§1234A Character of gain from termination-Passive investment

Technical topics regarding tax preparation.
#1
Wiles  
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Taxpayer received an $850K option for purchase of real estate that the taxpayer holds as a rental. The buyer (not the renter) was not able to complete the transaction and forfeited the deposit. Is it capital gain or ordinary income to the taxpayer?

Initial research of Sec 1234A suggests it is ordinary income because 1234A only applies to capital assets, which excludes Sec 1231 trade or business property.

However, my RIA Checkpoint Federal Tax Coordinator gave me a nugget in ¶ I-6276. It said that a passive investment would not be considered a trade or business property under Sec 1231, and therefore would not be excluded from Sec 1234A capital asset treatment. It cited the following cases:

CRI-LESLIE, LLC v. COMM., 121 AFTR 2d 2018-794 (882 F.3d 1026),
WASHINGTON MUTUAL, INC., ET AL. v. U.S., Cite as 119 AFTR 2d 2017-818 (130 Fed. Cl. 653)
WMI HOLDINGS CORP. v. U.S., Cite as 121 AFTR 2d 2018-1958 (891 F.3d 1016)

I did review the first case on this list and confirmed that is true.

The real estate is currently held by the taxpayer as a commercial rental. (It is actually residential property that is being used by an unrelated commercial business.) The taxpayer does not meet material participation. This is a passive activity.

But, I think I am missing something here. If the taxpayer sold this property at a loss, I would be claiming Sec 1231 treatment and claim ordinary loss. I know I can't play it both ways here. I am missing something.
Last edited by Wiles on 7-Dec-2019 11:27am, edited 1 time in total.
 

#2
Nilodop  
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I didn't read the cases, but section 469 does say, in part,
(c) Passive activity definedFor purposes of this section—
(1) In general The term “passive activity” means any activity—
(A) which involves the conduct of any trade or business, and
(B) in which the taxpayer does not materially participate.
(2) Passive activity includes any rental activity
Except as provided in paragraph (7), the term “passive activity” includes any rental activity.


So exactly what words does RIA use in saying that a passive investment would not be considered a trade or business property under Sec 1231?
 

#3
Wiles  
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So exactly what words does RIA use...
Thus, Code Sec. 1234A didn't apply to a forfeited deposit from the termination of a contract to sell a hotel operated by the taxpayer (that the taxpayer and IRS stipulated to be Code Sec. 1231 property). Since the hotel was depreciable property in the taxpayer's hands, it was excluded from the definition of a capital asset under Code Sec. 1221(a)(2). The Eleventh Circuit, affirming the Tax Court, found no basis for disregarding the plain, clear and unambiguous language of Code Sec. 1234A or its legislative history for the taxpayer's argument that Congress intended Code Sec. 1234A to apply to trade or business property. The Tax Court noted that Code Sec. 1234A would have applied if the hotel had been a passive investment of the taxpayer (and thus, a capital asset instead of Code Sec. 1231 property)
 

#4
Wiles  
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CRI-LESLIE, LLC v. COMM., 121 AFTR 2d 2018-794 (882 F.3d 1026)
As for absurdity, CRI-Leslie asserts two incongruities.First, it notes that while all “agree that, had the sale of the [p]roperty been completed,the [d]eposit would have been ... applied toward the purchase price and, thus, treated as capital gain” under Section 1231, under a plain-text reading of Sections 1221 and 1234A, “that same deposit must be treated as ordinary income because the parties terminated the [c]ontract rather than completing it.” Id. That, CRI-Leslie says, makes no sense—especially here, given that it certainly wasn't CRI-Leslie's fault that the Radisson sale cratered. Second, CRI-Leslie complains that reading Section 1234A to exclude trade-or-business property “effectively penalize[s]” taxpayers “for operating a trade or business as opposed to being a passive investor in real property,” in which case (as with a consummated transaction) any resulting income would merit capital-gains treatment. Id. at 35. Echoing the Tax Court's own admission, CRI-Leslie complains that such “disparate treatment” reflects “intellectual inconsistency.” Id. at 34. For both reasons, CRI-Leslie insists that the only rational way to read the Code is “to give the termination of a contract the same tax treatment afforded a sale or exchange of the property underlying the contract in order to eliminate differing tax treatment of economically equivalent transactions.” Id. at 15.

