A client, Mr. Davies, sold a patent on August 1, 2023, for $150,000. He had purchased the patent on January 1, 2020, for $120,000. Mr. Davies had been amortizing the patent over 15 years using the straight-line method. What is the character of the gain Mr. Davies recognized on the sale of the patent?
- ASection 1231 gain
- BPart ordinary income, part Section 1231 gain
- CLong-term capital gain
- DOrdinary income
Show answer & explanationAnswer & explanation
Correct answer: D. Ordinary income
A patent is a Section 197 intangible asset. While Section 197 assets are considered Section 1231 property, any gain on their disposition is recaptured as ordinary income to the extent of prior amortization deductions. Since the patent was held for over one year, the remaining gain, if any, beyond the recapture amount would typically be Section 1231 gain. However, for Section 197 intangibles, all gain is treated as ordinary income to the extent of prior amortization. If the gain exceeds the amortization, that excess is also treated as ordinary income, not Section 1231 gain, because Section 197 property is not subject to Section 1245 or 1250 recapture rules that would recharacterize only the depreciation portion.
Why the other options are wrong
- A. Incorrect. While Section 197 assets are often grouped with Section 1231 property, the specific recapture rules for intangibles convert the entire gain to ordinary income.
- B. Incorrect. The entire gain from a Section 197 intangible is generally characterized as ordinary income due to the nature of Section 197 recapture, even if it exceeds the amortization.
- C. Incorrect. Patents are not capital assets for this purpose; their sale generates ordinary income or Section 1231 gain (if not fully recaptured by amortization).
Section 197 Intangible Gain Character
Gain on the sale of a Section 197 intangible asset (like a patent) is generally treated as ordinary income to the extent of prior amortization, and any excess gain is also ordinary income.
- Section 197 intangibles are amortized over 15 years.
- Gain on disposition is ordinary income to the extent of prior amortization.
- Any gain exceeding amortization is also ordinary income, not Section 1231 gain.
Memory trick: Intangible Amortization, All Ordinary Temptation