Capital gain treatment denied when sale contract terminates

A court case¹ highlights the unexpected tax treatment when a contract for the sale of property used in a trade or business terminates. In February 2005, a taxpayer bought a hotel for $13.8 million and hired a third party to manage the operations. In July 2006, the taxpayer entered into an agreement to sell the hotel for $39 million and a buyer paid a $9.7 million deposit to be applied against the purchase price. The parties further negotiated and amended the contract, but in 2008, the agreement terminated and the taxpayer retained the deposit.

The taxpayer knew that the hotel was “property used in a trade or business” and that had the hotel sold, the taxpayer would have recognized long-term capital gain. Code Section 1231 provides that net gains on the sale or exchange of property used in a trade or business is treated as a long-term capital gain.

However, the tax code provides for a different treatment when a sales contract terminates. Code Section 1234A provides that gain from a cancellation of a contract is treated as a capital gain only when the property to be sold is a capital asset. The hotel, however, is not a capital asset. Code Section 1221(a)(2) specifically states that a capital asset does not include property used in a trade or business which is subject to a depreciation deduction or real property used in a trade or business. Therefore, because the hotel is not a capital asset, the cancellation of the contract was not treated as capital gain, but rather as ordinary income.

The tax laws can be confusing and inconsistent. Please contact an attorney from the Chuhak & Tecson Tax & Employee Benefits practice group to help you navigate through tax transactions or tax controversies.

Client alert authored by David B. Shiner (312 855 4319), principal.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

  ¹CRI-Leslie, LLC v. Com’r., 2018 WL 891400 (11th Cir. Feb 15, 2018), affirming 147 T.C. 217 (2016)