7834 / How is gain or loss on the sale of rental real estate treated?

Gain or loss on property used in a trade or business, including rental real estate, is not “capital gain or loss” – it is referred to as “IRC Section 1231 gain or loss.”¹ If all of the taxpayer’s IRC Section 1231 gains in a year exceed the IRC Section 1231 losses, the net gain is treated as long-term capital gain; however, such net gain must be treated as ordinary income to the extent of net IRC Section 1231 losses of the taxpayer in the five most recent prior years (which have not been previously offset by net gains of a later year).² If IRC Section 1231 losses exceed IRC Section 1231 gains, the net loss is treated as ordinary loss.³

In order to determine whether gains exceed losses, it is necessary to aggregate recognized gains (in excess of recaptured accelerated depreciation) and losses in the year on all IRC Section 1231 property. Nondeductible losses and nonrecognized gains are not included: for example, losses not deductible because they involve transactions between related parties (see Q 701), gains not recognized because they involve exchanges of like-kind property (see Q 710), or unreported gain on an installment sale (see Q 667).⁴

There are generally two kinds of gains and losses that must be included in the IRC Section 1231 netting process, as follows:

(1)  Includable gains and deductible losses on sales or exchanges of depreciable property and real property that have been held for more than one year and used in a trade or business (but not inventory, property held primarily for sale to customers in the ordinary course of business, or a copyright or certain other literary or artistic property), including certain sales involving timber, coal, iron ore, livestock, and unharvested crops;⁵ and

(2)  Includable gain and deductible losses (not compensated for by insurance) resulting from compulsory or involuntary conversion (as a result of destruction in whole or in part, theft, seizure, or an exercise of the power of requisition or condemnation) of property used in a trade or business (as defined above) or of any capital asset held for more than one year and held in connection with a trade or business or a transaction entered into for profit. However, gains and losses arising from fire, storm, shipwreck, or other casualty, or from theft, are included only if the gains exceed the losses.⁶ If losses arising from fire, storm, shipwreck, or other casualty, or theft, exceed gains from such items, then rather than including such items in the IRC Section 1231 netting process: (1) loss from any such item is deductible as a loss under IRC Section 165 (note that this deduction was substantially limited by the 2017 tax reform legislation to permit loss deductions only in the case of a federally declared disaster), and (2) gain from any such item is recognized as gain (generally as capital gain, but see Q 7836) to the extent that the amount realized on the involuntary conversion exceeds the cost of replacement property (if any) purchased within two years of the involuntary conversion.⁷

Where the sale is between related persons, see Q 7835.

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1.  IRC § 1231(a)(3).