Sections 1231, 1245 and 1250: Why the Character of a Gain on Business Property Is Decided in a Fixed Order

A machine bought for 100,000, depreciated to 40,000 and sold for 90,000 produces a gain of 50,000, and not one dollar of it is a capital gain. Depreciation recapture under Section 1245 takes it all as ordinary income first. Sell the same machine for 130,000 and the gain of 90,000 splits: 60,000 ordinary, up to the depreciation taken, and 30,000 under Section 1231, which after netting is a long-term capital gain. The order in which those rules are applied is fixed, and a candidate who applies them in the wrong order, or applies the real property rule to a machine, gets a number that is on the answer list precisely because someone made that mistake.

REG tests the character of gain on a single sale of business property: which section, how much ordinary, how much Section 1231. TCP takes the results across the year and across five years, into the netting and the lookback, and into the like-kind and installment rules that defer them. This article covers the whole sequence, and says at each step which section is examining it.

Three kinds of property

Category	What it is	Gain	Loss
Capital asset	Everything not excluded by Section 1221: investments, personal-use property	Capital	Capital, limited
Section 1231 property	Depreciable property and land used in a trade or business, held more than one year	Capital if the year's net is a gain, after recapture	Ordinary if the year's net is a loss
Ordinary asset	Inventory, receivables, business property held one year or less, creative works of their creator	Ordinary	Ordinary

Section 1231 is the taxpayer's best of both worlds: a net gain is taxed as a long-term capital gain, and a net loss is deducted as an ordinary loss without the capital loss limits. The recapture sections exist to take back part of that generosity. Depreciation was deducted against ordinary income; to the extent the sale price shows the deduction was too large, the gain that restores it is ordinary too.

The fixed order

1. Section 1245 recapture on depreciable personal property: gain is ordinary to the extent of all depreciation taken, including Section 179 expensing and bonus depreciation.
2. Section 1250 recapture on depreciable real property: gain is ordinary to the extent depreciation taken exceeded straight-line. For property placed in service after 1986, which must be depreciated straight-line, that excess is zero, and the section bites only through its two extensions below.
3. Section 291, for C corporations only: 20% of the amount that would have been Section 1245 recapture had the real property been personal property is ordinary.
4. Unrecaptured Section 1250 gain, for individuals: the straight-line depreciation on real property that escaped step 2 is still capital gain, but taxed at a maximum rate of 25% instead of the lower long-term rates.
5. Section 1231 netting: what is left after recapture, from every Section 1231 asset sold in the year, gains and losses together.
6. The five-year lookback: a net Section 1231 gain is ordinary to the extent of net Section 1231 losses deducted in the previous five years that have not already been recaptured this way.

Recapture applies to gains only. A loss on business property is never touched by Sections 1245 or 1250; it goes straight to the Section 1231 netting, which is why a bad year for asset sales produces ordinary losses.

Personal property, worked

Equipment cost 100,000 and 60,000 of depreciation has been taken, so the adjusted basis is 40,000. It has been held for three years.

Sale price	Gain or loss	Section 1245 ordinary	Section 1231
90,000	50,000 gain	50,000	0
130,000	90,000 gain	60,000	30,000
30,000	10,000 loss	0	(10,000)

The recapture is the lesser of the gain and the depreciation taken. At 90,000 the gain is smaller than the depreciation, so all of it is recaptured. At 130,000 the depreciation is the limit, and the 30,000 above the original cost is Section 1231 gain. At 30,000 there is no gain and no recapture, and the loss is Section 1231. Section 1245 property includes machinery, vehicles, equipment, furniture and most intangibles that are amortised; the test is depreciable property that is not a building or its structural components.

Real property, worked

A building cost 1,000,000, has been depreciated straight-line by 200,000 to a basis of 800,000, and is sold for 1,100,000 after ten years. The gain is 300,000.

