You own a small manufacturing shop as a sole proprietor. Over fifteen years, you've held a CNC machine that's now fully depreciated on your books but worth $90,000 on the open market. Your CPA suggests forming an S corporation and contributing the machine in exchange for stock and a note. You assume the gain — appreciation above the $0 adjusted basis — will be long-term capital gain. After all, you've held the asset for over a decade. You're picturing a 20% federal rate.
Then your tax return comes back. The full $90,000 is taxed as ordinary income at your top marginal rate. Holding period? Doesn't matter. Long-term character? Gone. The reason is a one-paragraph statute most owners have never heard of: Internal Revenue Code Section 1239.
If you have ever sold, leased, or contributed depreciable property to a corporation, partnership, or trust where you, your spouse, or your kids own a meaningful stake, this section deserves an hour of your time. It is a quiet recharacterization rule, and it does not care how long you've owned the asset, whether you took depreciation, or whether the buyer is technically a different legal entity. If the relationship test trips, capital gain becomes ordinary income — every dollar of it.
What Section 1239 Actually Does
Section 1239(a) is written in twenty-eight words. Strip it down and you get a simple rule: when related persons exchange property, any gain recognized by the seller is taxed as ordinary income if the property will be depreciable in the buyer's hands.
Two conditions must both be true:
- The buyer and seller are related persons as defined in Section 1239(b).
- The asset, after the sale, is subject to the depreciation allowance under Section 167 in the buyer's hands.
There is no exception for long holding periods. There is no exception for assets that were never depreciated by the seller. The rule applies whether the sale is at fair market value or below, whether cash or notes are used, and whether the transaction is structured as a sale, exchange, distribution, or a Section 351 contribution that triggers boot.
The policy makes sense once you see it: Congress did not want related parties continuously selling depreciable assets back and forth to "reset" basis at a higher number, generating fresh depreciation deductions against ordinary income while the seller pocketed capital gain at lower rates. Section 1239 closes that arbitrage by stripping the favorable character off the gain.
The Three Categories of Related Persons
Section 1239(b) defines three types of related persons. A transaction with any one of them risks ordinary-income treatment.
A Person and Their Controlled Entity
A "controlled entity" under Section 1239(c) means any of the following:
- A corporation in which the person owns, directly or indirectly, more than 50% of the value of the outstanding stock.
- A partnership in which the person owns, directly or indirectly, more than 50% of the capital or profits interest.
- Any other entity that is related to the person under specified paragraphs of Section 267(b), which extends to commonly controlled groups of trusts, corporations, and partnerships.
Note the threshold: more than 50%. Fifty percent exactly does not trigger the rule. But that brightness disappears the moment constructive ownership rules apply (we'll return to that in a moment).
A Taxpayer and Certain Trusts
A taxpayer and a trust are related under Section 1239 if the taxpayer or the taxpayer's spouse is a beneficiary of the trust — unless the beneficiary's interest is a "remote contingent interest." A remote contingent interest is one with an actuarial value of less than 5% on the date of the sale.
This wrinkle matters more than it looks. If you established an irrevocable trust for your children, and your spouse is named as a discretionary beneficiary so the trustee can sprinkle income out for family medical needs, you are now related to that trust. Selling your office building to the trust at fair market value? The gain is ordinary income.
An Executor and an Estate Beneficiary
The third category — executor and beneficiary — applies during the administration of an estate. A sale between the executor (representing the estate) and a beneficiary of the estate triggers Section 1239 except in the narrow case of a sale or exchange made in satisfaction of a pecuniary bequest (a bequest of a specific dollar amount, not a specific asset).
The Constructive Ownership Trap
The most surprising part of Section 1239 is what counts toward the 50% test. Section 1239(c)(2) borrows the constructive ownership rules of Section 267(c) (with one exception — paragraph (3) is omitted). Under those rules:
- Stock owned by a corporation, partnership, estate, or trust is treated as owned proportionally by its shareholders, partners, or beneficiaries.
- An individual is treated as owning the stock owned directly or indirectly by family members.
