Payment for Failed Real Estate Deal, Capital or Ordinary Gain?

Published Categorized as Capital vs. Ordinary, Federal Income Tax, Tax 2 Comments on Payment for Failed Real Estate Deal, Capital or Ordinary Gain?
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How is a termination payment for a failed real estate deal taxed?  Does it trigger capital or ordinary gain?  The court recently addressed this in CRI-Leslie, LLC v. Commissioner, 147 T.C. 8.

Facts & Procedural History

The taxpayer owned a Radison-branded hotel in Florida.  It entered into a contract to sell the hotel to a third party.  The contract fell thru and the taxpayer was entitled to keep the deposit money the would-be buyer had provided.  The taxpayer reported the deposit as long term capital gain on its income tax return.   An IRS audit resulted in litigation over whether the deposit was capital or ordinary gain for Federal income tax purposes.

Capital vs. Ordinary Gain or Loss

Our tax laws make a distinction between investment and business assets. Investment assets are generally referred to as capital assets. Business assets are generally referred to as ordinary assets.

Once there is a sale or other exchange of the asset, the characterization of the asset as capital or ordinary dictates what tax rate applies to the gain or loss. The idea is that capital or investment assets should be taxed at a lower rate than ordinary or business assets.

There are also rules that specify whether gains and/or losses from the sale or exchange of capital and ordinary assets can offset each other. The rules are somewhat involved and there are a myriad of nuanced rules.

Section 1231 is an example. It says that gain from the sale or exchange of certain business assets is capital and losses from the sale or exchange of certain business assets is ordinary. This can result in the gain from the sale or exchange being able to offset capital losses. If there is a loss from the sale or exchange, it can result in the loss being able to offset other business income. So the gain is capital and the loss is ordinary under Section 1231.

Section 1234A

Section 1234A applies to payments received due to cancellation, lapse, expiration, or other termination of a contract.

Earnest money that is forfeited in a real estate transaction that does not close is an example. Section 1234A says that the gain or loss received due to cancellation, lapse, expiration, or other termination of a contract for capital assets is capital in nature. So the gain or loss is capital under Section 1234A.

Termination Payments are Ordinary Gain

This brings us to the taxpayer’s argument in CRI-Leslie. The taxpayer argued that its gain was capital in nature even though the asset that was sold was not a capital asset. More specifically, the taxpayer argued that Section 1234A applies to Section 1231 gain–as Section 1231 treats gains as capital gains.

The taxpayer noted that this would be good tax policy as it would harmonize the results if the taxpayer had sold the property, as the gain would have been capital due to Section 1231. So it would seem that the termination payment should also be capital gain.

The IRS argued that Section 1234A does not mention Section 1231. It only mentions capital assets. So the IRS’s position was that Section 1234A did not apply to convert the income to capital gain.

The court agreed with the IRS, even though doing so could produce odd results. The court recognized the “disparate treatment,” noting that:

Forfeited deposits from the termination of a contract to sell [a business asset] are taxed at capital gain rates if the [business asset] is held as a passive investment. The same forfeited deposits are taxed as ordinary income if the [business asset] is used in a trade or business.

The court reached this conclusion based on a strict reading of Section 1234A, as advocated for by the IRS. It concluded that the code section is not ambiguous even though it can produce odd results.

The Takeaway

The takeaway is that taxpayers and their advisors need to take a second look at how they have and are characterizing termination payments. This is particularly true for those taxpayers who are currently under audit or whose returns are about to be audited.

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