Thinking of owning your own business? Opening your own business is exciting and thrilling. It's everything that comes after the excitement and thrill has worn off that dictates whether a small business will make it or not. It's up to you to maintain and stretch out the "thrill and excitement" period forever.  

Section 1231 Transactions

Taxable gains and losses that are subject to section 1231 treatment result from the following transactions:

  • Sales or exchanges of real property or depreciable personal property used in a trade or business and held longer than 1 year. This generally includes property held for the production of rents or royalties.
  • Sales or exchanges of leaseholds held in a trade or business for longer than 1 year.
  • Sales or exchanges of cattle and horses held 2 years or longer.
  • Sales or exchanges of other livestock (excluding poultry) held 1 year or longer.
  • Sales or exchanges of un-harvested crops, if the land and the crops are sold, exchanged, or involuntarily converted at the same time and to the same person, and the land has been held longer than 1 year.
  • The cutting of timber, or the disposal of timber, coal, or iron ore.
  • Condemnations of property held longer than 1 year, for business or as a capital asset in connection with a trade or business, or for investment.
  • Casualties or thefts of property held longer than 1 year, for business, for the production of rents or royalties, or for investment.

Section 1231 Gains and Losses

How the gains and losses from these transactions are treated (whether as ordinary or capital gain or loss) will depend on whether you have a net gain or a net loss from all section 1231 transactions.

If you have a net overall loss from section 1231 transactions, the loss is treated as an ordinary loss for tax purposes. If you have a net overall section 1231 gain, the gain is considered ordinary income up to the amount of any section 1231 losses from the previous 5 years that have not been recaptured as ordinary income. The rest of the gain would be treated as a long-term capital gain.

For example:
You had a net section 1231 loss of $12,000 in year 1, a net gain of $5,000 in year 2, a net gain of $4,000 in year 4, and a net gain of $8,000 in year 6.
The net gain of $8,000 in year 6 would be ordinary income of $3,000 for the un-recaptured loss from year 1 ($12,000 loss from year 1 less $5,000 recaptured in year 2 and $4,000 recaptured in year 4). The rest of the gain in year 6, ($8,000 minus $3,000 = $5,000) would be long-term capital gain.

Where To Report

Section 1231 gains and losses are reported in Part I of Form 4797, Sales of Business Property. Each transaction for the current year is reported individually, and there is a separate line for reporting the un-recaptured section 1231 loss from prior years.

Form 4797

Form 4797 can be used by individuals, sole proprietorships, partnerships, corporations, and S-corporations to report gains and losses from sales, exchanges, and involuntary conversions of depreciable and amortizable property used in a trade or business. There are certain transactions that must be reported on other forms first, and the results from these other forms are then transferred and included on Form 4797. These include:

Form 4684, Casualties and Thefts, to report involuntary conversions from casualties or thefts of business property.

Form 6252, Installment Sale Income, to report income from installment sales of business property.

Form 8824, Like-Kind Exchanges, to report the exchange of property used in a business or held for investment, for property of a like kind.

Form 4255, Recapture of Investment Credit, if you sold property on which you had taken an investment credit.

Form 8594, Asset Acquisition Statement, when you sell a group of assets that makes up a trade or business.