Section 1231 vs. Capital Gain—The Hidden Tax Break When You Sell Your Rental Property
Section 1231 is one of the few places in the Code that can give you “heads-I-win, tails-I-don’t-lose.” If you net a gain, it’s treated as long-term capital gain (preferential rates); net a loss, and it’s fully ordinary (no $3 k cap). Here’s how to lock it in when you unload a rental.
1. What Counts as Section 1231 Property?
- Real or depreciable property used in a trade or business and held > 1 year—your rental duplex, a self-storage facility, even a parking lot you depreciated.
- NOT inventory, notes, copyrights, or purely personal-use land.
- Land held for investment is a capital asset, but land held in a rental enterprise picks up §1231 flavor.
Publication 544 gives the full list and exceptions.
2. Depreciation Recapture: §1250 & §1245 First
Before you celebrate the low capital-gain rate, peel off:
- §1245 recapture—all prior depreciation on personal property (appliances, carpet) becomes ordinary income.
- §1250 recapture—for real estate, only the excess of accelerated over straight-line depreciation is ordinary, but any unrecaptured §1250 gain still pays tax at 25 %.
Only the remainder flows into the Section 1231 netting bucket.
3. The 5-Year Look-Back Rule
Did you have net §1231 losses in the last five years? If so, this year’s net gain is re-characterized as ordinary income up to that loss balance. It’s a one-way street—old gains never retro-re-characterize losses.
4. Walk-Through Example (2025 Dollars)
|
Item |
Amount |
|---|---|
|
Net sales price (duplex) |
$650,000 |
|
Adjusted basis |
$400,000 |
|
Gain |
$250,000 |
|
Less: §1250 unrecap’d @ 25 % |
$60,000 |
|
Remainder into §1231 bucket |
$190,000 |
|
Prior 5-year §1231 losses |
$40,000 |
|
Ordinary income (recaptured via look-back) |
$40,000 |
|
Long-term capital gain |
$150,000 |
Result: $60 k taxed at 25 %, $40 k at ordinary rates, $150 k at 15 %/20 % capital-gain rate.
5. California Conformity
- California generally follows §1231—including the look-back—under R&TC §18151 and Schedule D-1 instructions.
- Passive-activity limits still apply; unused §1231 losses may differ because CA depreciation and AMT adjustments shift the math.
7. Planning Tips to Maximize 1231 Treatment
- Hold > 1 year—an 11-month flip is ordinary.
- Bunch disposals—sell loss property in the same year as gain property to manufacture a deductible ordinary loss.
- Time gains after the 5-year window—let look-back losses expire.
- Consider an installment sale—spread gain into multiple years; look-back applies year-by-year.
- Pair with §1031 exchange when reinvesting; recapture and §1231 gain are deferred.
8. FAQs
Q1. Does land qualify?
Yes, if it’s held in a trade/business (e.g., rental parking lot) and > 1 year. Pure investment land is a capital asset.
Q2. Is the depreciation I “recapture” also subject to NIIT?
Ordinary recapture income under §§1245/1250 is not net investment income, but the §1250 25 % portion is.
Q3. What happens if I convert a rental to personal use before selling?
Allocate gain between periods of business vs. personal use; only the business-use slice is §1231. Publication 544 details the split.
Q4. Can I combine a rental sale with the sale of my S-corp equipment?
Yes—Section 1231 netting covers all your §1231 gains and losses for the year before look-back recapture.