United States

Ordinary income recognized when real property deposit forfeited

No capital gain treatment, as deposit related to section 1231 property


A recent Tax Court case highlights a distinction between capital assets and depreciable (or amortizable) assets used in a trade or business. These two categories are not identical, even though property in the latter category (section 1231 property) can produce capital gain when sold, under the favorable rule of section 1231. The taxpayer in CRI-Leslie, LLC v. Commissioner, 147 T.C. No. 8 (Sept. 7, 2016) did not actually sell its section 1231 property. Instead, it was entitled to keep a $9.7 million sale deposit it had received. The Tax Court denied the taxpayer’s claim of capital gain treatment.   

In 2006, the taxpayer had entered into an agreement to sell real property it owned, including a hotel, restaurant, swimming pool and land. However, the sale never closed. In 2008, the buyer had defaulted, and the agreement terminated by its own terms, with the taxpayer entitled to retain the deposit of $9.7 million.  

If the sale had closed, the taxpayer would have recognized long-term capital gain under section 1231. Because the taxpayer’s gain stemmed from a contract to sell rather than an actual sale, section 1231 did not help the taxpayer and the taxpayer turned to section 1234A, a provision generally intended to provide capital gain or loss treatment upon termination of contracts to purchase or sell capital assets.

The taxpayer argued that section 1234A’s approach supported matching the character of gain on a forfeited deposit to the gain that would have been realized on an actual sale of the underlying property. On that basis, the taxpayer reported capital gain on its partnership income tax return—gain that would be taxed to its owners at more favorable rates than ordinary income.

The IRS argued that because section 1234A applies only to capital assets, the taxpayer could not benefit from it, and the Tax Court agreed. Section 1234A by its terms applies to certain rights and obligations with respect to ‘capital assets.’ The Tax Court held that this reference to capital assets did not extend to section 1231 assets like the taxpayer’s hotel property, thus, section 1234A did not permit the taxpayer to report capital gain instead of ordinary income. Accordingly, the Tax Court’s decision in the CRI-Leslie case is a good reminder of the distinction between capital assets and section 1231 property.


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