Net Section 1231 Gains: The Best of Both Tax Worlds
What Is Section 1231 Property?
Section 1231 applies to real or depreciable property used in a trade or business and held for more than one year. Examples include:
Commercial or rental real estate
Manufacturing plants or warehouses
Agricultural land and farm buildings
Timber, coal, or certain types of natural resource property
Business equipment or machinery
It does not apply to inventory or property held primarily for sale, nor to personal-use property.
Why Net Section 1231 Gains Are Special
At the end of each tax year, you total all your Section 1231 transactions — sales, exchanges, involuntary conversions — to determine whether you have a net gain or a net loss.
Net Gain → Long-Term Capital Gain Treatment
Taxed at preferential long-term capital gains rates (0%, 15%, or 20%, depending on your income bracket).
Not subject to self-employment tax.
Can offset capital losses from other investments.
Net Loss → Ordinary Loss Treatment
Deductible against any type of income, including wages, interest, and dividends.
More valuable than a capital loss because it’s not subject to the $3,000 annual capital loss limitation.
This “best of both worlds” treatment is what makes Section 1231 so favorable.
The Lookback Recapture Rule
There is one important caveat:
If you claimed Section 1231 losses in any of the prior five years, then an equal amount of your current year’s Section 1231 gain must be recharacterized as ordinary income instead of capital gain.
This prevents taxpayers from taking big ordinary loss deductions one year and then flipping property for favorable capital gains shortly after.
Types of Investments That Consistently Generate §1231 Gains/Losses
Investments that regularly buy, improve, and sell business-use property are most likely to generate recurring §1231 gains and losses on K-1s:
Commercial real estate partnerships (office buildings, warehouses, retail centers)
Multifamily apartment complex syndications
Farmland investment funds
Timber and natural resource partnerships
Manufacturing and industrial property funds
Equipment leasing partnerships (machinery, aircraft, railcars)
In these structures, gains occur when assets appreciate in value or when improvements increase resale potential. Losses can occur when assets are sold in down markets or disposed of at less than their adjusted basis.
Bottom Line
Net Section 1231 gains are a rare taxpayer-friendly rule in the Internal Revenue Code:
Gains: enjoy capital gain tax rates.
Losses: enjoy ordinary loss treatment.
Both active and passive investors can benefit, though passive loss rules may limit the timing of loss deductions.
For investors in real estate and business-use asset funds, consistently seeing §1231 activity on a K-1 is often a sign that the investment is involved in substantial asset transactions — and potentially generating tax-advantaged outcomes.