Tax Treatment of Forfeited Deposits

| 9/15/2016

A recent Tax Court case, CRI-Leslie, LLC v. Commissioner, concluded that taxpayers recognized ordinary income rather than capital gain when they retained deposits from the buyer in a failed sale of real estate used by the seller in its trade or business.

CRI-Leslie owned a property that consisted of a plot of land and buildings. In July 2006, CRI-Leslie entered into an agreement to sell the property for $39 million and received $9.7 million of deposits from the prospective buyer as part of the agreement. The deposits would have been applied to the property’s purchase price if the sale had closed. The prospective buyer defaulted on the agreement in 2008 and forfeited the $9.7 million paid to CRI-Leslie. After the sale was not completed, CRI-Leslie recognized and reported $9.7 million of long-term capital gain for the nonrefundable deposit made by the potential buyer. The Tax Court held that the payment was taxable as ordinary income, not as a capital gain.

Because CRI-Leslie used the real estate in its trade or business, the real estate is considered IRC 1231 property. IRC Section 1231 establishes a favorable tax treatment for property used in a taxpayer’s trade or business. Section 1231 property generally is eligible for long-term capital gain treatment if it is sold at a gain, and ordinary loss treatment if it is sold at a loss. The court, the IRS, and the taxpayer all agreed the property was properly classified as Section 1231 property. As such, if the sale had occurred, any gain would have been considered long-term capital gain.

However, the rules for income from the sale, exchange, or termination of a contract to purchase property differ from the general rules regarding the sale of property. That statute provides for capital gain treatment only if the underlying property is a capital asset. In its analysis of the statute, the court concluded that 1231 property is not a capital asset, even though the gain on a sale would have resulted in capital gain. Therefore, the court held CRI-Leslie had ordinary income as a result of the forfeited deposit.

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Howard Wagner
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