IRS Publication 544: Asset Sales, Basis, and Depreciation Recapture

IRS Publication 544, Sales and Other Dispositions of Assets, explains how federal tax law treats the sale, exchange, abandonment, or other disposition of property, from stocks and personal belongings to business equipment and commercial real estate. Whether a gain is taxed at ordinary rates or the lower capital gains rates, whether a loss is fully deductible or capped, and whether tax can be deferred all come down to three things: how the asset is classified, what your basis is, and how long you held it.¹

How the IRS Classifies Your Property

Every asset falls into one of three categories, and the category controls the rate that applies to any gain or loss.

Capital assets are most things you own that Congress did not carve out: stocks, bonds, a personal residence, jewelry, a personal-use car, collectibles. The tax code defines them by exclusion. Inventory, depreciable business property, business receivables, certain creative works held by their creator, government publications received for free, certain commodity derivatives, hedging transactions, and business supplies are all excluded.²

Ordinary assets produce income taxed at your regular rates. Inventory, goods held primarily for sale to customers, and receivables from business operations are the main examples. Losses on ordinary assets offset other ordinary income dollar for dollar, without the annual caps that limit capital losses.

Section 1231 property is depreciable property and real estate used in a trade or business and held more than one year. If your Section 1231 gains for the year exceed your Section 1231 losses, the net is treated as a long-term capital gain and taxed at the lower rates. If the losses win, the net is treated as an ordinary loss that fully offsets other income. You aggregate every Section 1231 transaction on Form 4797 to run this netting.³⁴

Livestock carries its own holding periods inside Section 1231. Cattle and horses must be held at least 24 months; other livestock (excluding poultry, which never qualifies) at least 12 months. The clock starts on the acquisition date, not the date you put the animal to its qualifying use.

Figuring Your Basis

Basis is your investment in the property for tax purposes. When you dispose of the asset, basis gets subtracted from the amount realized to produce gain or loss. Where basis comes from depends on how you got the property.

Property You Bought

Starting basis is what you paid, including sales tax and settlement or closing costs tied to the purchase. Capital improvements and special assessments add to basis over time. Depreciation claimed on business use, casualty loss deductions, and nontaxable distributions reduce it. The running number after every adjustment is your adjusted basis.

Property You Inherited

Property acquired from a decedent generally gets a stepped-up basis equal to fair market value on the date of death. Stock a parent bought for $10,000 that was worth $200,000 at death has a $200,000 basis in your hands, and the appreciation during the decedent’s lifetime disappears for income tax purposes. The executor can elect an alternate valuation date six months after death if that produces a lower estate tax result.⁵

Property You Received as a Gift

Gifted property carries a dual-basis rule. For calculating a gain, your basis is the donor’s adjusted basis at the time of the gift. But if the fair market value at the time of the gift was lower than the donor’s basis, you use that fair market value as your basis for calculating a loss. Sell for a price between the two, and you recognize neither gain nor loss.⁶

Calculating Gain or Loss

The formula is amount realized minus adjusted basis. Positive is gain, negative is loss. The work is in the two inputs.

The amount realized is everything you receive in the disposition. Cash is only one piece. It also includes the fair market value of property or services you receive, and any liabilities the buyer assumes. Sell a rental building with a $150,000 mortgage the buyer takes on, and the $150,000 is part of your amount realized even though no cash changes hands for that piece. Selling expenses (brokerage commissions, legal fees, title insurance, transfer costs) come off the top before you compare to basis.

Holding period sets the rate. One year or less produces a short-term capital gain taxed at your ordinary rate. More than one year produces a long-term capital gain eligible for the 0%, 15%, or 20% rate, with the specific rate keyed to your taxable income and filing status.⁷ Ordinary assets like inventory and receivables always produce ordinary gain or loss regardless of holding period. Section 1231 assets must clear the one-year mark to enter the favorable netting.

