by Don Susswein and Rob Alinsky
RSM US LLP is an IMA member…
On Feb. 15, the Eleventh Circuit Court of Appeals agreed with the IRS that when a prospective buyer forfeits to the seller a deposit for the purchase of the prospective seller’s hotel – property considered ‘trade or business property’ to the seller and not a capital asset – the prospective seller’s gain on the forfeiture is not long-term capital gain under the provisions of section 1234A. Although that provision would have applied if the contract for sale had been with respect to a capital asset – such as a share of stock – the court strictly applied section 1234A, which refers specifically to ‘capital assets’ and not to the broader category of transactions generating capital gains or losses, which would have included gains arising under section 1231.1
In the case, the parties agreed that the actual gain on the seller’s sale, if it had occurred, would have been long-term capital gain, but that characterization would have arisen under section 1231, because the hotel was property used in a trade or business, despite the fact that the hotel would not have been a ‘capital asset’ to the seller. In contrast, section 1234A, which provides rules for the treatment of forfeitures of deposits and similar items, refers specifically to capital assets. That provision applies to “gain or loss attributable to the . . . termination of . . .[an] obligation . . . with respect to property which is . . . a capital asset in the hands of the taxpayer.”
This strict reading of the language of the Internal Revenue Code may lend support to those who argue that the new carried interest provisions of the Tax Cuts and Jobs Act, now found in section 1061, will not apply to capital gains arising under section 1231 – including many real estate transactions and potentially some private equity transactions. In that event, the normal one-year holding period may apply instead of the new three-year holding period that will clearly apply in the case of an otherwise covered profits interest giving rise to gain from the sale of capital assets, such as stocks or securities.
The taxpayer’s potential argument in such a case arising under section 1061, similar to the IRS’ argument in this case arising under section 1234A, is that the operative provisions of new section 1061 incorporate by reference the technical term ‘capital asset’ and do not refer more generically to ‘transactions generating capital gains.’ In particular, section 1061 changes the applicable holding period from one year to three years, “for purposes of paragraphs (3) and (4) of sections 1222.” Those paragraphs refer to gain or loss, “from the sale or exchange of a capital asset held for not more than 1 year.” For that reason, some believe that the new rules of section 1061 will not recast long-term capital gains arising under section 1231, even if the assets have not been held for the three-year holding period.
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