Module Overview

The disposition of property, whether by sale, exchange, or other methods, is generally considered a taxable event unless a statutory nonrecognition provision applies. The gain (loss) recognition process begins by calculating the amount realized. Amount realized includes cash received, the fair market value of any other property received, liabilities assumed by the transferee, minus selling costs. Once the amount realized is determined, it is compared to the property’s adjusted basis to establish any realized gain or loss. The next step is characterization, which affects the tax consequences based on the asset’s character and holding period. Before offsetting gains and losses under the Section 1231 rules, taxpayers must apply depreciation recapture provisions. For instance, IRC §1245 addresses gain up to the amount of prior depreciation on certain personal property and intangibles, treating this amount as ordinary income. Conversely, IRC §1250 pertains to depreciable real property and often results in unrecaptured §1250 gain, subject to a special capital gain rate cap rather than as ordinary income. After applying depreciation recapture, remaining gains and losses from business property are netted under IRC §1231. This means that net losses are treated as ordinary losses, while net gains are classified as long-term capital gains. However, a five-year lookback rule can recharacterize current §1231 gains as ordinary income to the extent of any prior net §1231 losses.

Specific Types of Property Dispositions

The tax consequences of a property disposition depend on the asset’s use, character, and the taxpayer’s holding period. Three common categories, sale of a principal residence, disposition of trade or business property, and sale of investment property, illustrate how statutory exceptions, recapture rules, and characterization principles operate.

Sale of a principal residence (§121). Section 121 permits qualifying taxpayers to exclude a portion of gain realized on the sale of a principal residence from gross income, subject to ownership and use tests and frequency limitations. Generally, an individual who has owned and used the property as a principal residence for at least two of the five years preceding the sale may exclude up to $250,000 of gain (or up to $500,000 for married filing jointly) provided statutory conditions are satisfied. The exclusion applies to gain that otherwise would be recognized, but taxpayers must observe the specific eligibility rules and exceptions set out in the statute and regulations. Note that periods of nonqualified use, prior business or rental use, and depreciation claimed while the property was not used as a qualified personal residence can affect the amount excluded and require careful coordination with recapture and basis rules.

Disposition of trade or business property. Sales or other dispositions of assets used in a trade or business frequently produce a mixture of ordinary income and capital gain because of depreciation recapture and special classification rules. Under IRC §1245, gain on the disposition of certain depreciable tangible and intangible personal property is recaptured as ordinary income to the extent of prior depreciation deductions. For depreciable real property, IRC §1250 and related provisions treat depreciation differently and may result in an ‘‘unrecaptured §1250 gain’’ outcome, which is characterized as capital gain but may be subject to a separate rate cap. After applying recapture rules, the remaining gain or loss from business property is typically netted under IRC §1231, where net losses are ordinary and net gains are long‑term capital gains, subject to statutory lookback rules that prevent inappropriate conversion of ordinary losses into capital gains.

Sale of investment property. Property held for investment, such as securities, typically produces capital gains or losses. The character of the gain depends on the holding period: assets held more than one year qualify for long‑term capital gain treatment, while assets held one year or less generate short‑term gains taxed at ordinary rates. Net capital gains and losses are subject to annual netting rules and limitations on the deduction of excess capital losses for individuals.

In all cases, proper tax reporting requires accurate measurement of amount realized, careful computation of adjusted basis (including prior cost recovery), and correct application of recapture and characterization rules.  

Character of Gain or Loss and Recognition

Step 1: Realized Gain or Loss

The starting point for tax treatment of a disposition is the computation of realized gain or loss. Under Internal Revenue Code §1001(a), realized gain equals the amount realized on the disposition less the adjusted basis of the property, while realized loss equals the adjusted basis less the amount realized. This realized amount is the basic measure of economic change that triggers tax consequences.

Section 1001(b) defines the amount realized as the sum of any money received plus the fair market value of other property received, plus the amount of liabilities of the transferor discharged by the transferee, reduced by selling costs. In practical terms, the amount realized includes cash, marketable property received in exchange, and relief from debt, but not incidental transaction costs that reduce the seller’s net proceeds.

Adjusted basis is the measure of the taxpayer’s investment in the property. For purchased property initial basis generally equals cost under IRC §1012 and includes acquisition costs that place the asset in service. Basis is increased by capital additions and certain adjustments and decreased by cost recovery deductions such as depreciation and by casualty losses, as provided in IRC §1016. Accurate records of acquisition cost, improvements, and depreciation are essential because adjusted basis directly affects the tax result on disposition.

• 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: “Section 1231 property” generally means depreciable property and real property used in a trade or business and held for more than one year, together with certain involuntary conversions of such property. Section 1231 property does not include inventory, accounts receivable, or property held primarily for sale to customers.

When depreciable property is disposed of at a gain, statutory recapture provisions reclassify portions of gain that would otherwise be capital into ordinary income to reflect prior cost recovery.

Section 1245 applies to depreciable tangible personal property and certain intangibles. Under §1245, the amount of gain equal to depreciation previously allowed or allowable is treated as ordinary income. Any remaining gain, if present, receives capital treatment or is subject to Section 1231 as appropriate.

Section 1250 governs depreciable real property. Because most post‑1986 real property depreciation is straight line, the ordinary income recapture under §1250 is limited in many cases. Instead, gain attributable to prior depreciation may be treated as unrecaptured §1250 gain, which is taxed as capital gain but may be subject to a special maximum rate for the depreciation portion.

After applying recapture rules, remaining gains and losses from the sale of trade or business property are netted under IRC section 1231. Net §1231 losses are treated as ordinary losses, while net §1231 gains are treated as long‑term capital gains. A statutory five‑year lookback rule requires taxpayers to recharacterize current‑year net §1231 gains as ordinary income to the extent of prior net §1231 losses claimed in the preceding five years.