Form 4797

Form 4797, Sales of Business Property, is the IRS form on which a taxpayer reports the disposition of property used in a trade or business: sales and exchanges of business real estate and depreciable business property, involuntary conversions other than casualty and theft, and dispositions of other noncapital assets apart from inventory. It also computes the recapture of section 179 and listed-property deductions when business use drops to 50 percent or less, and it is where a securities trader with a mark-to-market election under section 475(f) reports ordinary trading gains and losses.

The form exists because business property is taxed differently from both investments and inventory. Its parts separate each sale into the pieces the law treats differently: depreciation recapture taxed as ordinary income, gains and losses on long-held business property netted under section 1231, and short-held or otherwise ordinary items. Only the net section 1231 gain that qualifies for capital treatment moves on to Schedule D, which is where capital assets such as stocks and investment land are reported in the first place.

Where a sale goes first. The instructions open with a table. Depreciable business property, real or tangible, held one year or less goes to Part II whether it sold at a gain or a loss. Held more than a year, the same property goes to Part III if it sold at a gain (section 1245 for equipment and other personal property, section 1250 for buildings) and to Part I if it sold at a loss. Land used in the business, held more than a year, goes to Part I. When a building and its land are sold together at a gain, the price is allocated between them by fair market value, and the building is reported in Part III and the land in Part I.

Part III computes recapture, then hands the rest on. For each property it works out the total gain from the sale price, the cost or other basis plus selling expenses, and the depreciation allowed or allowable. The ordinary income under sections 1245, 1250 and a few narrower provisions is totaled on line 31 and carried to Part II as ordinary gain; what remains, line 32, goes to Part I as section 1231 gain, except that the part from a casualty or theft goes back to Form 4684. For a residential rental or commercial building depreciated under the system in force since 1987, section 1250 recapture does not apply, so the building's whole gain normally reaches Part I. The depreciation in that gain is still unrecaptured section 1250 gain, figured on a worksheet in the Schedule D instructions, and Publication 544 notes it "cannot be more than the net section 1231 gain". Equipment and appliances are different: their depreciation is recaptured as ordinary income up to the gain.

Part I nets, and the lookback can reclassify. Line 7 combines the year's section 1231 gains and losses, including a partner's or S corporation shareholder's share from Schedule K-1 and the section 1231 results of installment sales, carried in from Form 6252, and of like-kind exchanges, carried in from Form 8824. A net loss moves to Part II and is ordinary. A net gain is reduced on lines 8 and 9 by nonrecaptured net section 1231 losses from the five preceding years; that part is ordinary income, and only the rest is entered on Schedule D as long-term capital gain.

Part II is the ordinary bucket. It takes business property held a year or less, the recapture from Part III, a net section 1231 loss, ordinary amounts from Forms 4684, 6252 and 8824, a trader's mark-to-market gains and losses, and losses on section 1244 small business stock up to the statutory ceiling of $50,000, or $100,000 on a joint return. For an individual the net result goes to line 4 of Schedule 1 of Form 1040, so an ordinary loss offsets other income without the $3,000 capital-loss limit, subject to the at-risk and passive activity rules the instructions point to.

Part IV is a different kind of recapture. If section 179 expensing was claimed on property, or depreciation on listed property such as a vehicle, and business use falls to 50 percent or less, Part IV computes how much of the earlier deduction is taken back, and the amount is reported as other income on the form or schedule where the deduction was claimed.

Investments, homes and whole businesses. Form 4797 is not the place for capital assets held for investment, which go on Form 8949 and Schedule D. Depreciable property held for investment rather than in a business is a partial exception: its recapture is figured in Part III and the excess gain goes to Form 8949. A home that was partly used for business depends on where the business part was. Publication 523 says that for space within the living area, such as a home office or a rented spare bedroom, the gain need not be allocated and the sale of that part need not be reported on Form 4797, though gain equal to depreciation allowed or allowable after May 6, 1997 still cannot be excluded. A business or rental part separate from the dwelling, such as the rented unit of a duplex the owner lived in, is reported on Form 4797. And selling a whole business is treated as selling each asset separately, with each asset's gain or loss classified and reported on its own.

1. List each property and its holding period. Gather the sale price, the original cost plus improvements and selling expenses, and the depreciation allowed or allowable. Split a building from its land by fair market value.
2. Route each one using the instructions' table. Held a year or less goes to Part II. Held longer and sold at a gain, depreciable property goes to Part III; sold at a loss, or land, goes to Part I.
3. Run Part III. Recapture is totaled on line 31 and carried to Part II; the remainder on line 32 is carried to Part I.
4. Net Part I. Combine the year's section 1231 items, including Schedule K-1 amounts, then apply any nonrecaptured losses from the previous five years.
5. Carry the results. A net section 1231 gain that survives the lookback goes to Schedule D; the Part II total goes to Schedule 1 of Form 1040.

Take an example. Jun sells a duplex she has rented out for about eight years. Ignoring selling costs, the price allocates $300,000 to the building, $100,000 to the land and $1,000 to the appliances. The building cost $250,000 and has had $72,000 of depreciation, so its adjusted basis is $250,000 − $72,000 = $178,000 and its gain $300,000 − $178,000 = $122,000. The land cost $60,000, a gain of $40,000. The appliances cost $4,000 and are fully depreciated, so their $1,000 gain is all section 1245 recapture.

The building and the appliances go to Part III. Their total gain is $122,000 + $1,000 = $123,000; recapture on line 31 is $1,000 (the building's is zero, because it was depreciated straight line under the post-1986 rules), and that $1,000 is ordinary income in Part II. Line 32 carries $123,000 − $1,000 = $122,000 to Part I, where it joins the land's $40,000 for a net section 1231 gain of $162,000. Jun has no section 1231 losses in the previous five years, so all $162,000 goes to Schedule D as long-term capital gain. Of that, $72,000 is unrecaptured section 1250 gain, taxed at a rate of no more than 25 percent, and the other $162,000 − $72,000 = $90,000 is taxed at the regular long-term capital gain rates.

Pros

• Splits each sale into its recapture, its section 1231 piece and its ordinary piece on one form, so the different tax treatments are applied in a fixed order.
• A net section 1231 loss, and ordinary losses in Part II, offset other income without the $3,000 limit that applies to net capital losses.
• The lines that carry amounts in from Schedule K-1 and Forms 4684, 6252 and 8824 keep the whole year's business-property results in one netting.

Cons

• The routing depends on property type, gain or loss and holding period, and a sale entered in the wrong part can change both the character and the rate of the gain.
• The five-year lookback means the right answer depends on records from earlier returns, which a taxpayer may not have kept.
• A building and its land sold together have to be allocated by fair market value, a judgment the form leaves to the taxpayer.
• The unrecaptured section 1250 gain inside the result is figured on a separate Schedule D worksheet, so the form alone does not show the full tax effect of selling a rental.