Can Land Be a 1231 Asset?

Understanding the tax ramifications is essential when investing in real estate. A concept that real estate investors should be familiar with is 1231 assets. These are possessions used in commerce or business that have been stored for more than a year. Capital assets like depreciable property, real property used in a trade or business, machinery, and equipment are considered 1231 assets. But can land be a 1231 asset?

In this blog post, we will explore the tax law and the topic of whether land can be classified as a 1231 asset. We’ll also examine the factors that the IRS considers and the tax benefits of owning land as a 1231 asset.

Capital Gains and Losses and Netting Procedures

When selling a capital asset, you make a profit known as a capital gain.

Losses on the sale of capital assets purchased for investment are referred to as capital losses.

The IRS has established netting procedures to determine the taxpayer’s net income or losses for a particular tax year.

These procedures apply to individuals, trusts, and estates that sold or traded assets and had capital gains or losses during the tax year.

The netting procedures oblige taxpayers to divide their capital gains and losses into short-term and long-term categories.

Long-term capital gains and losses happen when an asset kept for more than a year is traded or sold.

Short-term capital gains and losses occur when an asset is sold or traded after being held for a year or less.

The resultant net capital gains or losses from the short and long terms are then added to determine the taxpayer’s net capital gain or loss for the tax year.

Any lingering capital losses may be carried over to subsequent tax years in order to be used as a credit against subsequent capital gains or other types of income.

What Assets Are 1231 Assets?

A 1231 asset is a real or depreciable property that is used in a trade or business and held for more than one year. The term comes from Section 1231 of the Internal Revenue Code. These assets can include depreciable property, business property, machinery, and equipment.

The disposition of these assets could produce a gain or a loss because they are not kept for sale regularly.

Profits from keeping an asset for longer than a year are considered long-term capital gains. These gains are taxed at a lower rate than regular income. The loss is regarded as an ordinary loss. It may be deducted from any ordinary income if the 1231 asset is sold for less than its fair market value.

If the loss exceeds the amount of ordinary income in a given year, it can be carried back up to three years or forward up to five years to offset future ordinary income.

If a taxpayer’s 1231 gains and losses for the year add up to a net loss, the whole loss is treated as an ordinary loss, no matter how long they’ve owned the business assets.

Depreciation Recapture Rules

The taxpayer will realize a portion of the gain equal to the depreciation previously claimed on the property when selling Section 1231 property for a profit. This should be reported as an ordinary gain.

Because it was previously written off as an expense against ordinary income and is now subject to the same ordinary income tax treatment, this gain equal to depreciation does not receive a favorable tax treatment. The term for this is recaptured depreciation.

Depreciation recapture rules are a set of tax provisions that apply when an asset is sold. Also in case of being disposed of and has been subject to depreciation deductions.

The rules’ purpose is to guarantee that the taxpayer must pay tax on the amount of depreciation that was previously claimed as a deduction over the asset’s lifetime.

The gain must be reduced by the amount of prior depreciation taken on the asset if it has been subject to depreciation deductions.

Then, this portion of the gain is taxed as regular income as opposed to capital gains.

Land as a 1231 Asset

Land can be classified as a Section 1231 asset in certain circumstances. Generally, the IRS considers land to be a capital asset rather than a 1231 asset.

However, if the land is an investment property used in a trade or business, it may be classified as a 1231 asset.

Farmland, for instance, can be used to produce cattle or cultivate crops. Similarly, personal property utilized for rentals might result in taxable revenue for the owner.

Another argument is that land can be subject to depreciation. This is a key factor in determining whether an asset is classified as a 1231 asset.

The IRS considers a number of aspects. These include the duration of possession of the property and the taxpayer’s reasons for acquiring and holding it. The IRS will also consider how much of a role the land asset plays in the company, such as how much of the property is used for farming or leasing.

Examples of Land as a 1231 Asset

There are several real-world examples of land that have been classified as a Section 1231 property.

For example, farmland used for agricultural purposes can be classified as a 1231 asset. Similarly, a rental property that includes land can also be classified as the same asset. Both times, the land is owned for longer than a year and is used in a trade or industry.

Owning land as a 1231 asset can provide tax benefits for the owner.

A farmer selling that type of land asset at a gain can benefit from the lower long-term capital gain tax rate.

If the land is sold at a loss, the loss can be applied toward other capital gains. This will help lower the farmer’s tax obligation. 

Similarly, if someone owns land-inclusive rental property that is a 1231 asset, they can benefit from the lower long-term capital gains tax rate when they sell the property for a profit.

Overall, owning land as a 1231 asset can help the owner save money on taxes. However, it’s important to follow the rules and regulations for that type of assets.

Working with a tax expert can help make sure the owner gets the most out of the tax benefits.

Final Thoughts

While land is generally considered a capital asset, it can be classified as a 1231 asset in certain circumstances.

If the land you buy is used in a trade or business and held for more than one year, it may qualify as a 1231 asset.

You could profit from lower long-term capital gains tax rates and the opportunity to deduct capital losses due to this. However, it’s important to think about the specific rules and factors that apply to 1231 assets. Also, make sure to work with a tax pro to make sure you follow the rules.