Taxing Lessons From Court Decisions

Decisions — Forfeiting the capital gain

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Image source: Free Picture 258479 Johanna Goodyear Dreamstime Stock Photos
Image source: Free Picture 258479 Johanna Goodyear Dreamstime Stock Photos

What is a capital asset? Section 1221 of the internal revenue code defines a capital asset primarily by explaining what a capital asset is not. For example, property used in a trade or business that is subject to depreciation, or real property used in a trade or business, are not capital assets. However, internal revenue code section 1231 says that when you sell this type of property at a gain after owning it for more than a year, you can use capital gain tax rates. And section 1234A says the capital gain treatment is extended to terminations of contractual rights (such as a forfeited deposit) related to property that is a capital asset.

Are you dizzy yet? In essence, section 1231 says that even though certain property is not a capital asset under section 1221, you can still use the more favorable capital gain rates in some circumstances. Section 1234A grants the same benefit to certain rights relating to capital assets.

In 147 T.C. No. 8 (CRI-Leslie, LLC), the taxpayer, a partnership, reported the gain from a $9.7 million forfeited deposit as a long-term capital gain on a 2008 federal income tax return.

The deposit was part of a sales agreement for a hotel that the taxpayer treated as business property and depreciated. The sales agreement was entered into in 2006 and terminated in 2008, when the prospective buyer defaulted on the agreement and forfeited the deposit.

The IRS agreed the hotel was real property used in the taxpayer’s business and that the hotel would have qualified for section 1231 tax treatment had the sale been finalized.

However, the IRS said section 1234A expressly references a “capital asset in the hands of the taxpayer.” Since the hotel was section 1231 property, it by definition was not a capital asset as defined in section 1221 and section 1234A does not apply.

This is the applicable wording from code section 1234A:


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).

The dispute is whether “capital asset” as used in section 1234A extends to property described in section 1231.

Why does the definition matter? In this case, if the $9.7 million deposit is taxed at capital gain rates, the tax would be approximately $1.5 million less than the tax assessed at ordinary rates.



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Right answer!

For the IRS.

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.

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.

Section 1234A applies to “property which is (or on acquisition would be) a capital asset in the hands of the taxpayer.”

We find it telling that the statute does not read: “property which has the same character as the property to which the * * * [right or obligation] relates has in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by him).”

Had Congress intended to cover section 1231 property under section 1234A, Congress could have, and likely would have, used wording parallel to that in sections 1234 and 1234B. The clarity of congressional purpose in restricting the reach of the statute to capital assets is ineluctable.

Accordingly, we hold that the plain meaning of the statute must govern here.

Editorial note: The key to the decision is to follow the round-robin. Section 1221 defines a capital asset. Section 1231 defines the tax treatment for a specific type of asset that is not a capital asset under section 1221. Section 1234A defines the tax treatment for contractual rights related to section 1231 property (in other words, property that is not a capital asset).

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