Properly taxing property deals.

• Author: McBride, Gary

Prospective real estate buyers are often required by the purchase agreement to forfeit their down payment or deposit if they default on performance of the contract. If the buyer does not default and the contract is completed, then the seller treats the down payment as part of the amount realized that contributes to the gain or loss on the sale; the buyer includes the down payment in the cost basis of the purchased property.

If the would-be buyer defaults, then the down payment is forfeited to the would-be seller as liquidated damages and the tax consequences, on both sides of the transaction, are more complicated.

Forfeiture of a down payment for real estate is the focus of this article and the subject of CRI-Lestie v. Comm'r., 147 T.C. No. 8 (9/7/2016), a case of first impression in the Tax Court.

CRI-Leslie (CL), a partnership that owned and operated a Radisson Hotel in Tampa, Florida, entered into a contract of sale in 2006 with a potential buyer, RPS, for 839 million. As part of the purchase agreement, RPS made a down payment of $9.7 million that was forfeitable by RPS. RPS failed to adequately perform (for reasons not explained in the case) so the contract was canceled and CL retained the $9.7 million. In reliance on section 1234A, Gains or losses from certain terminations, CL treated the $9.7 million as long-term capital gain on its Form 1065. The IRS and Tax Court disagreed and concluded that the retained down payment was ordinary income.

Section 1234A

Sec. 1234A, in pertinent part, provides that "[g]ain or loss attributable to the cancellation, lapse, expiration or other termination of ... a right or obligation ... with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer ... shall be treated as gain or loss from the sale of a capital asset." Therefore, the recipient of a forfeited down payment on real property is entitled to capital gain treatment if, and only if, the property is a capital asset.

Sec. 1234A was enacted in 1981 as part of the Economic Recovery Tax Act of 1981 (Pub L. No. 97-34) and was limited to contract termination payments with respect to straddles involving personal property actively traded on established exchanges. The Taxpayer Relief Act of 1997 (TRA) (Pub. L. No. 105-34), expanded section 1234A to include contract termination payments relating to all property, including interests in real property and non-actively traded personal property, and not merely straddles. The Senate report explained that courts had "given different answers as to whether transactions which terminate contractual interests are treated as a 'sale or exchange.'" The "lack of uniformity has caused uncertainty to both taxpayers and the Internal Revenue Service in the administration of the tax laws." (Senate Report to 1997 TRA)

Tax Court's Analysis in CRI-Leslie

The parties stipulated that the hotel constituted "property used in a trade or business" and because it was also held for more than one year, that the hotel was Sec. 1231 property [see Sec. 1231(b)(1)]. The parties further stipulated that if CL sold the hotel to RPS in 2008, its gain would have generated long-term capital gain [section 1231(a)(1)].

The taxpayer contended that Sec. 1234A was "inherently ambiguous" because, according to the taxpayer, Congress enacted Sec. 1234A with the intent of ensuring that taxpayers received the same tax characterization of gain on termination of the contract as gain on a completed sale. The taxpayer also noted that some commentators have referred to Sec. 1231 property as "quasi-capital assets."

The Tax Court rejected the taxpayer's argument and was "unable to find anything in the legislative history of section 1234A to support [the taxpayer's] assertion that Congress intended to include section 1231 property within its ambit." The Court concluded that the meaning of capital asset in Sec. 1234A is clear:

"Regardless of the myriad ways in which the term 'capital asset' may be understood in various contexts, section 1234A is a provision of this country's tax code. Therefore, we look to the Code for the appropriate definition, and specifically to section 1221. ... [S]ection 1221 defines 'capital asset' as any property held by a taxpayer unless specifically excluded. Sec. 1221(a). The exclusion relevant here is the second one, removing from the definition of capital asset 'property, used in ... [a taxpayer's] trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business.' Sec. 1221(a)(2)."

The Tax Court acknowledged the varied treatment of forfeited down payments depending on the classification of the asset in the owner's hands:

"Forfeited...