Alexandria, VA

Recapture of Section 1231  ordinary losses

A client calls and says he is selling his rental property after owning the property for a number of years. He wants to know if he will get long term capital gains treatment. The normal answer would be “yes”.

The problem is that he sold a 2nd rental property 4 years ago at a loss. This loss was treated as a ordinary loss.

Let’s look at an example,

Say the loss on the second rental property was 60,000.

Now the long term capital gain on the current home he is selling is 100,000. The IRS says the 1st 60,000 is going to be taxed as ordinary income to “recapture” the benefit of the earlier ordinary loss, and then the remaining 40,000 is eligible for the lower long term capital gain rates.

Why is there this rule. Because the Congress did not want taxpayers selling their “loss” properties in one year and taking an ordinary loss and postponing the sale of gain property til a later year to take advantage of the long term capital gain rates.

SEE IRS publication 544 https://www.irs.gov/pub/irs-pdf/p544.pdf

Your nonrecaptured section 1231 losses are
your net section 1231 losses for the previous 5
years that have not been applied against a net
section 1231 gain. Therefore, if in any of your
five preceding tax years you had section 1231
losses, a net gain for the current year from the
sale of section 1231 assets is ordinary gain to
the extent of your prior losses. These losses are
applied against your net section 1231 gain beginning
with the earliest loss in the 5-year period.

This is not the only recapture possible. The rental property is consider IRC 1250 property and the depreciation expense taken over the years was an offset to ordinary income. Gain on the disposition of section 1250 property is treated as ordinary income to the extent of “additional depreciation” allowed or allowable on the property.

Additional depreciation is the amount over and above the amount that would have been taken using straight line depreciation. Now there are exceptions to having to recapture this additional depreciation.

Most likely the rental property in our example was place in service as a rental after July 31, 1986. If the property was placed in service after July 31, 1986, then no depreciation recapture. Why? Because after July 31, 1986, the straight line method was the norm.

Keep in mind you can have recapture of depreciation on personal property (IRC 1245) sold at a gain.

Getting back to the recapture of the 1231 loss taken 4 years ago in our example, it is hard to know how the taxpayer or the IRS would remember to offset the current year long term capital gain. Thanks to computer software that keeps a record of 1231 losses.

Make sure you see your tax preparer for your particular situation.