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Selling or exchanging property that has been used in a trade or business may create a tax liability for the gain under Section 1231 of the Internal Revenue Code. You will be taxed at ordinary income rates instead of the long-term capital gains rate in certain circumstances. For most taxpayers, the ordinary income rate is higher than the capital gains rate. Use Form 4797 and Schedule D with Form 1040 to report your Section 1231 gain or loss.
Section 1231 covers the sale or exchange of real property used in a business or trade. Depreciable personal property, Section 197 intangibles and the sale or exchange of leaseholds also qualify if used for your business. You may treat the condemnation of a property as a Section 1231 exchange if you have held it for more than one year and initially purchased it with the intent to generate a profit. This requirement disqualifies most personal real estate investments.
Cattle and horses held for at least two years and used for breeding, dairy, draft or sport are classified as a Section 1231 commodity. Other types of livestock, excluding poultry, must only be held for one year to qualify for Section 1231 tax treatment. If you sell or exchange unharvested crops, you must include the underlying land as part of the contract. Sales of timber, coal and iron ore are also considered Section 1231 transactions if the commodity is severed from the land.
The tax treatment of your Section 1231 exchange depends on whether you have a net gain or loss from all Section 1231 transactions during the tax year. The gain is taxed as ordinary income up to the amount of nonrecaptured losses from the previous five years. Any remaining Section 1231 gains will be taxed at the long-term capital gains rate. Start with the earliest loss in the previous five years and apply it against your current year gain. Repeat this process until all previous losses have been used.
If depreciable property is sold or exchanged, you must recapture the depreciation already taken prior to the transfer of ownership. Keep records showing the manner in which you acquired the asset, acquisition date, original cost, adjustments to basis and depreciation or amortization deducted on your prior tax returns. If you acquired the property through a gift or non-taxable exchange, you must also include a notation indicating whether the adjusted basis was calculated based on depreciation and amortization claimed on your tax returns or depreciation and amortization claimed by another party prior to the transfer of ownership.
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