Right to Retain Forfeited Deposits from Canceled Sale of Property Not Capital Gain, Property Not Capital Asset (Cri-Leslie, LLC, TC)

CCH Tax Day Report

In a case of first impression, a TEFRA partnership was not allowed to subject its right to retain forfeited deposits from a canceled sale of real property to capital gain treatment. The property did not constitute “property that is a capital asset” and, therefore, Code Sec. 1234A did not apply. The property, a hotel, was acquired for use in the partnership’s hotel and restaurant business as property used in a trade or business classified under Code Sec. 1231. The partnership entered into an agreement to sell the property; however, the purchaser defaulted on the agreement and forfeited an amount paid to the partnership during the tax year. Had the partnership sold the property according to the agreement’s terms, the gain from the sale would have resulted in a Code Sec. 1231 gain, but the partnership reported the forfeited deposits as net long-term capital gain on its Schedule K. However, neither the statutory construction nor the case law supported an extension of the definition of “capital asset” as used in Code Sec. 1234A to property described in Code Sec. 1231 and a final partnership administrative adjustment recharacterized the capital gain as ordinary income.

In addition, Code Sec. 1234A specifically applies to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer. The plain meaning of Code Sec. 1234A indicates that the treatment of gains and losses from terminations of rights or obligations relating to property would depend on whether that property is a capital asset or is described in Code Sec. 1231. For instance, forfeited deposits from the termination of a contract to sell a hotel would be taxed at capital gain rates if the hotel was held as a passive investment. The same forfeited deposits would be taxed as ordinary income if the hotel was used in a trade or business. Finally, had the Congress intended to cover Code Sec. 1231 property under Code Sec. 1234A, it most likely would have, but by its plain terms, Code Sec. 1234A(1) applies to the termination of rights or obligations with respect to capital assets.

Cri-Leslie, LLC, 147 TC —, No. 8, Dec. 60,689

Other References:

Code Sec. 1231

CCH Reference – 2016FED ¶30,575.13

Code Sec. 1234A

CCH Reference – 2016FED ¶30,631.20

Tax Research Consultant

CCH Reference – TRC SALES: 15,054.65

CCH Reference – TRC SALES: 15,102

CCH Reference – TRC SALES: 33,064.15



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