Form 4797 Part II: Depreciation Recapture and Section 1231

Part II of Form 4797 is where you report ordinary gains and losses from the sale or disposition of business property. Three kinds of items land here: sales of business property held one year or less (Line 10), depreciation recapture calculated in Part III (Line 13), and a handful of other ordinary items the instructions route to this part. Line 17 nets everything into a single ordinary result that flows to your return.¹

The calculation for each entry is the same formula used anywhere else on the form: amount realized minus adjusted basis. What makes Part II distinct is the character of the result. Everything on this part is taxed at your ordinary income rates, and losses are fully deductible against other ordinary income without the $3,000 cap that applies to capital losses.

Short-Term Business Property on Line 10

If you sold, exchanged, or otherwise disposed of business property you held for one year or less, the entire gain or loss is ordinary and goes directly on Line 10.¹ Property held longer than a year is Section 1231 property, which starts in Part I instead.²

Amount realized includes cash received, the fair market value of any property received in exchange, and any of your debt the buyer takes on. Sell a short-term work vehicle for $10,000 and the buyer assumes a $2,000 loan on it, and the amount realized is $12,000.³

Adjusted basis is original cost, plus improvements, minus depreciation. One trap: basis must be reduced by the greater of the depreciation you actually claimed or the amount you were entitled to claim.⁴ Skip depreciation deductions for three years and your basis still drops as if you had taken them. The IRS calls this the “allowed or allowable” rule, and ignoring it understates the gain reported on Line 10.⁵

A quick example. You bought a computer system for $5,000, claimed $2,000 in depreciation, and held it for less than a year before selling it for $4,000. Adjusted basis is $3,000, so the gain is $1,000, all of it ordinary and reported on Line 10. Sell for $2,500 instead and the $500 loss is ordinary and fully deductible.

Depreciation Recapture on Line 13

Even when you have held an asset for more than a year, part of the gain often comes back to Part II as ordinary income. That part is depreciation recapture, calculated in Part III and carried to Line 13.⁶ The logic is simple: depreciation reduced your ordinary income in earlier years, so the IRS reverses that benefit when you sell at a gain.

Section 1245 Property

Section 1245 covers most tangible personal property used in a business — machinery, equipment, vehicles, furniture — along with certain depreciable intangibles.⁷ The ordinary recapture amount is the lesser of your total gain or the total depreciation taken on the asset.

Say you bought equipment for $50,000, claimed $40,000 of depreciation, and sold it for $55,000. Adjusted basis is $10,000, so the total gain is $45,000. The first $40,000 (matching prior depreciation) is Section 1245 ordinary income, calculated in Part III and carried to Part II, Line 13.¹ The remaining $5,000 is Section 1231 gain and goes to Part I. One sale, two different entries in two different parts of the form.

Section 1250 Property

Section 1250 governs depreciable real property, such as commercial buildings and rental structures. Only “additional depreciation” — the amount by which accelerated methods exceeded straight-line — is recaptured as ordinary income on Line 13.⁸

In practice, this matters mainly for real property placed in service before 1987. Non-residential real property placed in service after 1986 generally must use straight-line depreciation, so there is no additional depreciation and nothing to report under Section 1250 on Part II. Gain attributable to straight-line depreciation on that post-1986 real property is “unrecaptured Section 1250 gain,” taxed at a maximum 25% rate through Schedule D, not Part II.

Section 179 and Listed Property Recapture

Section 179 lets you expense the full cost of qualifying business equipment in the year of purchase. If business use of that property drops to 50% or less during the recovery period, the excess deduction has to be recaptured as ordinary income.⁹

The recapture amount equals the original Section 179 deduction minus the regular depreciation you would have been entitled to from the year the property was placed in service through the recapture year. The calculation is done in Part IV on Lines 33 through 35, and the resulting ordinary income is reported on the same form or schedule where you originally took the deduction.⁶ Note the routing: unlike Section 1245 recapture, Section 179 recapture does not flow onto Line 13 of Part II.

The same mechanism applies to “listed property” under Section 280F(b)(2), which covers vehicles and other mixed-use assets. If you claimed accelerated depreciation or Section 179 based on more than 50% business use, and use later falls below the threshold, the excess depreciation is recaptured through Part IV.

Installment Sales Push Recapture Into Year One

If you sell business property on an installment note, you can usually spread gain recognition over the payment years. Depreciation recapture is the exception. Under Section 453(i), all Section 1245 and 1250 recapture income must be recognized in the year of sale, no matter when the cash arrives.¹⁰

Sell equipment with $40,000 of recapture on a five-year note and that full $40,000 lands on Line 13 of Part II in year one, even if you received only a down payment. Only the portion of the gain above the recapture amount qualifies for installment treatment.

The Section 1231 Lookback Can Push Gain Back to Part II

A net Section 1231 gain is normally long-term capital gain. The lookback rule changes that. Under Section 1231(c), a net Section 1231 gain this year is treated as ordinary income to the extent of any unrecaptured net Section 1231 losses from the previous five tax years.²

Claim $30,000 of ordinary Section 1231 losses over the past five years with none recaptured, and the first $30,000 of this year’s Section 1231 gain is recharacterized as ordinary. The recharacterized portion is computed on Lines 8 and 9 of Part I and reported as ordinary income on Line 12 of Part II; anything above it goes to Schedule D as long-term capital gain.⁶ Sellers who had loss years recently and are now in a gain year often miss this.

Where the Part II Total Goes

Line 17 nets everything on Part II into a single ordinary gain or loss. For individuals filing Form 1040, that amount flows to Schedule 1 and is included in adjusted gross income. Partnerships, S corporations, and C corporations carry it to the corresponding income lines on their returns.¹¹

A net ordinary loss from Part II is fully deductible against other income. Capital losses are capped at $3,000 per year for individuals after offsetting capital gains; ordinary losses from Part II face no such limit. That is why getting the character right on this part matters. Report a short-term sale or a recapture amount as capital gain by mistake and you overpay; report a Section 1231 gain as ordinary without a lookback basis and you miss the preferential rate.

1
Internal Revenue Service. Form 4797 – Sales of Business Property
2
Office of the Law Revision Counsel. 26 USC 1231 – Property Used in the Trade or Business and Involuntary Conversions
3
Internal Revenue Service. Property (Basis, Sale of Home, etc.)
4
Office of the Law Revision Counsel. 26 USC 1016 – Adjustments to Basis
5
Internal Revenue Service. Depreciation and Recapture
6
Internal Revenue Service. Instructions for Form 4797
7
Office of the Law Revision Counsel. 26 US Code 1245 – Gain From Dispositions of Certain Depreciable Property
8
Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty
9
Internal Revenue Service. Publication 946 – How To Depreciate Property
10
Office of the Law Revision Counsel. 26 USC 453 – Installment Method
11
Internal Revenue Service. Instructions for Form 4797