Forfeited deposits are ordinary income

The Tax Court held that forfeited deposits the taxpayer retained from a terminated real estate sale agreement were ordinary income rather than capital gain. According to the court, by its plain language, Sec. 1234A does not apply to such deposits when the property has been used in the taxpayer’s trade or business.

Facts: CRI-Leslie was a Florida limited liability company (LLC) filing as a TEFRA (Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248) partnership for federal income tax purposes. In 2005, CRI-Leslie purchased a hotel in Tampa, Fla., for $13.8 million and used the property in its hotel and restaurant business. In 2006, CRI-Leslie agreed to sell the property to RPS LLC for $39 million and from 2006 to 2008 received deposits of $9.7 million under the agreement. The final sale never took place, and in 2008, by its terms, the agreement terminated, resulting in RPS’s forfeiture of the $9.7 million to CRI-Leslie.

On its 2008 federal income tax return, CRI-Leslie reported the $9.7 million as long-term capital gain. CRI-Leslie petitioned the Tax Court for relief after the IRS recharacterized the amount as ordinary income in its notice of final partnership administrative adjustment.

Issues: Under Sec. 1234A(1), a taxpayer’s gain or loss from the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property will be a capital gain or loss if the property is a capital asset of the taxpayer. Capital assets do not include real property used in a trade or business. If real property is used in a trade or business for more than one year, however, the property is Sec. 1231 property, and the net gain from the sale of such property is treated as long-term capital gain.

The taxpayer argued that the term “capital asset” as used in Sec. 1234A includes Sec. 1231 property because Congress intended Sec. 1234A to apply to contract termination payments involving Sec. 1231 property as well as capital assets. The IRS argued that the plain and unambiguous language of Sec. 1234A allows capital gain treatment only for contract termination payments involving capital assets.

Holding: The court held that Sec. 1234A does not apply to Sec. 1231 property because capital assets are the only property with respect to which Sec. 1234A expressly states gain or loss from a terminated right or obligation is eligible for capital gain treatment. Furthermore, the court noted, Sec. 1221(a), which defines capital assets, specifically excludes depreciable or real property used in the taxpayer’s trade or business. The court also could find nothing in the legislative history of Sec. 1234A to suggest that Congress intended to apply that statute to Sec. 1231 property.

The court acknowledged that it seemed inconsistent to treat as capital gain forfeited deposits from the termination of a contract to sell a hotel held as a passive investment while taxing them as ordinary income if the hotel is used in a trade or business. However, according to the court, “the plain meaning of section 1234A remains inescapable.”

• CRI-Leslie, LLC, 147 T.C. No. 8 (2016)

—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.