 Hello and welcome to the session in which we will discuss section 1231 assets. What are section 1231 assets? They are assets and they are business assets to be more specific. In other words, using business held for longer than one year. Now what is the idea? Why is it important to learn about those assets? Well, when you sell them, when you dispose of them, you are either going to have a gain or a loss. That's fine. Why is that important? Well, you have to characterize the gain or the loss. And the gain or the loss either can be characterized as capital gain, capital loss, or ordinary gain or ordinary loss. Well, what's special about section 1231 assets? Well, since these are business asset, Congress decide to give you an incentive to buy, replace your asset. When you buy an asset, when you buy an asset, you buy it from someone else who manufacture it. When you sell an asset, you sell it to someone else. And when you buy an asset, the assumption is you are increasing your business productivity. So they want to incentivize buying and selling assets for businesses. So as a result, if you have a gain on that sale, the gain could be potentially treated as long term capital gain. Why is that important? Because long term capital gain, they are treated at a lower tax rate. They have a preference treatment. If it's a loss, the loss is treated as an ordinary loss. And why is that good? Well, ordinary loss will do what will offset ordinary income. So simply put, if you have a gain, it's a potential long term capital gain, which is taxed at a lower rate. If it's a loss, it's an ordinary loss at offset your ordinary income. And as Hannah Montana would say, you're getting the best of both words. Now remember, if you have capital asset, capital asset, if you have losses, you can only deduct up to 3000 against your ordinary income. So now you can compare and contrast why section 1231 losses are important, because they can offset your ordinary income. The gains are potential long term capital gains. Now let's go ahead and start to talk a little bit more about 12 section 1231 assets, define them, talk about the details. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions, as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. So now let's talk about little bit more details about section 1231 assets. Those assets include real and personal property used in a trade or a business or for the production of income, including rental and health for the taxpayer more than one year. This is important. Now section 1231 asset, they break it into two subsection, one for personal property and we call it 1245 asset. If you don't know what personal property is, is furniture, desks, computers, vehicles, trucks. Those are section 1245 assets, which basically they are movable. In section 1250, there are real property and land. What are real property? Building. Building cannot be moved. Land cannot be moved. So what happened is we treat those two separate assets differently and both of these assets, they are used in business. That's one of the criteria of 1231 and the other criteria of 1231 is it's held more than one year. There's no such thing as short-term section 1231 assets. And you guys have no clue how many times I tricked my students into telling them we bought a vehicle for and we sold it eight months later. What is the tax consequences and they treated as section 1231. You can't. Yes, it's a business use, but it has to be held more than one year. In section 1231 does not include specifically inventory, property held primarily for sale of customers. Basically, that's what inventory is. That's ordinary asset, any patent, invention, model or design, whether or not patented, any secret formula or process, copyrights, literally, musical or artistic composition, any account receivable. Obviously, account receivable is the result of inventory notes receivable arising in the ordinary course of trade or a business. Those are ordinary assets. So how do we get to net capital gain or net capital losses for section 1231 assets? There are three steps in this process. I'm going to go over each step, explain each step separately, then we'll work a comprehensive example. Then we will look at the big picture again. Then we work a comprehensive example. So step one is you will look at your business casualty or theft losses of section 1231. So if you have an asset broken, a stalling, there is a disaster. First unit these out. Here's what's going to happen. The gains and losses from the disposition by casualty or theft are first netted against each other. So that's the first category you will net those to. If the result is a net gain, the net gain is treated as section 1231 gain. However, if the netting gained result and a loss, what is netting? You net them out. The gains minus the losses. The gains and the losses are not combined. So if you have a net gain, that's fine, net gain. If you have a net loss, you would say, okay, now I'm going to treat my gains and my losses separately. I don't, I don't combine them. If I have a net loss, if I have a net gain, I can combine them. So that's the first thing you need to know. And that's an important concept to remember. So let's take a look at example one. A taxpayer has casualty gain of 5,000, a theft loss of 2,000. What is the net? The net is a gain of 3,000. Can we net them? Yes, we can. We can net them and that's a potential, potentially treated as long term capital gain. You're going to see why I keep saying potentially. Let's, let's switch the scenario. Let's assume the taxpayer has a gain of two and a losses of five. Now what we do is we treat them separately because overall we have a net loss. The taxpayer have ordinary gain of 2,000, which in a separate bucket, an ordinary loss of 5,000, no netting because the overall is a net loss. Let's go to step two. Now we net section 1231, other gains and losses. Similar to step one, if the net result is a net gain, it's treated as section 1231 gain. However, if the, if the, if the result is a net loss, and this is again assets other than lost casualty and theft losses, then the gain in the losses are treated as ordinary gain and ordinary losses. Remember, ordinary losses are fully deductible against ordinary income. Okay, let's take a look at this example. Taxpayer B has a net casualty gain of 500. So this is the first category. In addition, B sells two section 1231 asset at a gain of 2,000 and a loss at four. So what's the net here? The net is plus 1600. Can I net them? And the answer is yes. So what do I have? I have a 500 casualty and theft gain of 500 in 1600. Overall, I have 12, 1231 a gain of 2,100. Let's take a look at step three. Now Congress is, is generous, but at some point they're going to say we're too generous. So in step