1245 recapture at ordinary rates when the property is sold — not the 25% §1250 rate. This is a critical distinction that affects the after-tax analysis of cost segregation.

Frequently Asked Questions