Taxing Lessons Case Summaries

Case — Tax Credits and Capital Gains

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TL Case Summ


Does the sale of tax credits qualify for capital gain treatment?


Taxpayer Says: The tax credits are a capital asset, and the sale should be reported as a capital gain.

Internal Revenue Service Says: The tax credits are a substitute for ordinary income because the proceeds from selling the credits were a substitute for a refund that would have been ordinary income.


From Internal Revenue Code Section 1221: Defines “capital asset” as property held by a taxpayer, except for eight categories of property specifically excluded from the definition. (None of the excluded categories is applicable to the state tax credits at issue.)

From Internal Revenue Code Section 1222: Capital gains are derived from the sale or exchange of capital assets. The sale of capital assets held for more than one year will result in long-term capital gain or loss.

From Gladden v. Commissioner, 112 T.C. 209, 218 (1999), revd. on a different issue 262 F.3d 851 (9th Cir. 2001): There is “no single definitive” definition of a capital asset.

From Lattera v. Commissioner, 437 F.3d399, 402-403 (3d Cir. 2006), affg. T.C. Memo. 2004-216: Faced with determining the character of assets that do not fit any of the section 1221 exceptions to the definition of a capital asset yet do not appear to properly fit that of a capital asset, courts use the substitute for ordinary income doctrine to exclude certain property.

From Commissioner v. P.G. Lake, Inc., 356 U.S. 260, 265-266 (1958): Under the substitute for ordinary income doctrine, “capital asset” does not include mere rights to receive ordinary income.


When you sell investments or certain property for more than you invested, the gain is taxed under special rules. For assets you hold longer than a year, the capital gain rules generally allow a lower tax rate than the one imposed on ordinary income. The purpose of these rules is to provide a measure of relief for gains that accrue over a long period of time.

Disputes arise because the tax code defines capital assets negatively, by what they are not. For example, inventory, accounts receivable and ordinary business supplies are generally not considered capital assets, and do not qualify for lower tax rates.

In this case, the taxpayer donated a qualified conservation easement to a qualified charitable organization and received income tax credits from the state of Colorado. The credits were transferable, and the taxpayer sold a portion of them to an unrelated third party. The taxpayer believed the credits were capital assets, and reported the gain as a capital gain.

The IRS disallowed capital gain treatment, saying the tax credits were not capital assets and that the proceeds from selling the credits were merely a substitute for a refund from Colorado that would have been ordinary income.


Make your selection, then see “The Court’s Decision” below for a full explanation

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit and

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.


Right answer!
Sorry, wrong answer :(
For the taxpayer. The tax credits do not represent a right to income; therefore, the substitute for ordinary income doctrine is inapplicable. None of the categories of property in section 1221 specifically excepted from the term capital asset is applicable to the tax credits. Accordingly, the tax credits are capital assets. (The court also found the taxpayer had no basis in the credits and that the gain was short-term.)