In Year 1, a taxpayer has a net §1231 gain of $20,000. In the previous five years, the taxpayer had the following net §1231 results: Year -1: $0; Year -2: $5,000 Loss; Year -3: $3,000 Loss; Year -4: $0; Year -5: $0. All losses were fully deducted as ordinary losses. How is the Year 1 gain taxed?

Answer options:

$20,000 long-term capital gain.

$20,000 ordinary income.

$8,000 ordinary income; $12,000 long-term capital gain.

$5,000 ordinary income; $15,000 long-term capital gain.

How to approach this question

Check the 5-year history. Sum up unrecaptured §1231 losses ($8,000). The current year's §1231 gain is ordinary up to that amount. The rest is capital.

Full Answer

C.$8,000 ordinary income; $12,000 long-term capital gain.✓ Correct

$8,000 ordinary income; $12,000 long-term capital gain.

IRC §1231(c) (the 'Lookback Rule') requires that net §1231 gains be treated as ordinary income to the extent of non-recaptured net §1231 losses from the five preceding taxable years. Total losses = $5,000 + $3,000 = $8,000. Thus, $8,000 of the $20,000 gain is ordinary; $12,000 is capital.

Common mistakes

Forgetting to look back 5 years or summing the losses incorrectly.

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