Section 1231: The Big Picture
Section 1231 applies to: depreciable property used in a trade or business (machinery, vehicles, equipment, real estate) AND held more than one year. It does NOT apply to inventory, copyrights, or property held for sale to customers.
The Section 1231 'magic': net gains are treated as long-term capital gain (preferential rates). Net losses are treated as ORDINARY losses (deductible against ordinary income without the $3,000 cap that limits regular capital losses).
Best of both worlds: Section 1231 gives business property the better of capital gain treatment (when profitable) and ordinary loss treatment (when at a loss). This is more favorable than treating all gains/losses as capital.
Calculation: net all your Section 1231 gains and losses for the year. If the result is a net gain, it's long-term capital gain. If a net loss, it's an ordinary loss.
5-year lookback rule: prior 5 years of unused 1231 ordinary losses recharacterize current 1231 gains as ordinary income (recapture). So if you took $50K of ordinary losses 3 years ago and have $100K of 1231 gain this year, the first $50K is ordinary income (recapturing the prior loss benefit) and only the remaining $50K is capital gain. Designed to prevent flip-flopping between gain/loss treatment.
Section 1245 Property and Recapture
Section 1245 covers depreciable PERSONAL property (machinery, equipment, vehicles, livestock, computers) and certain non-residential real property components.
Section 1245 recapture: at sale, the depreciation taken (up to the gain amount) is recaptured as ORDINARY income — not capital gain. This is full recapture at ordinary rates regardless of holding period.
Concrete example: business equipment purchased for $100K, depreciated to $40K basis ($60K of accumulated depreciation), sold for $80K. Total gain: $40K. All $40K is Section 1245 recapture (ordinary income) because the gain is less than accumulated depreciation. If sold for $130K instead, gain $90K = $60K Section 1245 recapture (ordinary) + $30K Section 1231 gain (long-term capital gain treatment).
1245 recapture is REGULAR ordinary income, taxed at marginal rates (10-37%). It's not subject to NIIT (since it's not investment income).
Section 179 expensing and bonus depreciation property: when you immediately expense rather than depreciating over years, the recapture math is the same — the 'depreciation' was just front-loaded. Sale of bonus-depreciated property generates 1245 recapture for the entire prior expense up to the gain.
Section 1250 Property and Recapture
Section 1250 covers depreciable REAL property (buildings, improvements, structural components). The standard recapture rule for 1250 property is more favorable than 1245.
For real estate, depreciation is now straight-line (mandated by Tax Reform Act of 1986). Section 1250 'recapture' applies to accelerated depreciation in excess of straight-line — but since modern real estate uses straight-line, this 'excess' is typically zero. So formally, there's little or no Section 1250 ordinary recapture.
BUT: 'Unrecaptured Section 1250 gain' is a special category. The portion of real estate gain attributable to depreciation taken (the straight-line depreciation) is taxed at a special 25% federal rate — higher than the standard 15-20% LTCG but lower than ordinary income rates.
Concrete example: rental property with $300K basis, $80K depreciation (basis now $220K), sold for $500K. Total gain: $280K. The $80K corresponding to depreciation is unrecaptured Section 1250 gain — taxed at 25% federal. The remaining $200K is regular LTCG — taxed at 15-20%. Plus 3.8% NIIT for high earners on both portions.
Strategic note: cost segregation studies that reclassify components from 1250 (real property) to 1245 (personal property) accelerate depreciation but also subject the recapture to ordinary income rates (1245) instead of 25% (1250). The trade-off: faster deductions earlier, possibly worse recapture later. For long-term holds, the time value of money typically favors cost segregation. For short-term holds, less so.
Different Property Types and Their Sections
Machinery and equipment: Section 1245. Recaptured at ordinary rates up to depreciation taken.
Vehicles (business use): Section 1245. Recaptured at ordinary rates.
Computers and software: Section 1245.
Buildings (commercial or residential rental): Section 1250. Unrecaptured gain at 25%, remainder LTCG.
Land improvements (parking lots, fences, landscaping): Section 1245 (if classified as personal property in cost segregation).
Building structural components: Section 1250.
Furniture in rental property: Section 1245.
Goodwill and other intangibles: not depreciable real property — Section 1245 recapture applies on gain to extent of amortization taken.
Knowing the section matters because the recapture rate differs (ordinary 32-37% for high earners vs 25% for 1250 vs 15-20% for pure LTCG).
1231 Lookback Recapture
Section 1231(c) creates a 5-year lookback rule: net 1231 gains in the current year are recharacterized as ORDINARY income to the extent of unrecaptured 1231 ordinary losses from the prior 5 years.
Concrete example: 2021 Section 1231 net loss of $40K (ordinary deduction). 2022-2025 no 1231 activity. 2026 Section 1231 net gain of $100K. The first $40K is ordinary income (recapturing the 2021 ordinary loss benefit). Remaining $60K is long-term capital gain.
Strategic implication: avoid creating 1231 ordinary losses if you'll have offsetting gains within 5 years. The lookback rule means you don't get a permanent ordinary loss benefit — you'll pay it back at ordinary rates when you have future gains.
Conversely, if you have a 1231 gain coming up, sell loss properties strategically. If you'd be in a 1231 loss anyway from disposing of a particular property, time it more than 5 years before the offsetting gain (preserving the ordinary loss treatment).
Many investors miss this rule. They take ordinary losses on bad investments thinking they've gotten a better tax deal than capital loss treatment, only to have the benefit recaptured years later when they sell winners.
Strategic Planning Around Recapture
Hold period planning: real property held more than 1 year qualifies for Section 1231 (long-term gain treatment on the non-depreciation portion). Holding less than 1 year = short-term capital gain on entire profit (ordinary rates).
1031 exchange: defers all the recapture (1245 and 1250) along with the gain. The deferred recapture transfers to the new property. Combined with stepped-up basis at death, recapture can be eliminated entirely if the strategy continues.
Cost segregation tradeoff: accelerating depreciation via cost segregation creates more 1245 (personal property) recapture at ordinary rates, vs the standard 1250 unrecaptured gain at 25%. Run the numbers — for long-term holds and high-bracket investors, the deferral usually wins.
Installment sales: spread the recapture across years to avoid bracket spikes in the year of sale. Section 453(i) doesn't allow installment treatment for depreciation recapture in some cases (it must be recognized in year of sale even with installment treatment for the rest of the gain) — check specific rules.
Like-kind property aggregation: in 1031 exchanges, the recapture from the relinquished property carries over to the new property's basis. Strategic 'trade-up' patterns minimize recognition of recapture across decades.
Charitable contribution alternative: donating fully-depreciated business property to charity provides charitable deduction equal to fair market value (with various limitations) and avoids recapture entirely. For high-basis-zero property, this can be more efficient than selling.