Owner	Ordinary income	Unrecaptured Section 1250 gain (25% rate)	Section 1231
Individual	0	200,000	100,000
C corporation	40,000 under Section 291	Not applicable	260,000

The individual's row is the one that surprises. There is no Section 1250 recapture because there was no accelerated depreciation, so nothing is ordinary; but the 200,000 of depreciation does not get the low capital gains rate either. It is capital gain at up to 25%, and the 100,000 of appreciation above cost is ordinary Section 1231 gain that, after netting, gets the 0, 15 or 20% rate. The corporation has no preferential rates to protect, so Congress gave it Section 291 instead: 20% of the 200,000 is ordinary, and the rest is Section 1231.

Land is Section 1231 property with no depreciation and therefore no recapture; its gain goes straight to the netting. A sale of a building with its land is split between the two.

The netting and the lookback

In the year the building above is sold by an individual, the same taxpayer sells a second piece of equipment at a Section 1231 loss of 30,000. Two years earlier the taxpayer deducted a net Section 1231 loss of 20,000 as an ordinary loss.

Step	Amount
Section 1231 gain from the building, after separating the unrecaptured 1250 gain	100,000
Section 1231 loss on the equipment	(30,000)
Net Section 1231 gain	70,000
Lookback: unrecaptured net Section 1231 loss from the prior five years	20,000 recharacterised as ordinary
Long-term capital gain	50,000

Had the equipment loss been 130,000 instead, the net would have been a 30,000 loss, deductible in full as ordinary, and it would itself become a lookback item for the next five years. The lookback is the mechanism that stops a taxpayer timing losses into one year, for ordinary treatment, and gains into the next, for capital treatment.

The netting and the lookback are where REG hands over to TCP. REG expects a candidate to compute the character of a single sale and to know that Section 1231 gains and losses are netted; TCP tests the netting across several assets, the five-year lookback, the interaction with capital loss carryovers, and the deferral rules under which the gain is not recognised at all this year: like-kind exchanges of real property and installment sales, both of which carry the recapture forward in their own way. The TCP study guide sets out that split, and the REG study guide the REG side.

Holding period and basis

Section 1231 requires the property to have been held for more than one year. Business property sold within a year is an ordinary asset: its gain is ordinary and its loss is ordinary, with no recapture computation needed because the result is the same. Basis for the computation is the adjusted basis, cost less depreciation allowed or allowable, and the word "allowable" matters: depreciation the taxpayer failed to claim still reduces basis, and the gain on sale is measured against the reduced figure. A candidate who computes the gain from original cost has answered a question about a different asset.

How the exam asks

Question pattern	Answer
Equipment sold above basis, below cost	All gain ordinary under Section 1245
Equipment sold above cost	Depreciation is ordinary; excess is Section 1231
Equipment sold at a loss	Section 1231 loss; no recapture
Building sold by an individual, straight-line depreciation	No ordinary income; depreciation is unrecaptured 1250 gain at up to 25%; rest is 1231
Same building sold by a C corporation	20% of the depreciation is ordinary under Section 291
Net 1231 gain, prior-year net 1231 losses	Ordinary to the extent of the lookback losses
Net 1231 loss	Ordinary loss in full
Business property held eleven months	Ordinary asset; not Section 1231

Where to practise this

Gain character is a procedure with a fixed order, and it is learned by running it on assets of every kind until the order is automatic. Prepito's REG course covers property transactions, basis, depreciation and recapture with practice questions that show the character split line by line, and the TCP course takes the same assets through netting, the lookback and the deferral rules. For the way to approach US property tax with no US background, see How to Study REG When You Have Never Filed a US Tax Return, and for the other REG topic built on basis, Partnership Basis vs S Corporation Basis.

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Sources: IRS Publication 544, Sales and Other Dispositions of Assets, IRS Publication 946, How to Depreciate Property, AICPA CPA Exam Blueprints. Worked figures are illustrative and the rates quoted are those in force for 2026; the Internal Revenue Code changes, so confirm the current rules and the Blueprint's REG and TCP allocation for your testing window.