What Section 1231 covers
Section 1231 applies to sales and exchanges of property used in a trade or business — including rental real estate — held for more than one year. The special feature: net Section 1231 gain is treated as long-term capital gain (taxed at 0%, 15%, or 20%), while a net Section 1231 loss is treated as an ordinary loss, fully deductible without the $3,000 capital-loss cap.
This asymmetry is intentional — Congress wanted to encourage business investment while protecting against large ordinary losses on dispositions.
How depreciation recapture is carved out first
Before computing Section 1231 gain, the tax code removes depreciation recapture from the gain:
Section 1245 recapture (personal property, cost-segregated components): the portion of gain equal to depreciation taken is ordinary income at your marginal rate — it never enters Section 1231.
Section 1250 recapture (buildings): for straight-line MACRS real property, there is usually no 'additional depreciation' (excess over straight-line), so true Section 1250 ordinary income recapture is typically zero. Instead, the straight-line depreciation amount becomes unrecaptured Section 1250 gain — a Section 1231 gain that is taxed at a maximum of 25%.
Whatever gain remains after these carve-outs flows into the Section 1231 bucket as a long-term capital gain taxed at the standard 0/15/20% rates.
The Section 1231 lookback rule
A trap catches investors who harvested Section 1231 losses in recent years: the 1231 lookback rule (IRC Section 1231(c)) requires you to recharacterize current-year net 1231 gain as ordinary income to the extent of non-recaptured net Section 1231 losses from the prior five years. If you wrote off a large Section 1231 loss in year one and have a 1231 gain in year five, the gain is taxed as ordinary income — not capital — up to the loss amount.
Form 4797 performs all these calculations. Part III figures Section 1245 and 1250 recapture; Part I accumulates the 1231 gain; the lookback check happens on the worksheet. Understanding which 'bucket' your gain falls into is what lets you estimate the real tax cost before you list.
Frequently asked questions
Is Section 1231 gain ordinary income or capital gain?
Net Section 1231 gain is treated as long-term capital gain, taxed at 0%, 15%, or 20%. But depreciation recapture (Sections 1245 and 1250) is carved out first and taxed at higher rates.
What is the difference between Section 1231 and Section 1250 gain?
Section 1231 is the category for business property dispositions. Section 1250 is a sub-rule that recaptures excess depreciation (and, for straight-line real property, creates 'unrecaptured Section 1250 gain' taxed at up to 25%) before the remaining gain enters the Section 1231 bucket.
Does the 1231 lookback rule always apply?
Only if you had net Section 1231 losses in the five years before the gain. If you have always had net 1231 gains, the lookback has no effect.
Sources
- IRS Topic No. 409 — Capital Gains and Losses
- IRS Publication 544 — Sales and Other Dispositions of Assets
- IRS Publication 527 — Residential Rental Property
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.