The Tax Court has held in CRI-Leslie, LLC v. Commissioner (147 T.C. No. 8) that a partnership recognized ordinary income from its gain from a terminated sale contract.
The partnership in the case (CRI-Leslie) owned and operated a real estate property that included a hotel, a restaurant, a swimming pool, a parking lot and landscaping. CRI-Leslie entered into an agreement to sell this property to another party (RPS) for $39.2 million. RPS paid a deposit of $9.7 million to be applied to the property’s purchase price when the sale of the property closed.
RPS didn’t close on the purchase of the property from CRI-Leslie, and the agreement terminated pursuant to its terms. Because RPS defaulted on the agreement, it forfeited the deposit to CRI-Leslie.
CRI-Leslie reported the $9.7 million as long-term capital gain, but the IRS took the position that the forfeited deposits should be treated as ordinary income. CRI-Leslie argued that Section 1234A supported the capital gain treatment. Under Section 1234A, taxpayers are required to recognize capital gain or loss related to the cancellation, lapse, expiration or other termination of a right or obligation (other than a securities futures contract as defined in Section 1234B) related to property that is (or would be) a capital asset in the hands of the taxpayer.
The property did not in fact constitute a capital asset in the hands of CRI-Leslie, but rather “property used in the trade or business” of CRI-Leslie under Section 1231. Such Section 1231 property is specifically excluded from the definition of capital asset under Section 1221(a)(2). However, Section 1231 provides that net gain from the sale or exchange of Section 1231 property held for more than one year is treated as long-term capital gain, so CRI-Leslie’s gain from the sale or exchange of the property would have been characterized as a long-term capital gain under Section 1231.
The court held that the taxpayer’s gain related to the forfeited deposits should constitute ordinary income. It based its decision on the fact that Section 1234A specifically refers to a “capital asset in the hands of the taxpayer,” and the property was not actually a capital asset in the hands of CRI-Leslie even though Section 1231 treated the gain from the sale or exchange of the property as capital gain. The court stated:
"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. . . . The clarity of congressional purpose in restricting the reach of the statute to capital assets is ineluctable."
Partner, Washington National Tax Office
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