Tax Court Finds Forfeited Deposits on Terminated Sale of Hotel Is Ordinary Income

Posted by Jana Benson,Dean Hinderliter, and John Cohn                   The Tax Court, adopting a narrow reading of the Internal Revenue Code, has held that, although the sale of Section 1231 property qualifies for capital gain treatment, the gain or loss attributable to the termination of a sale of Section 1231 property does not.Capital gain treatment (which can include a preferred tax rate) applies to the sale or exchange of capital assets under Section 1221. It also applies to the sale or exchange of Section 1231 property – that is, depreciable business property and real estate used in a trade or business and held for more than one year.However, in CRI-Leslie, LLC, Donald W. Wallace, Tax Matters Partner v. Commissioner of Internal Revenue, 147 T.C. No. 8 (September 7, 2016), the Tax Court held that capital gain treatment under Section 1234A does not extend to gains from a forfeited deposit on the sale of a hotel because the hotel is not a capital asset under Section 1221.
Section 1234A provides guidelines for determining the character of the taxpayer’s gain or loss “attributable to the cancellation, lapse, expiration, or other termination of a right or obligation.”  Gain or loss under Section 1234A receives capital gain treatment if the property connected to the terminated right or obligation is or would be a capital asset under Section 1221.  Property subject to depreciation under Section 167 and real property used in a trade or business are not capital assets under Section 1221(a)(2).  These types of property are “Section 1231 property,” and the Code grants long-term capital gain treatment to net gains on the sale of “Section 1231 property.”
Background. In 2006, CRI-Leslie, a Florida limited liability company, acquired and operated a hotel for several years.  Later, CRI-Leslie entered into an agreement to sell the hotel for approximately $39 million.  The buyer did not pay the $39 million purchase price on the day of closing, which ultimately terminated the agreement.  Before the closing date, CRI-Leslie received approximately $9.7 million of nonrefundable deposits in connection with the agreement.  CRI-Leslie reported the $9.7 million as long-term capital gain because the completed sale of the hotel would have generated long-term capital gain; however, the IRS categorized the $9.7 million as ordinary income.  CRI-Leslie asked the Tax Court to hear the case to determine whether the Commissioner of Internal Revenue (“Commissioner”) should have characterized the $9.7 million forfeited deposit as ordinary income.Decision. The Tax Court held that forfeited deposits related to the sale of “Section 1231 property” do not receive capital treatment because “Section 1231 property” is not a capital asset.  CRI-Leslie argued that Congress enacted Section 1234A to “ensure that taxpayers received the same tax characterization of gain or loss whether the property is sold or the contract to which the property is subject is terminated.”  CRI-Leslie and the Commissioner agreed that the completed sale of the hotel would have resulted in long-term capital gain under Section 1231, and, because of this, CRI-Leslie felt confident treating the forfeited deposit as long-term capital gain. The Commissioner’s response to this argument centered around the plain language of Section 1234A, which only provides capital gain treatment to terminated rights or obligations related to the sale of capital assets, not “Section 1231 property.”  The Commissioner’s argument ultimately prevailed, and the Tax Court stated:“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.” The Tax Court adopted a strict interpretation of Section 1234A, which is a result that will likely raise the eyebrows of many practitioners.Implications. Before CRI-Leslie, practitioners had no qualms treating “Section 1231 property” as a capital asset for the purposes of determining the character of gain under Section 1234A. Despite practitioners’ comfort, taxpayers and practitioners must now be aware that gain from terminated rights or obligations relating to “Section 1231 property” will be treated as ordinary gain.