Discussion:Forfeited Earnest Money Income

[start]An earnest money deposit, received on the execution of a sales contract, is not income until the taxpayer acquires an unconditional right to retain the deposit. Bourne v. Commissioner, 62 F.2d 648, 649 [11 AFTR 1346] (4th Cir. 1933), affg. 23 B.T.A. 1287 (1931). If the sale is consummated, it fixes the seller's right to retain the deposit, and the earnest money is included as part of the sales proceeds. Kang v. Commissioner, T.C. Memo. 1993-601 [1993 RIA TC Memo ¶93,601]; Kellstedt v. Commissioner, T.C. Memo. 1986-435 [¶86,435 PH Memo TC]. If the sale is not consummated, the sales contract fixes the seller's right to retain the deposit, and the deposit is included in income at the time that the contract fixes the seller's right to retain the deposit. Baird v. United States, 65 F.2d 911, 912 [12 AFTR 896] (5th Cir. 1933). Because earnest money is in the nature of a payment for an option, it is included in the seller's ordinary income when forfeited to him. Sec. 1234; Elrod v. Commissioner, 87 T.C. 1046, 1068-1069 (1986); see Kang v. Commissioner, supra (taxpayers' rights to earnest money were not fixed before they refunded a portion of it; amount they kept was included in ordinary income in year they made refund, not year they received earnest money). [end]

The year to report is like NYea comments the year of the lapse.

Dear Kevinh5 - sorry I did not follow the rules. I will try to do better next time. I had searched the archives, but most of the discussions pertained to the loss deduction, not the income side. Thanks for your help.

Discussion:Expired_option_on_land/entering_JV_with_contractor

"(b) ... In general, any gain to the grantor of an option arising from the failure of the holder to exercise it, and any gain or loss realized by the grantor of an option as a result of a closing transaction, such as repurchasing the option from the holder, is considered ordinary income or loss."

Yes, this is mighty awfully confusing!!

Are these two things different? Is there a definition somewhere?

My problem with accepting Roy’s capital gain result from 1234A is that this result is contrary, it seems to me, to general tax theory. Normally one needs an asset to have a capital gain. It used to be that “fruit” created ordinary income and “trees” created capital gains. In fact, I have thought of several ways 1234A can be abused employed to create capital gains and ordinary losses for clients or shifting cash. Furthermore, without a sale or exchange a related option payor in a trade or business can have an ordinary loss. And Section 267 seems to specifically deal in sales and exchanges among related parties.

The commentary is confusing. Much of it stems from commentary that occurred during 1234A’s evolution, commentary that is now outdated. I have not found any court cases regarding 1234A, and court cases can shed some light on applicatin. My old BNA portfolio (2003) merely restates the goal of Section 1234A without application AND retains pages of commentary about the old rules about options for transactions not covered under 1234A such as property that is not a capital asset.

However, at this time, I disagree with Roy about Section 1231 property being a capital asset under Section 1234A. Roy seems to use the Section 1234 regs to make his point but I see where 1.1234-1(a)(1) excludes 1231 property from capital asset treatment. 1.1234-1(a)(2), in my mind states that options on 1231 assets are treated as sales/exchanges of 1231 assets; which could create capital gains (after one factors in Sections 1245 and, occasionally 1250) or ordinary losses. But having a capital gain is not precisely the same as having a capital asset. 1.1234-1 (a) Sale or exchange—(1) Capital assets. Gain or loss from the sale or exchange of an option (or privilege) to buy or sell property which is (or if acquired would be) a capital asset in the hands of the taxpayer holding the option is considered as gain or loss from the sale or exchange of a capital asset (unless, under the provisions of subparagraph (2) of this paragraph, the gain or loss is subject to the provisions of section 1231). The period for which the taxpayer has held the option determines whether the capital gain or loss is short-term or long-term. (2) Section 1231 transactions. Gain or loss from the sale or exchange of an option to buy or sell property is considered a gain or loss subject to the provisions of section 1231 if, had the sale or exchange been of the property subject to the option, held by the taxpayer for the length of time he held the option, the sale or exchange would have been subject to the provisions of section 1231.

Publication 550 on page 56 states: "The cancellation, lapse, expiration, or other termination of a right or obligation (other than a securities futures contract) with respect to property that is a capital asset (or that would be a capital asset if you acquired it) is treated as a sale. Any gain or loss is treated as a capital gain or loss."

Publication 550 on page 48 states: “Any property you own is a capital asset, except the following noncapital assets. Property held mainly for sale to customers or property that will physically become a part of the merchandise that is for sale to customers. Depreciable property used in your trade or business, even if fully depreciated. Real property used in your trade or business. “

However, I could be wrong about Section 1231 as well.

