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Income Received from Forfeiture of Deposits on the Sale of a §1231 Asset Does Not Represent Capital Gains Under §1234A

The taxpayer in CRI-Leslie LLC et al. v. Commissioner, 147 T.C. No. 8 reported the forfeiture of $9.7 million deposits it retained when a buyer failed to close on the sale of a hotel property of the taxpayer as a capital gain.  The taxpayer argued that this treatment was the one provided for payments received for contract terminations of this sort by IRC §1234A.

Many CPAs may not immediately recognize that particular reference in the Internal Revenue Code, though some readers may recognize that section as the one that created a bit of stir when the Tax Court turned to in its later reversed opinion in the case of Pilgrim’s Pride Corporation v. Commissioner (141 TC No. 17, reversed, CA 5, 115 AFTR 2d ¶ 2015-477). 

Similar to Pilgrim’s Pride, the taxpayer argued that because, in its view, the transaction fit the definition found in §1234A, the result was treatment as capital gain (in Pilgrim’s Pride the Tax Court had ruled on a loss).  And, again, the question is whether that view of §1234A’s reach is correct.

To relieve the suspense for those who can’t wait to see the details of this mysterious §1234A, the provision provides:

Gain or loss attributable to the cancellation, lapse, expiration, or other termination of—

(1) a right or obligation (other than a securities futures contract, as defined in section 1234B) with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer, or

(2) a section 1256 contract (as defined in section 1256) not described in paragraph (1) which is a capital asset in the hands of the taxpayer,

shall be treated as gain or loss from the sale of a capital asset. The preceding sentence shall not apply to the retirement of any debt instrument (whether or not through a trust or other participation arrangement).

There is no question that a right or obligation had expired in this case and generated a gain of $9.7 million.  The IRS objected that the classification of the asset to which the right existed—that it simply wasn’t a capital asset in the hands of the taxpayer.

The taxpayer had been operating a hotel in the property in question, thus using the property in its trade or business. 

IRC §1221 is entitled “Capital asset defined” so the IRS argued this is where will find the definition of a capital asset.  While §1221 provides initially that any property owned by the taxpayer is a capital asset, it then goes on to exclude specific types of property from that classification.  The IRS pointed to the exception found at IRC §1221(a)(2) which excludes from the definition of capital assets “property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business…”  The hotel property falls squarely within this definition, the IRS pointed out, rendering the property not a capital asset and, therefore, the expiration of these contract rights outside the reach of §1234A.

But the taxpayer points out that the property is covered by IRC §1231.  That includes real property “used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 167, held for more than 1 year, and real property used in the trade or business, held for more than 1 year…” which is not inventory in the hands of the taxpayer.

IRC §1231(a) provides specifically:

(a) General rule

(1) Gains exceed losses


(A) the section 1231 gains for any taxable year, exceed

(B) the section 1231 losses for such taxable year,

such gains and losses shall be treated as long-term capital gains or long-term capital losses, as the case may be.

Thus, the taxpayer argues, since the sale would have generated what was effectively a long term capital gain had the sale gone through, Congress must have intended to include this sort of property in the type covered by §1234A.  And, the taxpayers argued, the legislative history of §1234A supports the view that Congress had just this intent.

The Tax Court noted that while legislative history and other evidence of Congressional intent may be useful in interpreting ambiguous provisions in the law, if the law itself is unambiguous then the law is applied as Congress wrote it, not as some evidence might suggest Congress intended to write the law.

While, as the Court concedes, some commentators have referred to §1231 assets as “quasi-capital assets,” §1221(a)(2), cited above, clearly classifies these assets as not capital assets. 

Rather, §1231 provides that, if certain conditions are met on the sale of this non-capital asset, the standard “ordinary gain” treatment won’t apply and the gain will be treated as long-term capital gains or losses.

Based on this, the Court holds:

Since section 1234A expressly refers to property that is "a capital asset in the hands of the taxpayer" and no other type of property, and since property described in section 1231 is excluded explicitly from the definition of “capital asset” in section 1221, we must conclude that the plain meaning of “capital asset” as used in section 1234A does not extend to section 1231 property. We therefore are not convinced by petitioner's argument that the statute is inherently ambiguous.

That doesn’t mean that a forfeited deposit on the sale of real property would never fall under §1234A’s rule—but it does mean how the property is used is key.  As the opinion continues:

If one looks to the plain meaning of section 1234A, it is true that the treatment of gains and losses from terminations of rights or obligations relating to property will depend on whether that property is a capital asset or is described in section 1231. Forfeited deposits from the termination of a contract to sell a hotel are taxed at capital gain rates if the hotel is held as a passive investment. The same forfeited deposits are taxed as ordinary income if the hotel is used in a trade or business. But regardless of any potential intellectual inconsistency in this disparate treatment, the plain meaning of section 1234A remains inescapable. We do not see any ambiguity in the apparent meaning of the statute.

It’s very easy for practitioners to see real property §1231 asset as capital assets since, from a practical perspective, sales of such assets by taxpayers generate a gain that eventually is treated on the tax return just like it was a gain from the sale of a true capital asset.  But this case reminds us that the asset is not itself a capital asset—it only gets this special treatment upon sale, and then only when §1231 gains exceed §1231 losses.

In this case the details of the Code section being relied upon by the taxpayer mattered—it did not state that it applied to assets where a gain on a sale would be treated as capital, but rather that it applied only to related assets that were capital assets in the hands of the taxpayer.  The Tax Court held that this was a distinction with a difference in this case.