In CRI-Leslie, LLC, the Eleventh Circuit confronted whether a taxpayer is entitled to capital gains treatment for a forfeited deposit on the sale of land.  CRI-Leslie, LLC, Donald W. Wallace, Tax Matters Partner v. Commissioner, 11th Cir., No. 16-17424, February 15, 2018.  It is not a stretch to describe this area as “among the most frustrating in income tax law.”  Sirbo Holdings, Inc. v. Commissioner, 509 F.2d 1220, 1223 (2d Cir. 1975).

In 2005, CRI-Leslie paid almost $14 million for a hotel and restaurant in Tampa on prime waterfront property.  It planned to eventually sell the property, but it hired a third party to run everything in the meantime.  Over a year later, CRI-Leslie agreed to sell the property for around $39 million.  As part of the deal, CRI-Leslie received a $9.7 million nonrefundable deposit to be credited to the purchase price at closing.  But in 2008, the buyer fell through and forfeited the deposit.  CRI-Leslie reported the $9.7 million deposit as long-term capital gain.  The IRS disagreed, and argued that the Code allows capital gains treatment only for finalized sales, not forfeited deposits.

The case made its way to the Eleventh Circuit, which began its analysis with section 1231.  Section 1231(a) states that “any recognized gain on the sale or exchange of property used in the trade or business” is “treated as long-term capital gains.”  (Emphasis added).  Section 1231 also provides that the “term ‘property used in the trade or business’ means property used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 167, held for more than 1 year, and real property used in the trade or business, held for more than 1 year ….”  If CRI-Leslie had actually sold the property, the $9.7 million would have been taxed as long-term capital gain under section 1231.

But the deal never happened, so the tax treatment of the deposit was governed by section 1234A, not section 1231.  Section 1234 states that any gain or loss resulting from the termination of an agreement to buy property will still be treated as capital gain, if the property is a “capital asset” for the purposes of section 1234A.  Thus, the narrower issue was whether the hotel was a capital asset.

The Eleventh Circuit held that the answer could not be clearer based on a plain reading of the Code.  For the purposes of section 1234A, “the term ‘capital asset’ means property held by the taxpayer (whether or not connected with his trade or business), but does not include … 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.”  IRC § 1221(a)(2) (emphasis added).

The problem for CRI-Leslie was that it stipulated that the hotel was real property used in its trade or business.  The Eleven Circuit held that this concession by CRI-Leslie was fatal because “capital asset” does not include real property used in a trade or business under section 1221(a)(2).  That meant that the hotel was not a capital asset under section 1221, so section 1234A – the special rule that says that property from the termination of a contract for the sale of a “capital assets” is still subject to capital gains treatment – did not apply.  As a result, the Eleventh Circuit held that the $9.7 million forfeited deposit was taxable as ordinary income.