Question

Explain the purpose behind the §1231 look-back rule. Compare to the "Best of Both Worlds". What does that mean?

Tax for individuals

Answer 1

The Section 1231 deals with gains and losses from the sale of property used in a trade or business as well as certain involuntary conversions. This section has been labeled as providing the “Best of both Worlds” for allowing

1. Net losses to be treated as “Ordinary Losses” and
2. Net gains to be treated as “Long-Term Capital Gains”.

That is, if there is a loss, reduce your ordinary income that could be taxed at high brackets, but if there is a gain, the gain will be taxed at the low rate as Long-Term Capital Gain.

Each tax year you sales are combined of all Section 1231 property to determine if you have a net gain or a loss. This is considered to be your Net Section 1231 Gain or Loss.

The Taxpayer determines the Net Section 1231 Gain or Loss in the following manner:

1. The first step is determining the basis of the property and what the asset was sold for (or in the case of an involuntary conversion, the fair market value “FMV” at the time it was converted).
2. The next step is to compare these two figures to determine whether there is a net gain or loss for each particular Section 1231 asset.
3. Finally, taxpayers must aggregate all of their Section 1231 sales for the year to determine the Net Section 1231 Gain or Loss

Net Section 1231 Loss: If there is a Net Section 1231 Loss then it is treated as an “ordinary” loss. Among other things, this means that a taxpayer:

• May offset this loss against their ordinary income;
• Is not limited as to how much of the loss may be used (i.e. no $3,000 per year limitation);
• The loss is eligible to give rise to a Net Operating Loss that may be carried back or forward.

Net Section 1231 Gain: If there is a Net Section 1231 Gain then it is treated as a “Long-term capital gain”. Among other things, this means that a taxpayer:

• Gets to offset this gain against other capital losses from sales of non-Section 1231 property;
• Gets the benefit of the lower long-term capital gains lower tax rates;

1. However, there is a catch. In a “recapture” situation, a taxpayer will not get the benefit of the long-term capital gain treatment and instead be stuck with treating it as ordinary income.

LOOK BACK RULE

The Section 1231(c) may deny the benefit of long-term capital gain treatment where the taxpayer had a Non-recaptured Section 1231 Loss in the 5 preceding years. So, for every year in which a taxpayer has a Net Section 1231 Gain, they must look back to the 5 preceding years to determine whether they had an aggregate Net Section 1231 Loss.

A taxpayer must take the Net Section 1231 Gains and Losses from each of the 5 preceding years. The taxpayer must then add all those Net Section 1231 Gains and Losses to determine if there is a “Non-recaptured Section 1231 Loss”. A Non-recaptured Section 1231 Loss occurs if the total Net Section 1231 Losses exceed the total Section 1231 Gains for the 5 preceding years.

In the event there is a Non-recaptured Section 1231 Loss, the Net Section 1231 Gain (in the current tax year) will be treated as ordinary income to the extent of the Non-recaptured Section 1231 Loss. The excess Net Section 1231 Gain, if any, in the current tax year will get the beneficial long-term capital gain treatment.