- "Family" includes brothers and sisters (whole or half blood), spouses, ancestors (parents, grandparents), and lineal descendants (children, grandchildren).
Stock owned by family members is fully attributed — there is no fractional allocation. If your daughter owns 30% of the operating company and you own 25%, you are constructively treated as owning 55%, which clears the more-than-50% bar.
An Illustrative Example
Treasury regulations include a fact pattern worth memorizing. Individual A owns 79% of Corporation X by value. A trust for A's children holds the remaining 21%. Under the attribution rules, A's children are deemed to own the trust's shares proportional to their actuarial interests. A, as the children's parent, then constructively owns whatever the children are deemed to own. A is therefore treated as owning 100% of Corporation X. Any sale of depreciable property from A to X — at any price, in any form — is recharacterized to ordinary income.
The lesson: ownership maps in family businesses are usually thicker than the cap table suggests. Layer in tiered LLCs, family limited partnerships, generation-skipping trusts, and small minority stakes held by parents or siblings, and the 50% threshold is often crossed without the principal owner realizing it.
Section 1239 Is Not Depreciation Recapture
A common source of confusion: practitioners conflate Section 1239 with the depreciation recapture rules of Sections 1245 and 1250. They are different, and Section 1239 is the broader, harsher rule.
Sections 1245 and 1250 recharacterize gain only up to the amount of depreciation taken on the asset. If you depreciated a building by $40,000 and sold it at a $100,000 gain to an unrelated buyer, $40,000 might be unrecaptured Section 1250 gain (taxed at up to 25%) and the remaining $60,000 would be Section 1231 gain (often taxed at long-term capital gain rates).
Section 1239 recharacterizes all the gain, not just the depreciation portion. Same building, same $100,000 gain, but the buyer is your wholly owned LLC: the entire $100,000 is ordinary income. The appreciation above prior depreciation gets no preferential treatment.
Section 1239 also applies to assets you never depreciated. Bought a piece of equipment intending to lease it personally, never claimed depreciation, then sold it to your S corporation? If the asset is depreciable in the corporation's hands, Section 1239 still applies.
The Surprise Scenarios
Three transaction patterns generate most Section 1239 surprises.
Scenario 1: Section 351 Contribution With Boot
A sole proprietor incorporates. They contribute appreciated equipment, vehicles, or real estate in exchange for stock plus a promissory note or assumption of liabilities. Under Section 351(b), gain is recognized to the extent of the boot received (cash, notes, or liabilities exceeding basis under Section 357(c)).
That recognized gain would normally retain its character — capital gain for capital assets, Section 1231 gain for trade-or-business assets. But because the founder will own more than 50% of the new corporation, Section 1239 turns that recognized gain into ordinary income.
Scenario 2: Liquidating or Operating Distributions
When a corporation distributes depreciable property to its controlling shareholder, the corporation recognizes gain on the distribution under Section 311(b) or Section 336. If the shareholder owns more than 50% of the corporation, Section 1239 converts that gain into ordinary income at the corporate level.
For an S corporation, the gain flows through to the shareholder on Schedule K-1. The shareholder pays tax on a $100,000 gain at ordinary rates — even if the building had been held for fifteen years and the corporation expected $80,000 of Section 1231 gain on the books.
Scenario 3: Sales Between Brother-Sister Entities
Two LLCs each owned 100% by the same individual decide to consolidate operations. LLC A sells its forklift fleet to LLC B at fair market value. Because both LLCs are controlled entities of the same person, they meet the Section 267(b) test that flows into Section 1239(c)(1)(C). Any gain on the forklift transfer is ordinary income to LLC A.
The same trap appears when a family-owned holding company sells equipment to an operating subsidiary owned by the founder's adult children — attribution makes the founder the constructive owner of both.
Patent Applications Are Depreciable Property
Section 1239(e) closes one specific loophole: a patent application is treated as depreciable property for purposes of Section 1239. This matters for inventors and technology businesses. If you transfer a patent application to a corporation you control — even before the patent issues — the gain is ordinary income.
The provision was added because, absent (e), an inventor might argue that a pre-grant patent application was a capital asset because it had not yet matured into depreciable intellectual property. The statute removes that argument.
