Question

In the current year, Alan reported a $104,925 net §1231 gain and a $4,000 net capital loss. Assuming Alan reported $53,500 of nonrecaptured §1231 losses during the prior 5 years, what amount of Alan's net §1231 gain for the current year, if any, is treated as ordinary income?

Answer 1

Section 1231, deals on the gain or loss on sale of depreciable or real assets which are held by the company for more than 1 year. The gain arising on any 1231 property will be treated as capital gains and loss of sec 1231 property will be treated as ordinary loss. However there is a rule of recapture of loss from property under section 1231 that if in any 5 previous year if there is any section 1231 loss, then upto that loss the gains from sec 1231 property will be treated as ordinary gain.

What will it make difference either as ordinary income of capital gain, the difference is in tax rates, the ordinary income are subject to higher taxes and long term capital gains are taxed at lower i.e 15% only. So in order to prevent the misuse of the provision of section 1231 to gain undue tax advange the clause of recapture of Sec 1231 losses is there.

In the given case, Alan has reported $104,925 net §1231 gain and a $4,000 net capital loss., the capital loss will be carried forward till the period it is settled with the capital gain. Here the net gain of $ 104950 needs to be analysed.

Alan also has $53,500 of nonrecaptured §1231 losses during the prior 5 years, so the gain of sec 1231 will be treated as gain from ordinary income till the extent uncaptured sec 1231 losses of $ 53500.

Thus Ordinary income to be treated in current year = $ 53500 (i.e upto the unapplied portion of previous losses).

and remaining of $ 51,425 ( 104925 - 53500) will be treated as capital gain, further there is a loss of $ 4000 as capital loss , will be reduced from capital gain and net capital loss will be = $ 47425.

Thus amount of Alan's net §1231 gain for the current year, if any, is treated as ordinary income = $ 53,500.