The original version of section 1231 applied only to gains and losses from involuntary conversions of business-use property. It was originally conceived as a way to help the shipping industry during World War II.
The present version of the Internal Revenue Code retained the section 1231 treatment for 1231 property held by a business. It now includes property that was lost in an involuntary conversion (theft, natural disaster, etc.) AND the sale or exchange of any business-use property
“Non-recaptured loss” is covered by 1231(c). It refers to a situation when a taxpayer claims a 1231 loss in year one, but seeks a 1231 gain in any of years two through six. Any gain which is less than the loss in year one will be characterized as ordinary income, rather long term capital gain (which has preferred tax rates). For example, A takes a $20,000 1231 loss in year one, and in year two takes a $10,000 1231 gain. All of the gain will be ordinary income. If in year three A takes another $25,000 1231 gain, $10,000 would be ordinary income (to “recapture” the remaining $10,000 in loss from year one) and $15,000 would be long term capital gain.
1231 gains and losses due to casualty or theft are set aside in what is often referred to as the firepot (tax). These gains and losses do not enter the hotchpot unless the gains exceed the losses. If the result is gain, both the gain and loss enter the hotchpot and are calculated with any other 1231 gains and losses. If there are more casualty losses than gains, the excess is treated as an ordinary loss. For example, B has a $50,000 casualty/involuntary conversion loss and a $100,000 gain from her trade or business. Without the firepot mechanism, which prevents the $50,000 loss from being included in the hotchpot, B would have to offset this $100,000 gain with the $50,000 loss. Ultimately, B would have a $50,000 1231 gain, taxed at capital gain rates. With the firepot mechanism, B has a $50,000 ordinary loss, which can be deducted from ordinary income, and a $100,000 capital gain, taxed at preferable rates. Depending on B's tax rate, this provision could lower B's tax burden by up to $10,000.
Section 1231 treatment allows taxpayers to enjoy tax favored treatment for 1231 property gains that are greater than losses on such property. This means that if the asset could be sold for a value greater than its basis then it would be taxed at a capital gains rate which is lower than an ordinary income rate. However, if the 1231 property resulted in a loss, then the taxpayer can treat it as an ordinary loss and such a loss may reduce the taxpayer's taxable income.
The reason Section 1231 is said to give the taxpayer the "best of both worlds" is that it allows the favorable capital gains tax rate on section 1231 property, while avoiding the negative implications of capital loss treatment. Capital losses can only be deducted to the extent of capital gains, so if you have capital loss in a taxable year but no capital gain, the loss cannot be deducted from ordinary income. However, ordinary loss can be used to offset taxable income, so if you are going to have a loss, this is the type you want.
It is important to remember that Section 1231 does not reclassify property as a capital asset. What it does is even better, allowing the taxpayer to treat net gains on 1231 property as capital gains but to treat net losses on such property as ordinary losses. However, there are important limitations.
Congress has decided not to let this "best of both worlds" treatment give taxpayers undesired benefits beyond its purpose. This treatment would compel a taxpayer to sell a §1231 loss asset at the end of a year to get an ordinary loss and hold a §1231 gain until the next taxable year to receive capital gains treatment. In order to control this undesired result, Congress included 1231(c).
Under 1231(c), the 1231 gain that was deferred until the second year in the example above will be recharacterized as ordinary income. This is done because the taxpayer has already received the benefit of having the loss in year one treated as an ordinary loss. Thus, if the 1231 gain is disposed of after year one, but before what becomes the seventh year under 1231(c)(2)(A), it will receive ordinary income treatment. If held onto and disposed of after the seventh year, it may be treated as a capital gain.