III. Section 1231: Some Limited Mismatching

III. Section 1231: Some Limited Mismatching

During World War II, the nation moved to a war economy. The Government seized many of the nation’s productive assets in order to convert them to production of items critical to the war effort. The Fifth Amendment to the Constitution of course requires that the owners of such properties be justly compensated. However, the owners of businesses may not have particularly wished to sell their assets to the Government and then to pay income tax (at wartime rates) on the taxable gains they were forced to recognize. Congress responded by enacting § 1231 – a sort of “heads-I-win-tails-you-lose” measure for taxpayers who found themselves with (substantial amounts of) unplanned-for taxable income. Basically, net gains from such transactions would be treated as capital gains; net losses from such transactions would be treated as ordinary losses. World War II ended a long time ago, but § 1231 is still with us. It has become a very important provision in the sale of a business’s productive assets.

Section 1231 applies to “property used in the trade or business” and to any capital asset held for more than one year in connection with a trade or business or a transaction entered into for profit. § 1231(a)(3). Section 1231(b) defines “property used in the trade or business” essentially as “property used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 167, held for more than 1 year, and real property used in the trade or business, held for more than 1 year[.]” § 1231(b)(1). Such property is the same as the property that § 1221(a)(2) describes, but which the taxpayer has held for more than one year. Such property does not encompass property that § 1221(a)(1, 3, and 5) describes.
Section 1231 requires two netting processes – both of which adopt the “heads-I-win-tails-you lose” characterization of transactions that net to a gain as capital and transactions that net to a loss as ordinary. If the first netting process yields a gain, the net gain becomes a part of the second netting process. Those who write about § 1231 often describe this in terms of mixing ingredients in two pots. If the mixture in the first pot yields a net positive, it is added to the second pot; otherwise, it is not added. We are talking about non-statutory terms so we can use any terminology we wish – but let’s consider the first netting process to occur in a “firepot.” The second netting process occurs in a “hotchpot.”
Firepot: Section 1231 initially adopts the “heads-I-win-tails-you-lose” principle for “involuntary conversions” resulting from casualty losses of “property used in the trade or business” or of a capital asset held for more than one year in connection with a trade or business or transaction entered into for profit. § 1231(a)(4)(C). If a taxpayer’s gains and losses from such “involuntary conversions” resulting from casualty losses net to a loss, then § 1231 does not apply to any such gains and losses. § 1231(a)(4) (carryout paragraph). The upshot of this “inapplicability” is that such gains and losses are treated as realized on the disposition of non-capital assets, so the net loss will be an ordinary loss. If the gains and losses from such transactions yield a net gain or if the net gain and loss is $0, then § 1231 is applicable to them. See Reg. § 1.1231-1(e)(3). Such transactions are added to the §1231 hotchpot.
Section 1231 Hotchpot: Section 1231 requires a netting of “section 1231 gains” and “section 1231 losses.” “Section 1231 gain” is

•gain recognized on the sale or exchange of “property used in the trade or business” plus

•gain recognized on the compulsory or involuntary conversion into money or other property as a result of whole or partial destruction, theft or seizure, or requisition or condemnation of “property used in the trade or business” or a “capital asset held for more than 1 year” that “is held in connection with a trade or business or a transaction entered into for profit.” § 1231(a)(3)(A). But

•Such gain does not include depreciation recapture. § 1245(d), § 1250(h), Reg. § 1.1245-6(a), Reg. § 1.1250-1(e)(1).

•If section 1231 gains for any taxable year exceed section 1231 losses, such gains and losses are treated as LTCG or LTCL as the case may be. § 1231(a)(1).

•If section 1231 gains do not exceed²¹⁰ section 1231 losses for the taxable year, then such gains and losses are not treated as gains and losses derived from sales or exchanges of capital assets. § 1231(a)(2).
A provision so taxpayer-friendly would be subject to some abuse. With only a little planning, a taxpayer may dispose of section 1231 “winners” in one taxable year and section 1231 “losers” in a different taxable year. Hence, § 1231(c) creates a so-called “5-year lookback rule.” For any year in which taxpayer recognizes net section 1231 gains, such gains are taxed as ordinary income to the extent taxpayer recognized section 1231 losses during the five most recent preceding taxable years. § 1231(c).

Do the CALI Lesson Basic Federal Income Taxation: Property Transactions: Identification of Section 1231 Property

IV. Some Basis Transfer Transactions: §§ 1031, 1033

Congress has identified some transactions in which it does not want taxpayers to “recognize” gain even though a taxpayer may have “realized” gain. The “technique” by which Congress accomplishes this is the basis transfer. Taxpayer simply keeps as the basis in the asset he acquires the basis in the asset he gave up. Some examples include –

•Like-kind exchanges under § 1031: Under certain defined conditions, taxpayer does not recognize gain or loss upon the exchange of property for other property of like kind. Instead, taxpayer has the same basis in the acquired property as he had in the property exchanged. § 1031(d) (with adjustments for receipt of and taxation of non-like kind property received).

•Involuntary conversions under § 1033: If taxpayer’s property is compulsorily or involuntarily converted because of theft, seizure, requisition or condemnation, taxpayer may, by complying with the rules of § 1033, elect to spend money received because of such conversion on replacement property. Taxpayer does not recognize the gain realized on such a conversion. Instead, taxpayer has the same basis in the replacement property that he had in the property compulsorily or involuntarily converted. § 1033(b) (with various adjustments).

•The gain or loss that a partner “realizes” upon contributions of property to a partnership in exchange for a partnership interest are not “recognized.” § 721. The partner’s basis in his partnership interest is the basis he had in the property contributed. § 722.

•The gain or loss that a shareholder “realizes” upon contributing property to a corporation in exchange for shares of stock in the corporation are not “recognized” if the conditions of § 351(a) are met. Shareholder’s basis in his shares is the basis of the property he contributed. § 358(a).
In these transactions and many more, tax on gain is not forgiven. It is merely deferred until the time when taxpayer disposes of the asset acquired in a taxable transaction.

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