But,here is more on 1231 and 1234A:

From commentary I have read by a Robert Wood, the legislative history for Section 1234A uses an example of a lessee making a payment to the lessor so that the lessee is released from a requirement to restore leased property back to its original condition. My first impression is that 1234A must relate to options for 1231 property as the rental property is more than likley depreciable. However, technically, if the lessee was required to return property to the lessor at the end of a lease in the same condition as it was at the beginning of the lease, the property should not have been depreciated. And, if not real property, the transaction cited in the legislative history would concern a capital asset.

Unless Roy is correct about 1231, at this point I am starting to believe I understand Section 1234A. It is a piece of tax law that adds to the complexity of the code and on the surface is as ambiguous as any partnership code section.

BTW Roy, that was a neat idea regarding 280B. No related party rules there either.

Note that Section 1234(a) discusses the tax treatment to the Purchaser of an option, it is limited to that only. Maybe that lessens some confusion?

Here's the quote I think he's referring to:

"In general, any gain to the grantor of an option arising from the failure of the holder to exercise it, and any gain or loss realized by the grantor of an option as a result of a closing transaction, such as repurchasing the option from the holder, is considered ordinary income or loss."

I've bolded part of the quoted material for clarity.  According to this regulation, ordinary income is the result - for the grantor - when the holder fails to exercise the option, which isn't a closing transaction.  The ordinary income is not "limited to a closing transction."  

What this means in the bigger discussion of ordinary vs. capital on lapsed options, I haven't the faintest clue.

 of an option to buy or sell property is considered a gain or loss 
 subject to the provisions of section 1231 if, had the sale or exchange 
 been of the property subject to the option, held by the taxpayer for 
 the length of time he held the option, the sale or exchange would have 
 been subject to the provisions of section 1231. 

??? This seems very clear to me.

1.1234-1(b) refers to a failure to exercise an option. That subsection first deals with the holder's tax situation. Then 1.1234-1(b) tosses in a line about the grantor (which Harry corrected me on, above) indicating that ordinary income results.

This reg seems to contradict 1234A. Sinc regs are not up to speed at times this could mean that Section 1234A would trump the regs. But it has been over ten years since 1234A was amended to include all property and not merely personal property.

Ozzie, you may get some peace (or piece) of mind if you call with your specific issue. The number is 202-622-3920.

On the other hand, the phone number in the Temp Reg goes to the iRS financial instrument section which may mean their sphere of knowledge is short of a land deal. But, they may know more of the history of these two Code Sections which may help you apply them.

1.1234-1(b) which coves the holder in the first 2 sentences and the grantor which is in the third sentence.

She said has often pondered the interaction between 1234A and 1234 regarding non-financial options. She has often thought that the disconnect should be addressed, but the financial instrument section has always had other priorities. (Now their priority is regulations regarding banks).

According to her Section 1234A takes precedence over the regulation for Section 1234, because any Code Section takes precedence over a regulation AND 1234A does in fact refer to options on property. She believes that the third sentence of regulation 1.1234-1(b) has (1) not been updated to consider subsequent legislation, and (2) it has been “plopped” into an “odd” spot. She mentioned that several regs are decades behind current legislation. Section 1234(a) was law regarding ONLY the holder (purchaser) of an option. Sections 1234(b) and (c ) discussed investments and straddles. Reg 1.1234-1 (a) discusses sales and exchanges by a holder and 1.1234-1 (b) discusses lapsed options by a holder AND then, for some unknown reason) throws in a sentence about ordinary income to a Grantor.

From what I have read, ordinary income was the rule regarding the receipt of funds by a grantor when an option had lapsed. The theory, borne out by court cases was that there was no exchange when an option lapsed so there could be no capital gain. Perhaps (I am speculating here) the IRS thought a regulation would minimize their work in future court cases and thought Section 1234 was the only fairly reasonable place to stick it.

I asked why there isn’t any case law on this since I would imagine that controversy would abound in this area. She believes that appeals agents will not take option cases to court since 1234A, as vague as it is, gives the taxpayer a better than 20% chance of winning the capital gain case. She stated that she has received calls from Appeals Officers over the years regarding this matter.

I then asked her about Ozzie’s situation involving Section 1231. Her “off-the-cuff” answer was that ordinary income would result to the grantor of the option. 1234A would not apply since the Farm is not a capital asset. 1.1234-1(a) does not apply since that reg (as well as entire Code Section 1234) applies to the holder. That leaves 1.1234-1(b) which specifies ordinary income treatment.

Could, however, an argument for capital gain run as follows: 1.) Section 1234A was passed to coordinate the treatment of the grantor and the holder of options, this seems to be Congressional intent. 2.) The third sentence of 1.1234-1 (b) is inappropriately placed 3.) Based on Congressional intent could we treat the grantor the same as the holder under 1.1234-1(a)(2)?

Also, without researching the issue, if the farm property is no longer used as a farm is it still 1231 property?

