There are three main property classifications listed with the Internal Revenue Code that assist in explaining tax regulations when business property is sold. Section 1245, 1231, and 1250 property are all included to provide guidelines to aid in financial planning when contemplating business disposition. Each of these sections provides different tax implications and should be taken into consideration when making decisions about business property. It is important to consult a qualified tax advisor to ensure that all laws are properly followed.
Property Section 1231
Section 1231 property is any property used in business that has been owned for more than a year including buildings, property, timber, and even certain animals. This, however, does not include intangible assets (copyrights, patents, etc.) or property/inventory that is for customer purchase.
The gain or loss from the disposition of Section 1231 property is included in business income. Any amount received from the disposition that equates to the depreciation recapture is treated as regular income. Yet, when the amount gained is more than the property’s basis and depreciation recapture amount, the income is then counted and taxed as capital gains. Therefore, it is taxed at a lower rate than regular income. On the other hand, if a loss occurs at disposition, it is classified as a loss and is 100% deductible to offset income. These deductions for losses are capped at $3,000 per tax year, but any amount over this limit is available for future use.
For instance, Business Inc. wants to dispose of machinery that they purchased for $1,200. However, over the years, the machinery has depreciated by $1,100. When they sell the machinery at $1,500, $1,100 is taxed as normal income, and $300 is taxed at a capital gains tax rate. The gain is then reported to the IRS on Form 4797.
Property Section 1245
Simply put, property that falls under Section 1245 is the same property that would fall under Section 1231 – except for buildings and their structural components. The difference between the two is that Section 1245 still has unrecaptured depreciation. So, once the property has been fully depreciated, it becomes Section 1231 property.
Section 1245 property follows similar tax guidelines as Section 1231 property. When sold at a gain, the amount that covers the uncaptured depreciation is taxed at regular income rates, and anything over the recaptured depreciation amount is taxed at a capital gains tax rate. If the property is sold at a loss, it is converted to Section 1231 property and follows the same rules for deduction. So, when a loss occurs with property disposition, it can be written off as a capital loss. This can be used to offset any capital gains made during the year. Additionally, if the property is sold at a profit, the recaptured depreciation can be deducted from the profit.
For example, Business Inc. owns a printer that was purchased for $240. It has depreciated in the amount of $180. Therefore, the tax basis for the printer is $60 ($240-$180). Business Inc. sells the printer for $250. This means that the company has a gain of $190 ($250-$60). Under Section 1245 tax regulations, out of the $250, $180 is taxed as normal income, and $70 is taxed at a capital gains tax rate.
Property Section 1250
Commercial buildings, rental houses, and structural components of a building (roofs and floors) are included in Section 1250. This property has a longer depreciation time span than the property that falls under Section 1245. Furthermore, this IRC Section focuses on property that follows the accelerated depreciation method. With this method, there is a larger depreciation deduction than what is commonly seen with the straight-line depreciation method.
When it is time to sell the property, the IRS applies regular tax rates to the difference between the straight-line method and the accelerated depreciation method. Any amount over the difference is taxed at a capital gains tax rate.
So, when Business Inc. goes to dispose of their warehouse, they must consider the difference between the two depreciation methods. Business Inc. initially bought their property for $175,000 and sold it for $150,000. If the difference between the two depreciation methods is $30,000, the $30,000 would then be taxed at an ordinary income rate and the $120,000 taxed at a capital gains tax rate.
Determining your Business’s Future
These are just a few of the numerous property section codes provided by the Internal Revenue Code to help determine how your business is taxed when disposing of assets. Having a basic understanding of these codes can help maximize your property’s value to its fullest potential. With the various regulations, it is important to consult a tax professional for more detailed information about how to properly calculate and report taxes. Contact your certified accountant to help you determine the most advantageous way to invest your money. Contact Kislay Shah CPA to discuss IRC codes specific to your business’s situation at kislay@shahcpaus.com or call 646-328-1326.