The disposition of property, whether through sale, exchange, or other means, is a taxable event for federal income tax purposes unless a specific exception applies. Generally, the gain or loss realized from the sale or exchange of property shall be recognized.

Specific Types of Property Dispositions

The tax treatment of property disposition can vary depending on the type of property being disposed of.   

• Sale of Personal Residence (§ 121): A significant exception to the general rule involves the sale of a taxpayer’s principal residence. § 121 (Exclusion of Gain From Sale of Principal Residence) allows individuals to exclude up to $250,000 of gain (and married couples filing jointly to exclude up to $500,000) from the sale of their home if they have owned and used it as their principal residence for at least two of the five years before the sale.
• Sale of Trade or Business-use Property: The sale of property used in a trade or business can result in ordinary income (due to depreciation recapture under sections like § 1245 and § 1250) and capital gains (potentially under § 1231, which provides special rules for gains and losses from the sale of certain business property and involuntary conversions).
• Sale of Investment Property: Gains and losses from the sale of investment property, such as stocks and bonds, are typically treated as capital gains and losses.

Calculating Gain or Loss (§ 1001(a))

The first step in determining the tax implications of a property disposition is to calculate the amount of the gain or loss. § 1001(a) (Computation of Gain or Loss) provides the formula for this calculation:

• Gain: The excess of the amount realized from the sale or other disposition of property over the adjusted basis of the property.
• Loss: The excess of the adjusted basis of the property over the amount realized.

Amount Realized (§ 1001(b))

The amount realized is defined in § 1001(b) (Amount Realized) as the sum of any money received plus the fair market value of any property (other than money) received. This includes not only the cash received from a sale but also the value of any other assets or services you receive in exchange for the property. It also includes any liabilities from which the seller is relieved as a result of the disposition. 

Adjusted Basis (§ 1011 et seq.)

The adjusted basis of property is your original basis (typically its cost under § 1012 (Basis of Property—Cost)) increased by certain capital expenditures and decreased by items such as depreciation, amortization, depletion, tax-free dividends, and casualty losses. § 1011 (Adjusted Basis for Determining Gain or Loss) provides the general rule for determining adjusted basis, and subsequent sections like § 1016 (Adjustments to Basis) detail the specific adjustments that need to be made. 

Once the amount of gain or loss is determined, the next crucial step is to determine its character. The character of the gain or loss (ordinary or capital) dictates how it will be taxed.

• Capital Assets (§ 1221): Most property held by individuals, such as stocks, bonds, and personal-use property, are considered capital assets under § 1221 (Definition of Capital Asset). The sale or exchange of a capital asset generally results in a capital gain or capital loss. Short-term capital gains or losses result from the sale of capital assets held for one year or less. Short-term capital gains are taxed at the same rates as ordinary income.  Long-term capital gains or losses result from the sale of capital assets held for more than one year. Long-term capital gains are generally taxed at lower rates than ordinary income.
• Ordinary Income Property: Certain types of property are not considered capital assets. These include property held primarily for sale to customers in the ordinary course of business (inventory), depreciable property used in a trade or business (gains from which may be subject to recapture), and certain copyrights and literary compositions. Gains from the sale of ordinary income property are taxed as ordinary income. Result indicates that the sale of real estate can be taxed as capital gain. However, this determination depends on various factors, including whether the property was held for investment or as inventory.
• Section 1231 property:
  • Depreciation recapture under Section 1245 of the Internal Revenue Code is a provision that recharacterizes a portion of the gain from the sale or other disposition of certain depreciable property as ordinary income, rather than capital gain. When Section 1245 property (i.e., tangible personal property subject to depreciation) is sold or otherwise disposed of at a gain, the gain is treated as ordinary income to the extent of the depreciation previously allowed or allowable on that property. Its primary purpose is to prevent taxpayers from converting ordinary income (obtained through depreciation deductions that reduce taxable income) into capital gains, which are often taxed at lower rates.

• • Unrecaptured Section 1250 gain is a specific type of long-term capital gain that can arise from the sale or other disposition of certain depreciable real property. It represents the portion of the gain attributable to depreciation taken on the property that is not subject to the full ordinary income recapture rules of Section 1250 but is still taxed at a special capital gain rate. Unrecaptured Section 1250 gain primarily comes into play when straight-line depreciation has been used on the real property. Since straight-line depreciation does not create “additional depreciation” in the same way accelerated methods do, the general Section 1250 recapture rules often don’t apply.