Planning Around the Trap
You cannot wave Section 1239 away with elections or holding periods, but you can structure around it.
Map the Ownership Family Tree Before the Transaction
Before any sale, lease, or contribution between an individual and a closely held entity, build the constructive ownership map. Include spouses, parents, grandparents, children, grandchildren, and siblings — and trace ownership through every intermediate trust, partnership, and corporation. Use the Section 267(c) family definitions exactly; do not assume a sibling's 10% stake is too small to matter.
Consider Whether the Buyer Is Truly Subject to Section 167
Section 1239 applies only if the asset is depreciable in the buyer's hands. If the buyer will hold the asset as inventory, as a non-business personal asset, or as land (not depreciable), Section 1239 does not apply. Land is the cleanest example: sales of unimproved land to a controlled entity escape Section 1239 even though they are related-party transactions.
Be careful with mixed-use real estate, though. Selling an apartment building (depreciable structure plus non-depreciable land) requires allocating the basis between land and improvements. Section 1239 applies only to the depreciable improvement portion.
Dilute the Ownership Below the Threshold
If you can genuinely dilute ownership below 50% — by bringing in real, unrelated third-party investors — Section 1239 may not apply. But the dilution must be substantive. The IRS has been clear that paper transactions with related parties designed solely to get under the threshold will not be respected.
Consider Installment Sales Carefully
A related-party installment sale of depreciable property under Section 453 is not blocked, but the deferral benefit is limited by Section 453(g): all the gain is recognized in the year of sale, regardless of the payment schedule. Combine this with Section 1239's ordinary-income treatment and the buyer's installment note has no tax advantage to the seller.
Document the Business Purpose
When related-party transactions are unavoidable — say, transferring an asset to position the business for outside financing — document the non-tax business purpose. Section 1239 will still apply, but a documented purpose insulates the transaction from broader recharacterization challenges (sham, lack of economic substance, disguised dividend) that the IRS layers on top.
Bookkeeping and Record-Keeping Implications
A Section 1239 transaction looks different in your books than an unrelated sale, even though the GAAP entries are the same. The character of the gain — ordinary versus capital — surfaces only on the tax return. That makes accurate books critical: you need to know, asset by asset, what each piece of property cost, how much depreciation was taken, when it was placed in service, and what its current fair market value is.
For family businesses managing multiple related entities, that record-keeping needs to span all the related ledgers. The same forklift might move from one entity's depreciation schedule to another's, and the tax outcome depends on having a complete trail. Plain-text, version-controlled accounting makes that history trivial to audit later — you can see exactly when an asset entered the system, how its basis was adjusted, and which entity recognized which gain.
Maintaining this discipline from the day an asset is purchased prevents the worst kind of Section 1239 surprise: discovering at tax time that the basis records don't agree, the holding period is uncertain, and the prior-year depreciation schedule was reconstructed from memory.
A Quick Diagnostic
Use this five-question diagnostic before any related-party transfer of property:
- Will the buyer treat the asset as depreciable under Section 167?
- Does the buyer count as a "controlled entity" of the seller — directly or via Section 267(c) attribution?
- Are any beneficiaries of the buying or selling trust the seller or seller's spouse?
- Is the transaction structured as a sale, exchange, contribution with boot, or distribution?
- Will the seller recognize gain on the transaction?
If you answer yes to questions 1, 2 (or 3), and 5, Section 1239 applies and the gain is ordinary income. Question 4 just tells you which transaction type triggered the gain — the result is the same.
Keep Your Finances Organized From the First Asset Purchase
Section 1239 is one of dozens of recharacterization rules that depend on accurate, multi-entity asset records. As your business grows and ownership structures multiply, maintaining clear, auditable records becomes the difference between a clean return and a surprise tax bill. Beancount.io provides plain-text accounting that gives you complete transparency and a version-controlled history of every transaction — across every entity you own — so you can trace basis, holding periods, and intercompany transfers years after the fact. Get started for free and see why developers and finance professionals are switching to plain-text accounting.