What Is Section 1231 Property and How Is It Taxed?

Section 1231 property is business-use property, held for more than a year, that gets a rare tax deal: a net gain from selling it is taxed at long-term capital gains rates, while a net loss is treated as an ordinary loss you can deduct in full against any kind of income. Tax professionals sometimes call it a “best of both worlds” rule because the taxpayer wins on both sides of a sale.¹

What Qualifies

Two tests. The asset has to be used in a trade or business, and you have to have held it for more than one year before selling or exchanging it.¹ That one-year minimum is a hard line. Sell at 364 days and you get ordinary treatment on the full result.

The qualifying assets themselves come in two broad categories. The first is depreciable personal property, meaning tangible business items whose cost you write off over time under Section 167 — machinery, company vehicles, office equipment. The second is real property used in the business, including land and buildings, whether or not the building is depreciable.¹ Purchased intangibles also qualify. Goodwill, franchises, customer lists, and other Section 197 intangibles used in the business and held for more than a year are treated as depreciable property for Section 1231 purposes.²

A few specialized categories are named in the statute:

Timber, coal, and domestic iron ore, when disposed of under the special rules of Section 631.¹
Livestock held for draft, breeding, dairy, or sporting purposes. Cattle and horses must be held at least 24 months. Hogs, sheep, goats, and fur-bearing animals need 12 months.³
Unharvested crops, but only when sold with the land to the same buyer in a single transaction.¹

What Doesn’t Qualify

Several categories of business assets are specifically excluded, and they cause problems on returns every year.

Inventory is out. Anything held primarily for sale to customers produces ordinary income or loss on disposal, whether it’s a retailer’s stock, a dealer’s lot, or a developer’s spec homes. Creative works held by their creator are also out. Copyrights, musical compositions, literary works, and similar property don’t qualify in the hands of the person who created them or someone who received them as a gift from the creator. A copyright you purchased from someone else and use in your business can qualify. Accounts receivable acquired in the ordinary course of business are ordinary assets, and U.S. government publications received below the public sale price are excluded when held by the original recipient.¹

Personal-use assets are not Section 1231 property either. Your home, your personal car, and anything else you don’t use in a trade or business follows the standard capital asset rules.

The line between inventory and Section 1231 property can blur. A construction company’s backhoe is Section 1231 property because the company uses it to run the business. But if that same company also buys and resells heavy equipment as a side line, the resale equipment is inventory. Use, not identity, decides.

How Gains and Losses Are Taxed

Section 1231 doesn’t tax each sale on its own. At year-end you net all your Section 1231 gains against all your Section 1231 losses, and the single net result drives the treatment for the whole group.

If gains exceed losses, every dollar of the net gain becomes a long-term capital gain. Long-term capital gains are taxed at 0%, 15%, or 20% depending on taxable income.⁴ For 2026, the 0% rate applies to taxable income up to $49,450 for single filers and $98,900 for married couples filing jointly, and the 20% rate begins above $545,500 and $613,700. Those rates sit well below the ordinary brackets, which reach 39.6% at the top following the scheduled expiration of the Tax Cuts and Jobs Act rate reductions at the end of 2025.⁵

If losses exceed gains, the entire net loss is an ordinary loss. It’s fully deductible against wages, business income, interest, or any other income, with no annual cap. Compare that to net capital losses for individuals, which are limited to $3,000 per year ($1,500 if married filing separately), with the rest carried forward.⁶ A $200,000 Section 1231 loss wipes out $200,000 of taxable income in the year it occurs. A $200,000 capital loss would take almost 67 years to deduct at the $3,000 cap.

Depreciation Recapture Comes First

Before any gain reaches the favorable capital gains rate, the IRS pulls back the depreciation you already deducted. The mechanics differ for personal property and real property.

Section 1245 on Personal Property

When you sell depreciable personal property at a gain, all of the depreciation or amortization you claimed comes back as ordinary income. Section 1245 does this by comparing sale price to “recomputed basis,” which is your adjusted basis plus the depreciation you took.⁷ Gain up to the total depreciation is ordinary. Only gain above the original purchase price gets Section 1231 treatment. Since most equipment doesn’t sell for more than it cost, Section 1245 often converts the entire gain to ordinary income.

