Internal Revenue Code Section 1231 gives sellers of business property a favorable asymmetry: when your qualifying sales for the year net out to a gain, that gain is taxed at long-term capital gains rates (topping out at 20% for most taxpayers in 2026); when they net out to a loss, that loss is treated as ordinary and can offset wages, business income, and other earnings with no annual cap.1Office of the Law Revision Counsel. 26 USC 1231 – Property Used in the Trade or Business and Involuntary Conversions The catch is that two rules — depreciation recapture and a five-year lookback — can pull much of an apparent capital gain back into ordinary income before you ever get the preferential rate.
What Property Section 1231 Covers
Section 1231 applies to two kinds of assets, both held for more than one year: depreciable property used in a trade or business (machinery, equipment, vehicles, furniture) and real property used in a trade or business (land and buildings).1Office of the Law Revision Counsel. 26 USC 1231 – Property Used in the Trade or Business and Involuntary Conversions Timber, coal, and domestic iron ore qualify when they fall under the cutting and disposal rules of Section 631. Livestock held for draft, breeding, dairy, or sporting purposes also qualifies, with longer holding periods that depend on the animal.
Several categories are carved out no matter how long you hold them. Inventory and property held primarily for sale to customers don’t qualify — the lumber a contractor stockpiles is inventory, though the warehouse storing it can still be Section 1231 property. Copyrights, literary and musical compositions, and similar creative works held by their creator (or by someone who received them as a gift from the creator) are excluded. Government publications received other than at the public sale price are excluded. And personal-use property, such as your home or personal car, falls outside Section 1231 entirely.
The section reaches beyond ordinary sales. When qualifying property is destroyed, stolen, condemned, or taken under threat of condemnation, insurance proceeds or condemnation awards that exceed your basis feed into the same calculation as a sale gain would. Casualty and theft gains and losses get netted against each other first; if losses win that sub-netting, they skip Section 1231 and become ordinary losses directly.2eCFR. 26 CFR 1.1231-1 – Gains and Losses From the Sale or Exchange of Certain Property Used in the Trade or Business
How the Netting Produces Your Tax Result
For the year, you combine all your Section 1231 gains (after depreciation recapture, discussed below) with all your Section 1231 losses. The result is binary:
- If gains exceed losses, the entire net amount is a long-term capital gain, taxed at 0%, 15%, or 20% for 2026 depending on your taxable income.
- If losses exceed gains, the entire net amount is an ordinary loss, deductible against any type of income with no annual cap. That is a real advantage over ordinary capital losses, which non-corporate taxpayers can only deduct against ordinary income up to $3,000 per year ($1,500 if married filing separately).3Office of the Law Revision Counsel. 26 USC 1211 – Limitation on Capital Losses
That asymmetry is the whole point of Section 1231. Capital treatment on the upside, ordinary treatment on the downside.
Depreciation Recapture Comes First
Before any gain enters the Section 1231 netting, depreciation recapture strips out the portion that reflects deductions you already took against ordinary income. The rules differ sharply for personal property and real property.
Section 1245: Personal Property
For depreciable personal property — machinery, equipment, vehicles — any gain up to the total depreciation you claimed is recharacterized as ordinary income. Only gain above your original cost proceeds to the Section 1231 calculation.4Office of the Law Revision Counsel. 26 USC 1245 – Gain From Dispositions of Certain Depreciable Property In practice, most equipment sells for less than it cost, so Section 1245 often recaptures the entire gain and nothing survives to the netting.
Section 1250: Real Property
Depreciable real property is treated more gently. Section 1250 only recaptures as ordinary income the depreciation that exceeded straight-line.5Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty Because most real property placed in service after 1986 is depreciated straight-line under MACRS, there is often no excess to recapture.
The straight-line depreciation still gets its own treatment, though. Gain attributable to it is “unrecaptured Section 1250 gain,” taxed at a maximum rate of 25% under Section 1(h). Only gain beyond total depreciation reaches the Section 1231 netting as potential long-term capital gain.
The Five-Year Lookback Rule
Left alone, the ordinary-loss/capital-gain asymmetry would let a taxpayer sell losers one year for a full ordinary deduction, then sell winners the next year at capital gains rates. Section 1231(c) shuts that down.1Office of the Law Revision Counsel. 26 USC 1231 – Property Used in the Trade or Business and Involuntary Conversions
Before your current-year net Section 1231 gain gets capital gain treatment, you look back at the five preceding tax years. Add up the net Section 1231 losses you claimed as ordinary during those years, then subtract any amounts already recaptured by intervening gains. That balance — your non-recaptured net Section 1231 losses — is recharacterized as ordinary income out of your current-year gain. Only the gain above that balance qualifies for capital gain rates.
Say you had a $50,000 net Section 1231 loss in 2023 that you deducted as ordinary, and now have a $75,000 net Section 1231 gain in 2026. The first $50,000 is taxed as ordinary income. The remaining $25,000 gets long-term capital gain treatment. The $50,000 then drops out of the lookback for future years.
The Rates on What Survives
Gain that clears both recapture and the lookback is taxed at 2026 long-term capital gains rates:
- 0% on taxable income up to $49,450 (single), $98,900 (married filing jointly), or $66,200 (head of household)
- 15% above those thresholds up to $545,500 (single), $613,700 (married filing jointly), or $579,600 (head of household)
- 20% above those upper thresholds6Tax Foundation. 2026 Tax Brackets and Federal Income Tax Rates
Unrecaptured Section 1250 gain sits at a maximum 25% rate. And Section 1231 gains can also be hit by the 3.8% net investment income tax when modified adjusted gross income exceeds $200,000 for single filers or $250,000 for joint filers.7Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
Where to Report It
Section 1231 transactions go on Form 4797 (Sales of Business Property), not Schedule D.8Internal Revenue Service. Instructions for Form 4797 Losses on business property held more than a year enter Part I, where the Section 1231 netting happens. Gains on depreciable property start in Part III, where Sections 1245 and 1250 recapture is calculated; anything left flows back to Part I.
If Part I nets to a gain and you have no non-recaptured Section 1231 losses from the prior five years, the gain moves to Schedule D as a long-term capital gain. If prior-year losses do need recapturing, that calculation runs on line 8 and only the excess reaches Schedule D. A net loss from Part I goes to your return as an ordinary loss and bypasses Schedule D entirely.