We cannot agree that enforcing the Code's plain language here produces a qualifyingly “absurd” result. The supposed anomalies that CRI-Leslie posits— between completed and canceled transactions, and between active managers and passive investors—may seem a little (or even more than a little) odd, but oddity is not absurdity. See, e.g., Exxon Mobil Corp. v. Allapattah Servs., Inc., 545 U.S. 546, 565 (2005). While “[t]here is an absurdity exception to the plain meaning rule,” it is necessarily “very narrow,” United States v. Nix, 438 F.3d 1284, 1286 (11th Cir. 2006), and applies only when a straightforward application of statutory text would compel a truly ridiculous—or to use Justice Story's word, “monstrous” —outcome. We are not in that ballpark here—particularly given that, when the sale fell through, CRI-Leslie got to keep not only the $9.7 million deposit (albeit at an ordinary-income tax rate) but also the Radisson Bay Harbor.
 

#5
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I know I can't play it both ways here.

Maybe there’s a third way to play it – your client has a 1231 asset, but you argue CRI-Leslie was wrongly decided. (Although I can’t say that it was). You’re in a different and wacky circuit.

With that said, you comment is slippery because you are not being asked to play it both ways. You are being asked to opine on a current and singular transaction involving gain. Further, if you go the straight cap gain/non-1231 route now, you can set things up to go the same way when the property is eventually sold (i.e. treat the future gain as straight LTCG and maybe don’t claim any QBI ever). If you think the property will ultimately be sold for a loss, you might go cap gain now and 1231 loss later. That might not be inconsistent. If the current gain reporting never gets examined, IRS will never know what you did in the past. They won’t even know there was a forfeited deposit in the past. But even if they do know and they try to throw that in your face in the year you claim a 1231 loss, then you’d simply say, “The property was Sec 1231 all along. We just think CRI-Leslie was wrongly decided and it was in a different circuit anyway. That’s why we reported the forfeited funds as capital gain instead of as ordinary.” This approach would necessarily mean you’d take QBI each year, but then again, what you do there isn’t really determinative of anything other than QBI. Ditto with respect to the issuance of 1099’s.

I get what you’re saying though…you’re trying not to think about the current year $850k in isolation…you’re also thinking about what the future might hold and how what you do now, and between now and a future sale, might affect (or taint) the way you report the future sale. That’s a sound thought process. I’m just trying to walk it all the way through to give you some ideas.

Some say the CRI case is about strict construction vs. congressional intent. The TC addressed congressional intent in its decision and found that there was no evidence that Congress intended anything other than what was written in the statute. Also note that many are citing the CRI case for the proposition that new Sec 1061 (carried interest) doesn’t apply to gain arising from Sec 1231 assets. I like that idea.
 

#6
dave829  
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If Wiles’ client is in CA (Wiles is in Bay Area CA), then the position that CRI-Leslie (a 9th Circuit Court of Appeals case) was wrongly decided is unsupportable due to the Golsen Rule. And hoping that the gain reporting never gets examined is also an unsupportable position due to section 10.37(a)(2)(vi) of Circular 230, which states that a “practitioner must not, * * * in evaluating a Federal tax matter, take into account the possibility that a tax return will not be audited or that a matter will not be raised on audit.”
Last edited by dave829 on 9-Dec-2019 3:53pm, edited 1 time in total.
 

#7
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(a 9th Circuit Court of Appeals case)


The case was in Florida and involved a hotel in Tampa.
And hoping that the gain reporting never gets examined is also an unsupportable position


That’s great, but that wasn’t my position. Read it again. Those comments were in the context of how to handle the future gain, not the forfeited earnest money deposit.
 

#8
dave829  
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Jeff-Ohio, you're right about the Appeals circuit. CRI-Leslie was an 11th Circuit case. But you're wrong about "playing the audit lottery" not being your position, because you said:

Jeff-Ohio wrote:If the current gain reporting never gets examined, IRS will never know what you did in the past. They won’t even know there was a forfeited deposit in the past. But even if they do know and they try to throw that in your face in the year you claim a 1231 loss, then you’d simply say, “The property was Sec 1231 all along. We just think CRI-Leslie was wrongly decided and it was in a different circuit anyway. That’s why we reported the forfeited funds as capital gain instead of as ordinary.”
 

#9
Wiles  
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Time out! Let's not worry about who killed who...

Anybody have anything to say about whether or not a passive rental can get 1231 loss treatment when disposed? I have never thought this was a problem.
 

#10
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But you're wrong about "playing the audit lottery"


No, I’m not.

I didn’t say, “If the prior transaction never gets audited, then do this. If it does get audited, then do that.” I simply said that IF the earlier transaction never gets audited, then the IRS will never even know what what the taxpayer did in the past (most likely). That is simply stating an opinion, which might even be factual, as to what the IRS may or may not know of the prior transaction. Further, I even said, “Even if they do know…”

I’m basically making the case that if Wiles is worried there might be an eventual loss on sale, reporting such loss as a Sec 1231 loss isn’t patently inconsistent with reporting the forfeiture gain as capital. That is the case whether or not the IRS knows about the forfeiture and how Wiles reported it.

