Originally published on Forbes.com.
A company that got to keep a non-refundable deposit on the planned sale of a hotel had to recognize ordinary income rather than capital gain when the deal fell through. That was the result in Eleventh Circuit decision in the case of CRI-Leslie LLC (upholding a 2016 regular Tax Court decision).
I was altogether unsurprised by the decision. Actually, much as I am inclined to root for the taxpayer, I would have been disturbed if it had gone the other way, since I would have had to scramble around to see if there were any open returns where I had gotten it wrong. There is a worthwhile lesson in this decision about paying attention to the sometimes subtle language in the Code, but we’ll give you the story first.
A Baseball Diversion
As usual, the story behind the story is more intrinsically interesting than the tax decision. The property in question was the Radisson Bay Harbor Hotel in Tampa. I’m not sure about now, but according to this story, it is where the Yankees stayed during spring training back in 2005. Of course, but possibly not such a wild coincidence, the hotel was owned by George Steinbrenner.
Steinbrenner sold the hotel to CRI-Leslie LLC in 2005. Of course, George Steinbrenner and the New York Yankees have nothing at all to do with the case, but I could not resist sharing that. It is one of those little details that differentiate my coverage from the rest of the tax blogosphere. I’m not going to get into the 1999 shooting spree, but I don’t want you to think that I missed it.
CRI-Leslie was planning to sell the property, but they hired somebody to run it for them in the meantime. In 2006, they entered into a contract to sell the property to RPS LLC for $39 million. RPS LLC made deposits totaling $9,700,000, but when it failed close in 2008, CRI-Leslie got to keep them. That’s income to CRI-Leslie. Nobody was questioning that. But is it ordinary income, as I would have thought, or capital gain, as CRI-Leslie was arguing?
Why Capital Gain?
Code Section 1234A provides that gain or loss attributable to the cancellation, lapse, expiration or other termination of a right or obligation which is or 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. Well, there you have it. If CRI-Leslie had sold the hotel it would have gotten capital gain treatment on the sale. Nobody questions that. So it should get capital gains treatment on the forfeited deposit it got to keep if you follow along with Code Section 1234A.
Why Not Capital Gain?
There is this subtle nuance, that can be quite important, but is often ignored. CRI-Leslie was not just sitting on the hotel, holding it as an investment. It was operating and they were taking depreciation deductions. That fact throws it out of the definition of a capital asset which is in Code Section 1221. Code Section 1221 defines capital asset negatively. It is pretty much everything except certain things including:
property, used in his 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;
Now it is true that Code Section 1231 will cause net gains from property used in a trade or business to be taxed as long term capital gains, but that does not make those assets capital assets. If they are sold at a loss the loss is ordinary. And if they are sold at a gain and there have been Section 1231 losses in the last five years, the gain is ordinary to that extent. That can be a nasty surprise. And then there is depreciation recapture and unrecaptured Section 1250 depreciation. Don’t get me started.
But That Doesn’t Make Any Sense
The Tax Court had gone with the second choice. Not a capital asset – not a capital gain. CRI-Leslie’s unavailing argument was that Congress had really meant 1234A to apply to 1231 assets, implying that Congress was filled with people with the mental acuity of pretty dopey tax preparers, rather than wise lawmakers. The Tax Court went with the assumption that Congress knew what it was doing:
But regardless of any potential intellectual inconsistency in this disparate treatment, the plain meaning of section 1234A remains inescapable. We do not see any ambiguity in the apparent meaning of the statute
The Eleventh Circuit pretty much saw it the same way:
As a formal matter, it is of course only the statutory text (as relevant here, I.R.C. §§ 1221 and 1234A) that is “law” in the constitutional sense—that’s all that was enacted through the bicameral legislative process and presented to the President for his signature. See U.S. Const. art. I § 7, cls. 2–3. And as a practical matter, conscientious adherence to the statutory text best ensures that citizens have fair notice of the rules that govern their conduct, incentivizes Congress to write clear laws, and keeps courts within their proper lane.
So in the end, this case is actually pretty straightforward: Section 1234A provides for capital-gains treatment of income resulting from canceled sales only where the underlying property constitutes a “capital asset,” and Section 1221 defines “capital asset” in a way that all agree excludes the property at issue here. Accordingly, CRI-Leslie is not entitled to treat its $9.7 million deposit as capital gain. Q.E.D.
The Eleventh Circuit may have also been putting out a warning as the recent tax bill seems to in need of technical correction, which may or many not happen. The courts will be following Reilly’s First Law of Tax Planning – It is what it is. Deal with it.
A Little History On 1234A And A Planning Note
When 1234A was added to the Code in 1981, it only applied to personal property. And personal property that is used in a trade or business rarely produces a capital gain, since stuff like trucks and cars and machinery tends to wear out. Gain on sale it usually just depreciation recapture. It was not until 1234A was amended in 1997, that it would apply to real estate, where significant appreciation is more common, although as we know hardly inevitable.
Generally speaking the tax treatment of real estate used in a trade or business is more favorable than real estate held for investment. Here is an instance where this would not be the case. Of course deals falling through with substantial non-refundable deposits is not something that people plan on. Whether real estate is a 1231 asset can, however, be a little gray and this might be a circumstances where the gain from a forfeiture could be a contingency worth planning for.
Other Coverage
Wolters Kluwer had a brief piece on the Eleventh Circuit decision. Tony Nitti covered the original Tax Court decision in some depth in 2016. Tony seemed to think there was a good chance the Eleventh Circuit would overturn the Tax Court, but as we see no such luck.
Jeff Borghino had an in depth discussion of 1234A in the Tax Adviser, that addressed the decision. I’d call that a “must read” if you think this might have planning implications for you. Jeff’s article predates the 11th Circuit decision, but since the appeal upheld the Tax Court it is still good.
Ed Zollars had something in Current Federal Tax Developments ending with a cautionary on the Tax Cuts and Jobs Act.
Some advisers are finding some “odd” results arising from a plain language reading of some provisions of the Tax Cuts and Jobs Act. But regardless of how “strange” the result may seem, advisers must remember that the Courts are likely to enforce what they may see as the “odd” result and leave it up to Congress to modify the law if they feel it is necessary to remove the oddity.
Don Susswein and Rob Alinsky of RSM speculate that the plain language tenor of the decision might help taxpayers facing the new three year holding period on carried interest gains.
There is more, most of it brief. It is enough so that I might have skipped this one in good conscience, but nobody else noticed the tenuous New York Yankees connection.