Depreciation Recapture on Business Assets

Every year you claim depreciation on a business asset, you cut ordinary income. When you sell that asset for more than its depreciated value, some or all of the gain gets pulled back into ordinary income so those earlier deductions do not convert into capital gain. Recapture runs through Form 4797.⁸

Section 1245: Full Recapture on Personal Property

Section 1245 covers tangible personal property used in a business: equipment, machinery, vehicles, furniture. Gain on a sale is ordinary income up to the total depreciation (and Section 179 expensing) you claimed on the asset. Only gain above that total gets Section 1231 treatment.⁹ Business personal property rarely appreciates above its original cost, so recapture typically swallows most or all of the gain on equipment sales.

Section 1250: Excess Depreciation on Real Property

Section 1250 covers depreciable real property, primarily commercial buildings and rental structures. Recapture here is limited to “additional depreciation,” meaning the amount by which the depreciation you actually claimed exceeds what straight-line would have produced.¹⁰ Real property placed in service after 1986 generally must use straight-line, so there is usually no excess depreciation to recapture. The math still matters for buildings placed in service when accelerated methods were allowed.

Unrecaptured Section 1250 Gain

Straight-line depreciation on real property does not escape entirely. The gain attributable to it is called unrecaptured Section 1250 gain and is taxed at a maximum 25% rate rather than the standard 15% or 20%.⁷ Selling a fully depreciated rental building often produces three layers: unrecaptured Section 1250 gain at 25%, remaining long-term capital gain at 15% or 20%, and any actual Section 1250 recapture at ordinary rates. Numbers flow from Form 4797 to Schedule D.

The Section 1231 Five-Year Lookback

Section 1231 netting carries a catch that undoes the benefit for taxpayers who recently claimed ordinary losses. If this year’s Section 1231 transactions net to a gain, you look back five preceding tax years. Any net Section 1231 losses you deducted as ordinary losses during that window get recaptured: an equal amount of this year’s net gain is recharacterized as ordinary income.³ Only the portion of this year’s gain above those unrecaptured losses gets long-term capital treatment. Miss the lookback and you overstate the favorable rate.

Deferrals and Special Timing Rules

Not every disposition is a straightforward cash sale, and several transaction types have their own timing or loss-disallowance rules.

Installment Sales

If you sell property and receive at least one payment after the year of sale, you generally must use the installment method, which spreads the taxable gain across the years you actually collect.¹¹ Divide total gain by contract price to get a gross profit percentage, then apply that percentage to each year’s principal payments. Report the results on Form 6252.

Two exceptions matter. Dealer dispositions (property held for sale to customers, like a developer’s lots) cannot use the installment method. And Section 1245 or 1250 depreciation recapture is recognized in the year of sale regardless of when payments arrive; only gain above the recapture spreads over the payment period.

Involuntary Conversions

When property is destroyed, stolen, or condemned, you can defer the gain by reinvesting the proceeds in replacement property similar or related in service or use. Reinvest at least the full amount and no gain is recognized. Reinvest less and gain is recognized only to the extent of the shortfall.¹²

You generally have two years after the close of the first tax year in which gain is realized to buy the replacement. Condemned real property held for business or investment use gets a three-year window. Property in a federally declared disaster area may qualify for a four-year window.

Like-Kind Exchanges

Section 1031 lets you swap real property held for business or investment use without recognizing gain, if you follow the rules exactly. Since 2018 the provision applies only to real property; equipment, vehicles, and other personal property no longer qualify.¹³

Timing is strict. Identify potential replacement properties within 45 calendar days of transferring the relinquished property. Close on the replacement within 180 calendar days of that transfer or by the due date of your return for the year of the transfer (including extensions), whichever comes first. Miss either deadline and the entire gain becomes taxable. Most exchanges run through a qualified intermediary because taking the proceeds into your own hands can disqualify the transaction.

Abandonment

If you abandon business property instead of selling it, the loss is always ordinary, even if a sale would have produced a capital loss. Abandonment is not a sale or exchange, so the capital loss caps do not apply. To claim the deduction, you must permanently give up possession and use of the property expecting nothing in return. Report the loss on Form 4797.

