In a case of first impression, the Eleventh Circuit affirmed that a taxpayer could not treat as long-term capital gain its retention of a nonrefundable deposit after a would-be buyer defaulted on an agreement to purchase real property used in the taxpayer’s trade or business. CRI-Leslie, LLC v. Comm’r, 882 F.3d 1026 (11th Cir. 2018).
Under the facts of the case, the taxpayer, CRI-Leslie LLC, entered into an agreement to sell real property used in CRI-Leslie’s trade or business for $39.2 million, $9.7 million of which was paid immediately to CRI-Leslie as a nonrefundable deposit. The deal ultimately fell through, and the would-be buyer forfeited the $9.7 million deposit. CRI-Leslie treated its retention of the forfeited deposit as a long-term capital gain for federal income tax purposes. The Internal Revenue Service determined, and the U.S. Tax Court agreed, that CRI-Leslie improperly treated its retention of the forfeited deposit as long-term capital gain, rather than ordinary income.
The Internal Revenue Code of 1986, as amended, generally provides for more favorable tax rates on “net capital gain” than it does on ordinary income. Net capital gain is “the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for such year.” Long-term capital gain, in turn, is “gain from the sale or exchange of a capital asset held for more than 1 year.”
Section 1221(a) defines “capital asset” as “property held by the taxpayer (whether or not connected with his trade or business)” but explicitly excludes “property, used in [the 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 [the taxpayer’s] trade or business.” (emphasis added.)
CRI-Leslie and the IRS stipulated that CRI-Leslie’s real property was real property used in CRI-Leslie’s trade or business within the meaning of section 1221(a). Accordingly, CRI-Leslie conceded that its real property was not a capital asset as defined in section 1221. Even so, if the sale of CRI-Leslie’s real property had been completed, the gain from the sale would have nevertheless been treated as long-term capital gain under a different Code provision—namely, section 1231. Very generally, under section 1231, if a taxpayer recognizes gain from the sale or exchange of real property that is used in a trade or business and held for more than one year, the gain is eligible to be treated as long-term capital gain. But since the sale did not occur, the treatment of CRI-Leslie’s retention of the forfeited deposit depended on the application of yet another Code provision, section 1234A. Code section 1234A generally treats the gain or loss arising from the cancellation of an agreement to buy or sell property as a gain or loss from the sale of a capital asset, provided the property at issue qualifies as a capital asset.
Because section 1234A applies only to property that is a “capital asset,” the issue before the Eleventh Circuit was whether CRI-Leslie’s real property was a capital asset in CRI-Leslie’s hands for purposes of section 1234A. The Eleventh Circuit determined that the definition of capital asset in section 1221, by its terms, is controlling for purposes of Subtitle A of the Code, which includes section 1234A. Consequently, based on the Code’s plain language, and based on CRI-Leslie’s concession that its real property was not a capital asset under section 1221(a), the Eleventh Circuit concluded that section 1234A did not apply and thus that CRI-Leslie’s retention of the forfeited deposit constituted ordinary income to CRI-Leslie.
CRI-Leslie argued that disallowing capital gains treatment of a cancelled sale of real property used in the taxpayer’s trade or business unjustly rewarded passive investors while penalizing investors who managed the property they planned to sell. Moreover, the disallowance created an “absurd” result in which the forfeited deposit was ordinary income if the sale was cancelled but long-term capital gain if the sale was completed. Such an approach, CRI-Leslie argued, created two disparate rates for the same economic transaction. CRI-Leslie further cited to legislative history accompanying amendments to section 1234A in 1997, which, according to CRI-Leslie, supported that Congress intended section 1234A to apply to property outside of the section 1221 definition of capital asset—and in particular to include trade or business property subject to section 1231.
The Eleventh Circuit was not persuaded. According to the court, “if an asset is Section-1231 property, then by definition—literally—it is not Section-1234A property.” In concluding his opinion for the court, Judge Kevin Newsom observed: “Now it may well be, as CRI-Leslie asserts, that Congress really did mean for the amended Section 1234A to reach beyond ‘capital assets’ as defined in Section 1221 to include Section-1231 property. Perhaps, that is, Congress just stubbed its toe between the hearing room and the House and Senate floors. Even so, it’s not our place or prerogative to bandage the resulting wound. . . . If Congress thinks that we’ve misapprehended its true intent—or, more accurately, that the language that it enacted in [Code sections] 1221 and 1234A inaccurately reflects its true intent—then it can and should say so by amending the Code.” The opinion is Judge Newsom’s second tax case in his short tenure on the court.
Posted by Wes Sheumaker and Caroline Reaves.