three, that's why we said we kept saying potentially long-term capital gain. In step three, what we have to do is we have to look at something called the look back period. And what does that mean? It means if you have section 1231 gain, you just don't automatically say, yes, it's section 1231 gain. Therefore, I will treat it as a capital long-term capital gain. You would like to do that, but before you get to that final answer, you have to look back in the past five years, look back period and see if you had any ordinary losses from section 1231. If you do, those ordinary losses will come back and they will catch up with you and they will reduce your capital gain for this period. Let's look at the rules. Net section 1231 gain is treated as capital gain after depreciation recaptured in a five-year look back period. If during the last five years, a section 1231 loss was deducted against ordinary income, the equivalent of that loss, so you got to bring the loss and gets recaptured as ordinary income after the remaining gain is treated as capital gain. In other words, what we're saying is this. If the netting process of section 1231 gains and losses results in a gain, you got to stop, you got to have a look back period. The gain must be recharacterized as ordinary income to the extent you have to look back and recharacterize it of any unused net section 1231 losses over the five previous years. Any excess gain is treated as long-term capital gain. So before you say it's a long-term capital gain, you have to look back five years. If you have any ordinary losses from section 1231, they reduce your capital gain. The best way to illustrate this is to look at an example. Adam, a C corporation, acquired machinery for its business use in 20x3. On February 15, 20x4 held it longer than a year. The machinery was sold at a gain of 50,000. Okay, so what is that gain? Well, this is a business use asset, potentially long-term capital gain. Now, back in 2020x2, Adam had a section 1231 loss. Adam was able to take an advantage of that. Well, guess what? Now, if you took advantage of that 1231 loss, and it's within the past five years, guess what? That $50,000 that you thought that's going to be capital gain, 15,000 of it will be treated as ordinary income. And what's the remain is 35. That's the long-term capital gain. So this is what we mean by the recapture. Adam should report an ordinary gain of 15 and a section 1231 gain of 35,000. Now, again, what's what is the benefit of this? This is basic, the 15,000 is based on your ordinary tax rate. Usually it should be, usually it's higher than your than capital gain, long-term capital gain, they have that tax preference 0, 10 and 15%. So let's summarize everything that we did thus far. The first thing we do is we net casualty gains and losses together from section 1231 assets. Again, those are business use capital asset. And we could have a gain. If we have a gain, we net the gain and we added the section 1231 gain. If we had a loss as a result of this step, losses and gains are treated separately. Gains are ordinary gains. Losses from section 1231 are deductible for AGI, which is ordinary losses. Other casualty losses are deductible from AGI. So that's that. Now, if we have a gain, we combine it with other section 1231 gains and losses. At this point, we could have a loss. If we have a loss, we go back to the net loss scenario. If we have a gain, we could have a potential section 1231 gain by using the look back period. The look back period will determine if we have to go back and catch up on anything, which is basically recapture any losses as ordinary income and anything remain as long term capital gain. Let's take a look at the first example. During year X1, a single taxpayer reported net casualty theft gain of 400. In addition, the taxpayer sold two assets at a loss of 1700 and again of 700. So if we notice from the casualty and theft, we have a 400 separate 1700 loss and 1700 loss and again of 700, we have this as a negative, a loss of 1000. So we have ordinary loss of 1000, ordinary income of 400. Overall, we have an ordinary loss, ordinary loss of 600 for year X1. Now, in year X2, the taxpayer reported casualty or theft gain of 200. In addition, the taxpayer sold two assets at a gain of 2100 and a loss of 700. So we have 2200 gains from the casualty or theft and we have from the other asset 1400, 1400 again. So together the net is 1600. So for year X2, how do we treat the 1600? Well, at face value, this will be long term, long term capital gain. However, since we took a 600 ordinary loss in the prior year, what's going to happen is 600, 600 of it will be ordinary income, 1000 of it will be long term capital gain. So this is the, we recharacterize 600 of it. So for the year X1, the taxpayer would report a loss of 600. The section 1231 loss is treated as ordinary loss. For year X2, a net gain of 1600 resulted, however, 600 of it is recharacterized as ordinary income and remaining is treated as long term capital gain. Let's take a look at another example. For the year, for the tax years, 20X1 to 20X4, I reported the following section 1231 results. Loss of 20,000 in X1, loss of 18,000 in X2, a gain of 10,000 in X3, a gain of 36,000 in X4. Determine the nature of net section 1231 gains for the years 20X3 and 20X4. Well, they're asking us for 20X3 and 20X4. When we look at 20X3 and we see that we have a $10,000 gain, potentially section 1231, but if we look, we look back, we see that that 10,000 will have to be recharacterized as ordinary income. Now, from this 18,000 or left width is 8,000 of net section 1231 in the loss period look back. In year 20X4, we have 36,000. Again, we have to do the same thing look back period. So of this 36,000, potentially long term capital gain, 8,000 of it will be recharacterized from year X2 and 20,000 of it will also be recharacterized from 20X1. As a result, if we take 28,000, 36 minus 8 minus 20, which is minus 28, we should have, if my math is right, 12,000. So 12,000 would be long term capital gain and the remaining will be treated as ordinary income. So in this question, Maggie has a total loss of 38,000 from the prior years. Therefore, the entire gain of 10,000 is ordinary income. In addition, 28,000 of the gain reported in 20X4 is treated as ordinary income while the remaining remaining, I guess the remaining is 8,000. The remaining 8,000 is treated as long term capital gain. So this is basically in a nutshell, the section 1231, whether you section 1231 asset, whether you are a CPA candidate studying for the CPA exam or an enrolled agent or an accounting student, it's very important that you understand this topic inside out. It's tested, you need to know it. Good luck, study hard. I'm always here to help you and stay safe.