The Wash Sale Rule

Sell stock or securities at a loss and buy substantially identical shares within 30 days before or after the sale, and the loss is disallowed. The 61-day window (30 days each side plus the sale day) blocks harvesting a loss while staying in essentially the same position. The disallowed loss is not gone; it adds to the basis of the replacement shares and shows up when you eventually sell those without triggering another wash sale.¹⁴

Selling a Home

Publication 544 does not cover the Section 121 exclusion for a principal residence in detail; the IRS handles it in Publication 523. The exclusion lets you exclude up to $250,000 of gain ($500,000 for joint filers) on your main home if you owned it for at least two of the five years before the sale and used it as your primary residence for at least two of those five years.¹⁵ Members of the uniformed services, foreign service, and intelligence community can elect to suspend the five-year window for up to 10 years while on qualified extended duty.

The exclusion still interacts with Pub 544’s rules. If you used part of the home as a rental or home office and claimed depreciation, that depreciation is recaptured as ordinary income even though the rest of the gain can be excluded.

The Extra 3.8% on Investment Income

High-income taxpayers owe an additional 3.8% net investment income tax on top of the capital gains rate. It applies to the lesser of net investment income or the amount by which modified adjusted gross income exceeds the threshold for your filing status: $250,000 for joint filers, $200,000 for single or head of household, and $125,000 for married filing separately.¹⁶ These thresholds are not indexed for inflation.

Net investment income here includes capital gains, interest, dividends, rental income, royalties, and income from passive business activities. It excludes wages, self-employment income, and gains from an active trade or business in which you materially participate, unless the business trades financial instruments or commodities. A joint-filing couple selling a rental with $400,000 of gain can face the 25% rate on unrecaptured depreciation, the 15% or 20% rate on the rest, and the 3.8% surtax layered on top.

Forms and Penalties

Which form you file depends on the asset:

Form 8949 and Schedule D report capital asset sales. Form 8949 reconciles the proceeds on Forms 1099-B and 1099-S with the amounts on your return, and totals flow to Schedule D.¹⁷
Form 4797 reports sales of business property, Section 1231 netting, and Section 1245 and 1250 recapture.
Form 6252 reports installment sale income.
Form 8824 reports like-kind exchanges.
Form 4684 reports casualties and thefts.

Failing to report a disposition or underreporting the gain can trigger the accuracy-related penalty of 20% of the underpaid tax when the underpayment is due to negligence or a substantial understatement. For individuals, a substantial understatement means understating your tax by the greater of 10% of the correct tax or $5,000.¹⁸ Interest runs from the original due date and compounds until paid. Because the IRS receives Forms 1099-B and 1099-S directly from brokers and closing agents, unreported dispositions are among the easiest discrepancies for the matching system to catch.

1
Internal Revenue Service. Publication 544 – Sales and Other Dispositions of Assets
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Office of the Law Revision Counsel. 26 USC 1221 – Capital Asset Defined
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Office of the Law Revision Counsel. 26 USC 1231 – Property Used in the Trade or Business and Involuntary Conversions
4
Internal Revenue Service. Form 4797 – Sales of Business Property
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Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
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Office of the Law Revision Counsel. 26 USC 1015 – Basis of Property Acquired by Gifts and Transfers in Trust
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Internal Revenue Service. IRS Topic 409 – Capital Gains and Losses
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Internal Revenue Service. Instructions for Form 4797
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Office of the Law Revision Counsel. 26 USC 1245 – Gain From Dispositions of Certain Depreciable Property
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Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty
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Office of the Law Revision Counsel. 26 USC 453 – Installment Method
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Office of the Law Revision Counsel. 26 USC 1033 – Involuntary Conversions
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Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
14
Internal Revenue Service. Revenue Ruling 2008-5 – Section 1091 Wash Sales
15
Internal Revenue Service. Topic No. 701, Sale of Your Home
16
Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
17
Internal Revenue Service. About Form 8949, Sales and Other Dispositions of Capital Assets
18
Internal Revenue Service. Accuracy-Related Penalty