Question

Hans runs a sole proprietorship. Hans has reported the following net §1231 gains and losses since he began business. The net §1231 gains shown are before the look-back rule. Note: leave no answers blank. Enter zero if applicable. Year Net §1231 gains/(losses) Year 1 $ (67,500) Year 2 $16,250 Year 3 $0 Year 4 $0 Year 5 $11,000 Year 6 $0 Year 7 (current year) $51,250.

a. What amount, if any, of the Year 7 (current year) $51,250 net §1231 gain is treated as ordinary income?
b. Assume that the $51,250 net §1231 gain occurs in Year 6 instead of Year 7. What amount of the gain would be treated as ordinary income in Year 6?

Answer 1

In Year 7, the entire net §1231 gain of $51,250 is treated as ordinary income due to the look-back rule. If the net §1231 gain of $51,250 occurred in Year 6, none of it would be recaptured as ordinary income since the Year 1 loss is outside the look-back period.

Step-by-step explanation:

The §1231 gains and losses are unique to U.S. tax law and affect the taxation of property used in a trade or business. A net §1231 gain reflects the excess of §1231 gains over §1231 losses and can potentially be taxed at favorable capital gains rates instead of ordinary income rates. However, the look-back rule requires recapturing net §1231 gains as ordinary income to the extent that there were net §1231 losses in the five preceding tax years that were treated as ordinary losses.

a. In Year 7, Hans has a net §1231 gain of $51,250. Applying the look-back rule, we must analyze the preceding five years for any §1231 losses. Here, Hans had a net §1231 loss of $67,500 in Year 1, which he would need to recapture. Therefore, the full $51,250 gain for Year 7 would be treated as ordinary income due to the look-back rule.

b. If the $51,250 net §1231 gain occurred in Year 6 instead, the same look-back rule applies. The $67,500 loss from Year 1 still needs to be recaptured, but because only gains for the past five years must be considered, the Year 1 loss is now outside the look-back period, and therefore, none of the $51,250 gain reported in Year 6 would be recaptured as ordinary income.