Often, when a real estate deal falls through, the buyer forfeits the down payment or deposit. When this happens, what are the tax implications for the buyer and seller? The answer, as with many tax questions, is “it depends.” In this case, it depends on whether the property is considered a “capital asset.”
Internal Revenue Code (IRC) Section 1234A provides that: “gain or loss attributable to the cancellation, lapse, expiration or other termination of . . . a right or obligation . . . with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer . . . shall be treated as gain or loss from the sale of a capital asset.” In other words, a forfeited deposit on real estate is treated as a capital gain (to the seller) and a capital loss (to the prospective buyer) if the real estate is a capital asset. IRC Section 1221(a) defines “capital asset” very broadly as “property held by the taxpayer” unless it is specifically excluded under that section. Two exclusions are relevant to our discussion:
- Real property used in the taxpayer’s trade or business; and
- Property held primarily for sale to customers in the ordinary course of the taxpayer’s business.
These types of properties are not capital assets, so forfeiture of a deposit would be treated as an ordinary income (to the seller) or an ordinary loss (to the buyer).
Case in Point
A 2016 U.S. Tax Court case dealt with this precise issue. In CRI-Leslie v. Commissioner, a hotel owner and operator had entered into a contract to sell the hotel to a prospective buyer for $39 million. Under the contract, the buyer made deposits totaling $9.7 million. The buyer was unable to consummate the transaction, and the seller retained the deposits. For tax purposes, the seller reported the $9.7 million in deposits as net long-term capital gain. The IRS challenged this treatment, arguing that the forfeited deposits constituted ordinary income (taxed at substantially higher rates).
The Tax Court agreed with the IRS. Because the hotel was used in the seller’s business, it was not a capital asset and, therefore, the forfeited deposits were not eligible for capital gain treatment under Section 1234A. The court rejected the seller’s argument that capital gain treatment was appropriate because, had the sale been completed, it would have generated long-term capital gain under IRC Section 1231. That section provides for capital gain or loss on the sale of depreciable business property that has been held for more than one year.
The court found that the hotel property did not meet the definition of “capital asset” as used in Section 1234A and there was nothing to suggest that Congress intended that section to apply to Section 1231 property. It summarized the tax treatment of forfeited deposits as follows: “Forfeited deposits from the termination of a contract to sell a hotel are taxed at capital gain rates if the hotel is held as a passive investment. The same forfeited deposits are taxed as ordinary income if the hotel is used in a trade or business.”
Related Read: Capital Gains Planning: When Timing is Everything
What About Other Types of Property?
As discussed above, forfeiture of a deposit on real estate used in a trade or business (e.g., a hotel) is ordinary income to the seller and an ordinary loss for the prospective buyer. Here’s a brief summary of the treatment of other property types:
- Personal Residence
A personal residence is a capital asset. However, owners of personal residences generally are not entitled to deduct capital losses, so a prospective buyer of a personal residence would not be able to deduct a forfeited deposit. From the seller’s perspective, the forfeited deposit would be capital gain, which, presumably, would be ineligible for the home sale exclusion since the property was not sold.
- Property Held for Sale
As noted earlier, property held primarily for sale to customers is not a capital asset. For example, a real estate dealer that retains a forfeited deposit would receive ordinary income. The tax treatment of the prospective buyer would depend on the type of property and whether it would be a capital asset in the buyer’s hands. If the property is a personal residence, the buyer would have a nondeductible capital loss. If it is property to be used in a trade or business, the buyer would have a deductible expense.
- Investment Property
Forfeiture of a deposit on real estate held as an investment generally results in capital gain for the seller and capital loss for the prospective buyer.
- Rental Property
Whether or not rental real estate is treated as a capital asset (passive investment) or a noncapital asset (trade or business) varies depending on the facts and circumstances. A discussion of the factors considered in determining whether rental real estate is an investment, or instead a trade or business is beyond the scope of this article. If it is a capital asset, forfeiture of a deposit would be treated as capital gain to the seller and capital loss to the prospective buyer. If it is a noncapital asset, forfeiture of a deposit would be treated as ordinary income to the seller and an ordinary expense to the prospective buyer.
Related Read: Prepare and Plan for Real Estate Sales in Advance
Ask a Professional
The tax treatment of real estate transactions is quite complex. To understand the tax implications of your real estate dealings and develop strategies for minimizing your costs, it is a good idea to consult a tax professional.
For more information, please contact Ryan Kertes at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.