Section 1250 and Unrecaptured Gain on Real Property

Real property gets a gentler rule. Section 1250 only recaptures “additional depreciation,” meaning depreciation beyond straight-line. Most real property placed in service after 1986 uses straight-line, so Section 1250 rarely produces ordinary income on modern buildings.⁸

The depreciation doesn’t slip away, though. Gain attributable to straight-line depreciation on real property is called “unrecaptured Section 1250 gain” and is taxed at a maximum rate of 25% rather than the usual 0/15/20 rates.⁵ So a sale of a commercial building at a profit layers the tax: the piece tied to depreciation is taxed at up to 25%, and any additional gain above the original purchase price flows through Section 1231 to regular long-term capital gains rates.

The Five-Year Lookback Rule

There’s a guardrail on the favorable side. If you claimed Section 1231 ordinary losses in any of the five preceding tax years, a current-year net Section 1231 gain has to pay those benefits back before it qualifies for capital gains rates.¹

Your current gain is recharacterized as ordinary income to the extent of any net Section 1231 losses from the last five years that haven’t already been recaptured. Only what’s left over gets long-term capital gains treatment.⁹ Say you had a $50,000 net Section 1231 loss two years ago and a $75,000 net Section 1231 gain this year. The first $50,000 of this year’s gain is ordinary. Only the remaining $25,000 gets capital gains rates. Without the rule, you could line up losses one year and gains the next and win both sides indefinitely.

The lookback calculation appears on Line 8 of Form 4797. Keep Section 1231 records for at least six years (the current year plus five prior) so you can run the computation correctly.

Sales to Related Parties

Selling depreciable property to a related party overrides Section 1231. Under Section 1239, any gain on the sale is ordinary income if the property will be depreciable in the buyer’s hands.¹⁰ The buyer gets a stepped-up depreciable basis, and the seller loses the capital gains rate.

“Related persons” here includes you and any corporation or partnership in which you own more than 50% of the value or interests, trusts where you or your spouse is a beneficiary, and an executor selling to an estate beneficiary. Constructive ownership rules pull in family members and entities indirectly, so ownership through relatives counts.¹⁰ Run the Section 1239 analysis before closing any sale to a family-controlled LLC or similar entity.

The Net Investment Income Tax

Higher-income taxpayers face a 3.8% surtax on net investment income, and Section 1231 gains can be swept in. It depends on how actively you were involved in the business. Gains from a business in which you materially participated are excluded from net investment income. Gains from passive activities are included.¹¹

The surtax applies to the lesser of your net investment income or the amount your modified adjusted gross income exceeds the filing-status threshold: $200,000 for single, $250,000 for married filing jointly, and $125,000 for married filing separately. These thresholds are not indexed for inflation.¹¹ A passive landlord selling a rental property at a large gain is a textbook exposure.

How to Report It

Section 1231 transactions go on Form 4797, Sales of Business Property. Where each transaction lands depends on whether depreciation recapture applies.⁹

Gains on depreciable property typically start in Part III, where the recapture math happens. The Section 1245 or Section 1250 ordinary-income portion stays in Part III. Any remaining gain moves up to Part I for the Section 1231 netting. Losses go straight to Part I, and so do sales of non-depreciable real property like raw land.⁹

After netting in Part I, a net gain with no unrecaptured Section 1231 losses in the prior five years transfers to Schedule D as a long-term capital gain. If prior losses do exist, Line 8 converts the appropriate slice to ordinary income before the rest flows through.⁹

1
Office of the Law Revision Counsel. 26 USC 1231 – Property Used in the Trade or Business and Involuntary Conversions
2
Internal Revenue Service. IRS Written Determination 0243002 – Section 197 Intangible Treatment
3
eCFR. 26 CFR 1.1231-2 – Livestock Held for Draft, Breeding, Dairy, or Sporting Purposes
4
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
5
Office of the Law Revision Counsel. 26 USC 1 – Tax Imposed
6
Office of the Law Revision Counsel. 26 US Code 1211 – Limitation on Capital Losses
7
Office of the Law Revision Counsel. 26 USC 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. Instructions for Form 4797
10
Office of the Law Revision Counsel. 26 US Code 1239 – Gain from Sale of Depreciable Property Between Certain Related Taxpayers
11
Internal Revenue Service. Net Investment Income Tax