Similarly, if a client says, “What are my chances of being audited?” You can most certainly answer it. It’s public knowledge. But what you can’t do, as a practitioner, is advise the client as to a particular course of action based on his or her chance of being audited. Perhaps nuanced, these are two very different things. One thing involves stating a public fact and that’s it. The other thing involves actually giving advice.
 

#11
dave829  
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Wiles wrote:Anybody have anything to say about whether or not a passive rental can get 1231 loss treatment when disposed? I have never thought this was a problem.

CRI-Leslie stands for the principle that a forfeited deposit received on the sale of 1231 property (property used in a trade or business) is ordinary income, not capital gain under 1234A, because the property is not a capital asset. The parties stipulated that the property was 1231 property.

The decision did not rule that all rental property is 1231 property. To make that leap, you’d have to conclude that all rental property is property used in a trade or business. And as we’ve seen with the lengthy discussions of whether net rental income qualifies for the 199A deduction, not all rentals qualify. For 199A purposes, it depends upon whether the rental activity constitutes a 162 business or meets two other situations (rental to commonly-controlled RPE, satisfy rental safe harbor).

It doesn't matter whether the rental is "passive" or "active." What matters is whether the client’s rental activity is a business. If it is, then CRI-Leslie says that the forfeited $850K deposit is ordinary income. If it isn’t, then 1234A classifies the $850K as capital gain.

Some may argue that you don’t have to follow CRI-Leslie because it was an 11th Circuit decision and you are in the 9th Circuit. However, it’s important to point out that the 11th Circuit upheld the Tax Court on CRI-Leslie and if you took an opposite position, you would also be challenging the Tax Court. CRI-Leslie is the only decision on whether a forfeited deposit received on the sale of 1231 property qualifies as capital gain under 1234A, so there are no other cases that would support your position. Challenging the only court case on point to this issue may be risky. I wouldn't do it, and I would tell my clients to go elsewhere if that's what they wanted.
 

#12
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Anybody have anything to say about whether or not a passive rental can get 1231 loss treatment when disposed?

When this QBI stuff came out, everybody acted like we were presented with some brand new question: Was rental real estate a trade/business?

This isn’t a brand new concept. At least in one post, I pointed out that if it wasn’t, you wouldn’t get a 1231 loss on a sale (for a loss)…and Sec 1231 has been around forever.

and if you took an opposite position, you would also be challenging the Tax Court.

Indeed. See the first few sentences of the last paragraph in Post #5
 

#13
Wiles  
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OK. Yes. This is similar to the QBI rental discussions. From those, we know passive and trade or business are two different determinations.

The research I posted above refers to “passive investments” not “passive trade or business”. So the key, here, is not whether it is passive or active. It’s whether it’s an investment or a trade or business.

I wonder how anybody could have a passive investment in a hotel trade or business. Maybe if they leased it to a hotel management company?
 

#14
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From those, we know passive and trade or business are two different determinations.

We knew that before the QBI discussions.

It’s whether it’s an investment or a trade or business.

We know that.

I wonder how anybody could have a passive investment in a hotel trade or business.

Why do you wonder that? It seems you’re now going in circles. If the asset is used in a trade or business, it’s a Sec 1231 asset. CRI-Leslie would tell us that it’s (the forfeited deposit) is ordinary income in that case because Sec 1234A doesn’t cover 1231 assets. If the asset is not so used (in a trade or business), the asset is investment in nature. A capital asset. In that case, the forfeited deposit is covered by 1234A and is a capital gain. Same thing Dave said in Post #11.

Like I said, some say, like this guy, that CRI-Leslie is bad law…and that the statute should be read in light of some congressional intent:

https://papers.ssrn.com/sol3/papers.cfm ... id=3152387

The guy bases his theory, as to congressional intent, pretty much, on a Bittker treatise. Well, if you read the Tax Court case, as Dave has urged us to do in a way, notwithstanding the plain language of the statute, the judge entertained the argument that Congress intended Sec 1234A to cover 1231 assets. The judge probably didn’t have to do this (because of the plain words of the statute). (Nor did he have to dive into case law, but he did anyway). The judge concluded that there was no congressional intent for 1234A to cover 1231 assets, despite the Bittker treatise. And this is judge is no joke: It was Laro.

As Dave says, it’s a risky proposition to go against this case. But then again, it’s in a different circuit, as noted. I wouldn’t drop this client if he wants cap gain on the forfeited deposit, but then again, I wouldn’t be hopeful he’d win on the issue, or the 20% penalty. I think you know what you have to do here: Let the client decide. If he believes CRI-Leslie is a real big hurdle, then his only other option is to argue that his property is an investment. But then again, he could maybe argue both straight capital and, if that fails, then Sec 1231 treatment with CRI being wrongly decided.
 


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