In CRI-Leslie LLC, et al. v. Commissioner (147 T.C. No. 8), the Tax Court ruled that a capital asset as defined in Section 1234A does not include depreciable property described in Section 1231. Accordingly, forfeited deposits related to the termination of a contract for the sale of an operating hotel are ordinary income, not long-term capital gain.

Facts

CRI-Leslie was a partnership operating in the real estate industry that owned the property at issue, the Radisson Bay Harbor Hotel, which it acquired in 2005 for $13.8 million. After acquisition, CRI-Leslie arranged for a third party to manage the hotel and restaurant on the property.

In 2006, CRI-Leslie agreed to sell the property to RPS, LLC for $ 39 million. The sales agreement included a clause that, should the deal not close timely, the agreement would terminate and CRI-Leslie would keep all deposits paid. The deal did fail and CRI-Leslie retained $9.7 million of deposits from RPS, LLC, which it reported as net long-term capital gain on Schedule K.

The IRS disagreed and determined that the deposits should be treated as ordinary income. Both parties agree that the property was real property used in business within the meaning of Section 1221(a)(2) that constitutes "property used in a trade or business," as defined by Section 1231(b)(1).

Law and analysis

Section 1234A treats gain or loss attributable to the termination of a right or obligation with respect to a capital asset as capital gain or loss. Section 1221(a)(2) excludes depreciable property used in the taxpayer's trade or business, as well as real property used in a trade or business, from the definition of capital asset.

CRI-Leslie argued that Section 1234A is ambiguous and Congress intended it to apply to payments from terminations relating to Section 1231 property as well, because gains from Section 1231 assets result in capital gain. The IRS argued that Section 1234A is unambiguous and that gain on the partnership's real property cannot be governed by Section 1234A as it is Section 1231 property, which by definition is not a capital asset as defined in Section 1221.

The Court agreed with the IRS that the statute is not ambiguous and there is no indication that Congress intended to include Section 1231 property in the ambit of Section 1234A. Accordingly, the plain meaning of "capital asset" in Section 1234A does not include Section 1231 property. Thus, the forfeited deposits must be treated as ordinary income because there was no sale or exchange.

Implications

The Court's decision is consistent with a plain reading of the term "capital asset" and leaves the extinguishment doctrine alive and well for certain transactions outside Section 1234A. Although this reading produced an unfavorable result for the taxpayer at issue, it can also create a favorable result when the taxpayer seeks an ordinary loss and wishes to avoid the application of Section 1234A, such as the counterparty in this case.

Interestingly, the Court did not address the continuing validity of its decision in Pilgrim's Pride v. Commissioner, which was later overruled by the 5th Circuit. 141 T.C. 533 (2013), rev'd, 779 F.3d 311 (5th Cir. 2015). It would appear that, under the Tax Court's reading of Section 1234A in Pilgrim's Pride, CRI-Leslie would have been entitled to a capital gain as long as the contract for the sale of the property itself was a capital asset, regardless of whether the underlying property was a capital asset. It is unclear whether the taxpayer asserted this alternative theory for capital gain. As a result, whether the Tax Court's decision in Pilgrim's Pride has continuing viability outside of the 5th Circuit remains uncertain.

In addition, although the Tax Court mentioned Section 1234, it did not apply that option regime to the deposit, presumably because of prior case law that deposits are not Section 1234 options.

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