A sale is a transfer of property for money or debt (mortgage, note, or other promise to pay). A transfer of property for other property or services may be taxed the same way as a sale.

Ordering rules for capital gains. Since there are multiple kinds of capital gains on which to calculate tax, an ordering system is used to apply different gains to the tax rates. The kinds of gains are included in taxable income in the following order:

If a taxpayer has a “net capital gain” (net long-term capital gain in excess of net short-term capital loss), the gain is subject to a preferential tax rate as discussed above. Thus, a taxpayer has to net multiple long-term and short-term capital transactions that take place during a year to calculate tax liability. In calculating a taxpayer’s net capital gain or net capital loss, take the following steps:

The net capital gain computation is illustrated with the following examples:

Net capital losses. Computing an individual’s net capital loss is done the same way as the computation of a net capital gain. A net capital loss is incurred when the total capital losses for the period exceed the total capital gains for the period.

Individual taxpayers may deduct net capital losses against ordinary income in amounts up to $3,000 per year. Unused capital losses in a particular year may be carried forward indefinitely. Capital losses and capital loss carryovers first offset capital gains using these ordering rules:

Any remaining net capital loss may be used to offset ordinary income, subject to the $3,000 annual limitation.

When unused capital losses are carried forward, they maintain their character as either long-term or short-term. If a taxpayer has both net long-term losses and net short-term losses in the same year, the net short-term losses are deducted first.

Section 1231 gains and lossessection 1231 gain/lossGain or loss on real and personal property used in a business.. Section 1231 assets are not capital assets, but they are given special tax treatment. Gains on section 1231 assets may be treated as long-term capital gains, while losses in some cases may be deducted as ordinary losses. Section 1231 assets include:

Depreciation is recaptured before special tax treatment. Since long-term capital gains traditionally have been taxed at a lower rate than ordinary income, taxpayers have attempted to maximize the amount of income treated as capital gain.

Congress enacted depreciation recapture provisions to prevent taxpayers from converting ordinary income into capital gains by claiming maximum depreciation deductions over the life of the asset and then selling the asset and receiving capital gain treatment on the resulting gain at sale. There are three major depreciation recapture provisions: (1) Section 1245, which generally applies to personal property, (2) Section 1250, which applies to real estate, and (3) “unrecaptured depreciation” previously taken on real estate is taxed at a rate of up to 25%.

Under section 1245, any gain recognized on the disposition of a section 1245section 1245 gainGain on a section 1231 asset that originates from depreciation expense. asset will be classified as ordinary income up to an amount equal to the depreciation claimed after 1961. Any gain in excess of this amount is classified as section 1231 gain. Section 1245 property is:

Section 1245 recapture is the total depreciation claimed on section 1245 property after 1961. The ordinary income recognized upon the sale of an asset under section 1245 is the lesser of (1) the recomputed basis less the adjusted basis, or (2) the amount realized less the adjusted basis. The recomputed basis of an asset is the adjusted basis of the property plus section 1245 recapture potential. Any gain recognized in excess of the amount of ordinary income is section 1231 gain.

Section 1250section 1250Gain on real property that originates from depreciation expense computed using an accelerated depreciation method. applies to the gain on the sale of real property, other than the real property that is included in the definition of section 1245 property. The section 1250 recapture potential is equal to the excess of depreciation expense claimed over the life of the asset under an accelerated method of depreciation over the amount of straight-line depreciation, had that method been used. If property is depreciated using the straight-line method, there is no section 1250 recapture potential. Since the use of the straight-line method is required for real property acquired after 1986, there will be no section 1250 recapture on the disposition of such property. In practice, section 1250 recapture is seldom seen.

A 25% tax rate applies to real property gains attributable to depreciation previously taken and not already recaptured under the section 1250 or section 1245 rules discussed above. Any remaining gain attributable to “unrecaptured depreciation” previously taken, including straight-line depreciation, is taxed at 25% rather than the long-term capital gain rate of 15%. When the taxpayer’s ordinary tax rate is only 10 or 15%, the depreciation recapture will be taxed at 10 or 15% to the extent of the remaining amount in the 10 or 15% bracket and then at 25%. The application of the 25% rate for “unrecaptured depreciation” is frequently seen in practice because it applies to every rental property that is first depreciated and then sold at a gain.