Now, for fun, can anyone guess at the implications of 1234(a)(3)(A)? If you have an option to buy inventory (lets say you are a land developer) and Section 1234 does not apply to your option, how is that option treated?

United States Freight Company v. United States, KTC 1970-59 (Ct.Cls. 1970

1. http://www.pbs.org/nbr/site/features/special/subdir/ye-tax-tips-2008_QA-realestate/ See this Q&A from the Nightly Business Report's 2008 Y/E Tax Tips:

QUESTION: Forfeited Deposit On Investment Property

I entered into a sales agreement with a land developer on December 2005 in which I received $60,000 up front. The sale was contingent upon zoning approval, which was granted, and slated to close 1/15/08. The developer backed out due to the economy. Is the 60K taxed as regular income or capital gains?

-- N.M., Vancouver, WA

ANSWER:

I asked my friend and colleague, Peter Blank, editor of the Kiplinger Tax Letter, to weigh in on this one. His response:

While the matter is not entirely free from doubt, it appears that under Internal Revenue Code section 1234A, you are entitled to capital gain treatment for a forfeited deposit on investment property. In your case, the gain would be long term since the sales contract was held for more than one year. But if you are a developer of real estate and would have to report ordinary income on the sale of the property, the forfeited deposit would be taxed as ordinary income. -- Kevin McCormally, Editorial Director, Kiplinger Washington Editors

2. Also read this favorable (LTCG) article by Edward Roche, Jr. called "Lease Cancellation Payments are Capital Gain? Yes! The TRA '97 Change to 1234A overturned Hort". His 1231 Asset = Captial Asset analysis is compelling. [Published in the Journal of Taxation, June 2005, Vol 102, No. 06.]

3. Thx to MWPXYZ for all of his efforts, phone calls and comments.

Yes, it was held for more than 1 year. It went on for 2 years. However, in all my reaseach and reading of other professionals' thoughts here and on ABA-TAX, some even feel that the holding period relates back to the original asset (land, in my case). Others feel the contract date controls, including the gut reaction by a local tax attorney-friend who works for a high-price downtown firm.

Boatman v. Commissioner, 32 T.C. 1188

While a vendor of real estate, in case of default by the vendee, can elect one of several remedies, it is quite obvious that the vendor in this case accepted the $12,000 as liquidated damages which was his right under the contract. Such liquidated damages are taxable as ordinary income. A. M. Johnson, 32 B.T.A. 156; see also Emily B. Harrison, 7 T.C. 1; Doyle v. Commissioner, 110 F.2d 157. In the Johnson case this Court said:

  The petitioner proceeds on the theory that the payments of $90,000 and $360,000 were made pursuant to the terms of a contract of sale of the company stock and, hence, related to the disposition of a capital asset held for more than two years. The petitioner's theory is based on a false premise. The payment was made not because of the disposition of a capital asset. It was a payment of liquidated damages for failure to complete a sale. 
 
  After the payment the petitioner had exactly the same capital assets as before the transaction was entered into. The entire transaction took place during the taxable year of 1929. Consequently, there is no basis for contending that the $450,000 income arose from the disposition of a capital asset. The income was ordinary income, taxable at the prescribed rates.

In addition:

Petitioner had more than "pure" options, which merely confer a right to bind the owner to sell by a further juridical act of exercise or notice. The documents here without further ado so bound the owners, who would thereupon be released only if petitioner thereafter failed to tender his performance.

In addition from the IRS: IRS Letter Ruling 200823012

Under the origin-of-the-claim doctrine, the taxability of the proceeds of a settlement or a judgment depends on the nature of the claim and the actual basis of recovery. United States v. Gilmore, 372 U.S. 39 (1963) . If the amount received represents damages for lost profits, it is taxable as ordinary income. However, if the recovery is received as the replacement of capital destroyed or injured rather than for lost profits, the money received is a return of capital and taxable only to the extent it exceeds the basis of the destroyed capital. Freeman v. Commissioner, 33 T.C. 323, 327 (1959) . The burden is on the taxpayer to demonstrate that the amounts received are for capital replacement. Raytheon Production Corporation v. Commissioner, 1 T.C. 952 (1943) , aff'd, 144 F.2d 110 (1st Cir. 1944) , cert. denied, 323 U.S. 779 (1944).

Further:

"Section 1234A of the Code 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 a capital asset in the hands of the taxpayer will be treated as gain or loss from the sale of a capital asset."

Failure to exercise option. If the holder of an option to buy or sell property incurs a loss on failure to exercise the option, the option is deemed to have been sold or exchanged on the date that it expired. Any such loss to the holder of an option is treated under the general rule provided in paragraph (a) of this section. In general, any gain to the grantor of an option arising from the failure of the holder to exercise it, and any gain or loss realized by the grantor of an option as a result of a closing transaction, such as repurchasing the option from the holder, is considered ordinary income or loss.