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Welcome back. As we continue discussing the character of recognized gains and losses.
Recall that the type of asset that we sell will drive
the character of the gain or loss during a property transaction.
In particular, there are three key types of assets.
First, an ordinary asset is one that is used in a trader business that's held for
one year or less and assets such as inventory
and accounts receivable are always ordinary assets.
Second, we have capital assets which are assets held for investment,
production of income or personal use.
Usually, we think of stocks,
funds or personal assets such as a house or a vehicle.
In the previous set of videos,
we focused on ordinary assets and capital assets which produced
respectively ordinary income or losses and capital gains and losses.
Recall that ordinary income and in fact,
short-term capital gains are subject to the higher ordinary income tax rates,
while long-term capital gains are subject to the lower preferential tax rates.
Now, the third type of asset that we haven't talked
about is known as a section 1231 asset.
In this video I'll introduce section 1231 assets and show how they're
incorporated in the netting procedure that we covered in the last video.
So first, section 1231 assets are neither ordinary assets nor capital assets.
So they're are not inventory,
accounts receivable or notes receivable,
and not copyrights compositions,
U.S. government publications or personally use assets.
What section 1231 refers to is depreciable personalty and
realty as well as land used in a trader business or for the production of income.
A key element to be a section 1231 asset
is that the asset must be held for more than one year.
That is this is,
by definition, a long-term asset.
There is no such thing as a short-term 1231 asset.
This long term holding period is absolutely critical to be
met in order to be designated as a section 1231 asset.
So some examples here could be land used for the production of income held for
more than a year or an office building used in a trade or business held
for more than a year or a business machine held for more than a year.
So why are these section 1231 assets and not capital assets?
Well, the key here is the section 1231 assets received extremely favorable tax treatment.
If you sell a section 1231 asset at a gain,
it gets the long-term capital gain treatment.
So the gains are taxed at preferential rates.
However, if you sell a section 1231 asset at a loss,
that loss is an ordinary loss,
fully deductible and can be used to offset ordinary income.
So the section 1231 loss is not subject to
that 3,000-dollar limitation that applies to capital losses.
So in all, section 1231 gets the best of both worlds.
If there is a gain, it's lightly taxed and if there is a loss it
is fully deductible against ordinary income. So, not bad.
Of course, if the tax rules provide some major benefits,
rest assured that some taxpayers will try to exploit these rules even further.
One easy scheme here would be to the extent you have them,
is to sell the section 1231 assets where you have
losses in one year to get the ordinary lost deduction.
And then in the next year,
sell the section 1231 assets where you have
gains so that you can get preferential tax rates.
So here, you play the game where you win in both years,
because you group your loss assets together to maximize
your deduction and then group
your gain assets together in another year to minimize your tax rates.
While the IRS wants to prevent these kinds of timing games.
So what they'll do is,
to the extent you sold section 1231 assets at a gain this year,
the taxpayer will have to look back to the prior five years to
check if any section 1231 assets were sold at a loss.
Here, the IRS will effectively net the two years together so that
the character of any of the section 1231 gain will be treated
not as a preferential item tax that preferential rates but
actually as an ordinary income item taxed at ordinary tax rates.
This essentially becomes a reclassification exercise.
So if there was a section 1231 loss in the previous five years,
the current-year net 1231 gain will be offset by
the 1231 losses that were deducted in the previous five years as ordinary losses.
So the amount of current-year 1231 gain that is offset by prior years as 1231 losses
is treated as ordinary income instead of receiving long-term capital gains treatment.
Now, to the extent you have a current year net section 1231 gain that survives
this lookback rule that is the current year section 1231 gain is larger than
any section 1231 loss in the last five years or if this rule doesn't
apply because the taxpayer didn't have any section 1231 losses in the past five years,
then the net section 1231 gain in the current year will be
given long-term capital gains treatment and tax as 0/15 or 20%.
That is, in order to get the preferential tax rates on the section 1231 gain,
the net section 1231 gain must be larger than
any section 1231 losses you incurred in the last five years.
If it's not, again,
that gain is actually reclassified and then taxed at ordinary rates.
But if it's larger, then you retain the preferential tax rates that would normally apply.
So why does the IRS do this?
Well again, taxpayers might want to group
all the losses in one year to get the ordinary deduction that year,
then group all the gains in the next year to get preferential tax rates in the next year,
and so they'll play this timing game.
However, if the taxpayer had sold all the loss in gain property in the same year,
they would have offset each other because they'd be in the same category.
That is, they'd be section 1231 assets.
And so how that net section 1231 gain or loss will be taxed will
be simply whether the net section 1231 amount would be a gain or loss.
If it's a net gain, it will be taxed at preferential rates and if it's a net loss,
it would be deductible as ordinary income.
So does lookback loss rule effectively nets these gains and losses across years in
order to specify the correct character of the current year's net section 1231 gain.
Petro Lisowsky, PhD, CPAAssociate Professor of Accountancy
